How Crowding Out Takes Place?

Crowding out effect is a situation where increase in government spending to stimulate the economy which is in recession will eventually lead to a fall in both private consumption & investment. In other word, the initial increase in AD may be offset by the fall in the latter two

This is closely related to budget deficit where total government spending exceeds total tax revenue. In a period of economy slowdown or recession, public spending like construction of schools, hospitals, repairing roads & bridges etc will definitely increase. So a government will need more financial resources to accommodate this. Unfortunately, tax receipts will fall as many people will be laid off & firms incur losses. In a nutshell, budget deficit will widen in this period

In UK, the deficit is already standing at £8.99 billion as of February 2009 & this was 8 times the figure seen a year earlier. It is in conjunction with the fell in tax revenue by 10%. Total government debt is equivalent to 49% of GDP. However the worst is far from over as they yet to include the potential £1 trillion to £1.5 trillion debts from Royal Bank of Scotland & Lloyds Banking Group which they have to include, since they have taken stakes in these 2

How increase in government borrowing can crowd out both private spending & investment?

(1) Increase in tax. Ballooning deficit will have to be balanced in the future. This means as economy embarks on recovery path, government will have to reduce its spending & increase income tax, corporation tax & VAT. Public & firms expecting that future tax rate will be high are discouraged from spending as they know that they are worse off anyway. Increase in savings may offset the initial increase in AD (aggregate demand)

(2) Increase in interest rates. When a government borrows in large scale, they have to increase interest rates to attract people to hold bonds. However, increase in bond yields will be followed by increase in interest rates offered by commercial banks. This is because they have to compete with government to attract funds. The costs of paying higher rates to depositors will be passed on to people who hold mortgages & businesses that take financing. As such, consumers & firms will be discouraged from spending

(3) Lesser money to spend. As people buy bonds, it is said that they will have lesser money to spend. Also when firms buy government bonds, they have lesser funds to invest

Arguments on why crowding out is unlikely:

(1) High marginal propensity to consume. It depends on whom the tax is targeted at & which sector of the economy receives more funding. Generally, people with lower income have very high tendency to spend when there is an increase in their disposable income. Also if government increases public spending onto areas where salaries are relatively low, it will positively boost consumption

(2) Interest rates may not increase. In the period of recession, generally stock market is not performing. Demand for shares will fall, sending its price much lower. People are more attracted to bonds as long term investment which is also safer. The chance of government defaulting is very low. When demand for bonds increase, its price will escalate. Given that, bond yields & bond price are inversely related, interest rates will be kept low