The term 'crowding in' refers to a situation whereby an increase in government spending leads to an increase in economic output that is sufficient to stimulate a net increase in private sector investment. The reverse situation, crowding out, occurs when net private sector investment is reduced by the increased government spending because of the higher interest rates it induces..
The two conflicting forces that determine which effect will dominate are:
The higher interest rates here are assumed via the workings of the IS-LM Model i.e. an increase in government spending will shift the IS curve to the right, causing it to intercept the LM curve at a new equilibrium point where interest rates are higher and economic output is higher.
With a higher level of economic output firms will benefit from increased demand for their output which will entice them to expand production and invest more. At the same time, the cost of investment is increased by the higher interest rate on loanable funds. So, there is some controversy as to which of these conflicting forces will dominate the other.
The disagreement over the crowding out vs crowding in effect really boils down to a difference in perspective with regard to ideology in the economics profession. We all know that there are different schools of thought in economics, and that is nowhere more apparent than in the role of government spending.
Depending upon your own values you may regard government as a wasteful institution that would be better stripped down to its bare essentials, or you may regard it as a vital instrument for achieving a fairer society and a more stable business cycle.
The truth is that different circumstances require different approaches, and whilst a developed economy that is producing close to full capacity is likely to be better left alone, a developing economy or one entering a severe recession does have the potential to prosper with a little helping hand from some extra government spending.
Naturally, even when significant factors of production are lying idle, the nature of that government spending will determine its efficacy and whether or not it leads to a beneficial crowding in of private sector investment.
I should point out that I have already written an article specifically about the crowding out effect, and the circumstances under which it dominates, so click the link for details on that.
As indicated above, the key point relates to what influence any increase in government spending has upon the prevailing interest rate (and also the price level), because that will determine whether or not net private sector investment is being discouraged by higher costs.
Depending on the level of economic development that already exists in a country, there will be a greater or lesser potential for some beneficial extra spending by the government. In the rich developed world we may take for granted many of the institutions and opportunities that support private enterprise and a high standard of living, but many of these institutions are severely lacking in poorer countries.
For free markets to truly flourish, the following must be in place:
Governments usually play a vital role in ensuring these things, and without them there is little opportunity for individual people to prosper regardless of their potential.
In an advanced economy, the key determination on whether or not it makes sense to increase government spending comes down to whether or not there are significant idle factors of production that can be spurred into action.
Unless there is plenty of spare capacity in the economy such that output can increase without causing interest rates and prices to rise (i.e., where the economy is operating on the flat section of the aggregate supply curve), then it is likely that the crowding out effect will dominate the crowding in effect and productivity will end up suffering.
Government is highly inefficient, and in most circumstances public sector officials are in no way better at spending taxpayers money than the taxpayers are at spending it themselves. However, just as in the developing world, there are exceptions to this rule. The need for national infrastructure projects, or the maintenance and upgrading of existing infrastructure, is usually the most promising avenue for increased government spending.
Most of the controversy arises over the proper role of government in managing the economy during economic downturns. First impressions might lead us to think that stimulus spending policies should always be desirable when the economy heads into a recession. However, in all but the most severe downturns in the business cycle, a strong argument can be made that leaves little scope for beneficial government intervention. The net crowding in effect will usually be dominated in most cases, but see 'The Crowding Out Effect' for a full explanation.
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