The Crowding Out Effect
By Steve Bain
The notion of a crowding out effect in economics has been around for well over a hundred years, and was originally used as an argument against the use of excessive government borrowing.
The idea is that the finite amount of funds available for borrowing would mean that any excessive government borrowing would necessarily reduce private sector borrowing for investment by swallowing up too much of the loanable-funds pot.
This does, of course, only directly related to that part of private sector investment that is funded from borrowing, since retained profits can also be used for investment purposes without the need to borrow any of those loanable-funds.
With that said, you could also develop an argument to show that even retained profits might be diverted if excessive government borrowing causes interest rates to rise - because financial asset purchases would become a relatively more attractive alternative to investing in business ventures, and clearly that would partially subdue business investment.
Fiscal Expansion and Interest Rates
Using the IS-LM model (click the link for details on how the model works) we can illustrate how an expansive discretionary fiscal policy might lead to higher interest rates.
The idea here is that, in times of economic slowdowns/recession, the government will act to increase income/output in the economy in order to boost jobs and reduce unemployment.
If this is done via an increase in government spending to stimulate the economy, the affect will be to shift the IS curve to the right as illustrated i n the diagram.
Now, this will indeed increase income/output, and at a higher income level most people are likely to want to hold more cash in order to increase their purchasing power. For any given money supply, the extra demand should increase the price of holding money i.e. the interest rate will rise.
The extent to which income/output grows depends on the slope of the LM curve, which in turn depends on the responsiveness of money-demand to interest rates. Given the LM curve used in the diagram, income rises from Y1 to Y2, and the Interest rate rises moderately from R1 to R2.
Consider, however, what would have happened if the LM curve had been horizontal. In this case income/output would have grown all the way to Y3, and interest rates would have been completely unaffected. Alternatively, with a vertical LM curve the government would completely fail to raise income/output at all, but the interest rate would be pushed up all the way to R3.
The particularly extreme examples of vertical and horizontal LM curves will be the focus of another article, where I look into the sorts of economic situations in which this might happen. For details see:
The general case illustrates that crowding out occurs when expansionary fiscal policy leads to higher interest rates. In these circumstances, as people demand higher cash balances as their incomes rise, the relative scarcity of available money pushes up interest rates making some business investment projects become less viable. This is because the projected profits of some of those investments will no longer be enough to cover the extra cost of borrowing.
The crowding out is not restricted to business investment. Higher interest rates will also dampen consumer spending. Furthermore, since higher interest rates will push exchange rates higher, exports will also be depressed whilst imports will increase, both of which lead to a deteriorating balance of trade.
In short, the government's fiscal expansion has crowded out many types of spending, especially the most interest sensitive types, which we assume is mostly business investment.