The Crowding Out effect is a Monetarist criticism of expansionary fiscal policy. As seen in the multiplier effect, government spending will shift Aggregate Demand (AD) further than expected when an expansionary fiscal policy is implemented. However, Monetarists believe that because of this expansionary fiscal policy, the government will need to borrow money by selling government bonds. This leads to a rise in interest rates, i.e. from R1 to R3. The increased borrowing ‘crowds out’ private investing.
The Crowding Out Effect
A rise in interest rates would discourage private investors from investing, and private consumption may also decrease as many large purchases are made on credit. So the result could be a rise from AD1 to AD2, instead of AD1 to AD3.
Impact of The Crowding Out Effect
If the government wants to increase spending, it can finance the higher spending by:
1. Increasing tax
If the government increases the tax on the private sector, for example by higher income taxes or higher corporate taxes, then this will reduce the disposable income of consumers and firms. All other things remaining equal, increasing tax on consumers will lead to lower consumer spending. Therefore, higher government spending financed by the higher tax should not increase overall Aggregate Demand because the rise in G (government spending) is offset by a fall in C (consumer spending).
2. Increasing borrowing
If the government increases borrowing, it has to borrow from the private sector. To finance this increased debt, the government will sell bonds to the private sector through the central bank. This activity is referred to as Open Market Operations. These bonds could be sold to private individuals, pension funds or investment trusts. If the private sector buys these government securities, they will not be able to the same funds to invest in the private sector. Therefore, government borrowing crowds out private sector investment.