Crowding-out effect and other Influences

Crowding-out effect
It occurs when budget deficits caused by expansionary fiscal policy lead to higher interest rate and lower private investment.

Government borrowing => increase demand for loanable funds => increase real interest rate => reduce profitability of investment projects => lower private investment => reduce the impact of expansionary fiscal policy on aggregate demand => inefficient public sector crowding out efficient private sector without any gain in GDP

Government spending =>shift aggregate demand =>budget decficit =>increase demand for loan =>increase interest rate, lower private investment =>adjust AD back

Note:
Unlike Keynesian model, prices are flexible Under classical economist’s view.

Keynesian model
It recommends that fiscal policy should be used (countercyclical policy) to smooth the business cycle. Expansionary fiscal policy to help the economy out of recessions and boost employment. Restrictive fiscal policies to rein in aggregate demand when the economy is growing too fast.

Some economist’s view
Deficit spending =>increase interest rate =>attract foreign investment =>increase loanable fund =>reduce interest rate =>offset crowding out effect

Increase saving =>increase loanable fund => interest rate unchanged

Increase foreign investment=>appreciate dollars=>increase imports decrease exportàtrade deficit and budget deficit

New classical model
Expansionary fiscal policy => budget deficits and debt => private individuals realize that taxes will eventually increase and so increase saving => fall in private consumption =>negates the rise in government spending and hold AD constant

Summary: If tax cut, no change in output, price, interest rate, unemployment => ineffective

Note:
Tax cut increase saving but no spending, opposite to Keynesian view that tax cut cause increase in disposable income =>increase consumption

Supply side model:
Governments should fuel economic growth by promoting supply rather than demand. Lower marginal tax rates => increase in efficient private sector investment => higher incomes => increased tax receipts despite lower tax rates.

Emprical evidence
Fiscal policy:
Countercyclical due to automatic stabilizer rather than actively change fiscal policy.

Budget deficits and real interest rates:
According to the crowding out model, deficits leads to higher demand for loanable funds and thus higher real interest rates. However, any rise in real interest rates increases the supply of capital from home and abroad. Empirical evidence suggests that the link between the two is very weak and crowding out effect is mixed.

Budget deficits and trade deficits:
Deficit leads to inflow of foreign capital flows and thus appreciate domestic currency and causes influx of imports, higher trade deficit is resulted at last.

Inflation:
Little support budget deficit cause inflation