What Is Crowding Out?

Summary

The video explains 'crowding out,' a situation where government spending, through expansionary fiscal policies, reduces private spending and investment. It illustrates how when an economy is at full employment, increased government borrowing raises interest rates, leading to reduced private consumption and investment. However, during a recession, government spending can utilize underemployed resources, boosting GDP without crowding out private-sector spending. The video explores the impact of government borrowing on the market for loanable funds and the broader economy, emphasizing how crowding out depends on the economic context.

Takeaways

• 📉 Crowding out occurs when government expansionary fiscal policies reduce private sector spending.
• 🏗️ When an economy is at full employment, government spending to build infrastructure may not increase GDP because resources are already fully used.
• 💸 Government borrowing to fund projects increases the demand for loanable funds, leading to higher interest rates.
• 📊 A rise in interest rates incentivizes more savings but reduces private consumption and investment.
• 🏦 Higher interest rates make borrowing more expensive for private firms, lowering their demand for loanable funds.
• ⚖️ In a fully employed economy, government borrowing can crowd out $50 billion of private spending if savings increase by the same amount.
• 🚧 Crowding out affects both private investment and private consumption, reducing overall private sector activity.
• 📈 Crowding out assumes the economy is at full employment, where resources are already fully utilized.
• 📉 If the economy is in a recession with underemployed resources, government spending may not lead to crowding out.
• 🔄 In a recession, government spending can increase GDP by hiring underused resources, boosting overall economic activity.

Q & A

What is 'crowding out'?

'Crowding out' refers to a situation where government expansionary fiscal policies reduce private sector spending and investment. This occurs when government borrowing increases interest rates, making borrowing more expensive for private entities.

What is the impact of crowding out in an economy at full employment?

In an economy operating at full employment, crowding out means that government spending will not increase GDP. Instead, it diverts resources like labor and capital from the private sector, reducing private consumption and investment.

Why doesn't government spending increase GDP in a full employment economy?

When an economy is at full employment, resources such as labor and capital are already fully utilized. Any additional government spending pulls resources away from the private sector, preventing an overall increase in GDP.

How does government borrowing affect the market for loanable funds?

When the government borrows, it increases the demand for loanable funds, which raises the equilibrium interest rate. This makes borrowing more expensive for the private sector, leading to a decrease in private consumption and investment.

What happens to interest rates when the government borrows money?

Government borrowing increases the demand for loanable funds, which leads to higher interest rates. In the example given, the interest rate rises from 7% to 9%.

How does a higher interest rate affect private savings and consumption?

A higher interest rate encourages more private savings because the return on savings increases. However, it also reduces private consumption because more money is being saved rather than spent.

What is the relationship between interest rates and private investment?

Higher interest rates make borrowing more expensive for businesses, which leads to a decrease in private investment. In the example, at a 9% interest rate, private investment falls by $50 billion.

Does crowding out always occur when the government borrows money?

No, crowding out primarily occurs when the economy is at full employment. If the economy is in a recession with underused resources, government spending can boost GDP without crowding out private sector spending.

What happens if the government borrows during a recession?

In a recession, government borrowing and spending can use underutilized resources, such as unemployed workers and idle capital, to boost GDP without reducing private consumption or investment.

Why is crowding out not an issue during a recession?

During a recession, resources are underemployed, so government spending does not compete with private sector spending. Instead, it helps to activate unused labor and capital, increasing overall economic activity and GDP.