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Fiscal Policy - Crowding Out

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 19 May 2023

The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free-market economists argued against the rising share of GDP being taken by the public sector.

Revision Video: Crowding Out - analysis and evaluation

Crowding Out - Revision Video

Crowding out refers to the negative impact that government spending can have on private investment. The theory of crowding out suggests that when the government increases its spending, it will increase the demand for goods and services, which can lead to higher interest rates and inflation. This, in turn, can make borrowing more expensive for private investors, reducing their ability to invest in new projects and businesses. As a result, private investment may decrease or "crowd out" as the government spending increases.

The effect of crowding out can also occur through the use of monetary policy. When the central bank increases the money supply to finance government spending, it can lead to inflation and higher interest rates. This can make borrowing more expensive for private investors and reduce their ability to invest in new projects and businesses.

Crowding out can be more or less pronounced depending on the state of the economy, if the economy is at full employment and resources are scarce, the crowding out effect is more likely to happen, while if the economy is in a recession and resources are idle, the crowding out effect is less likely to happen.

It's important to note that crowding out is not a universally accepted theory and there are other arguments that suggest that government spending can have a positive impact on private investment. For example, the Keynesian theory of multiplier effect suggests that government spending can increase economic activity and boost private investment.

Additionally, some critics argue that the crowding out effect is overstated and that government spending can have a positive impact on private investment by increasing aggregate demand and creating a more stable economic environment. Thus, the crowding out effect is still a matter of debate among economists and it's important to consider the specific economic conditions of a country when evaluating the potential impact of government spending.

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