Key Diagrams - Fiscal Policy and Crowding Out

In this video we walk through a diagram that might be used when analysing and evaluating fiscal policy and crowding-out.

The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower. This is resource crowding-out.

Increased government spending & borrowing may lead to higher demand for loanable funds and therefore a rise in market interest rates on bonds. This might then increase borrowing costs for private sector businesses and lead to a fall in their planned investment. This can lead to financial crowding out.

What is crowding-in?

When an increase in government spending & investment leads to an expansion of real GDP which in turn incentivizes private sector firms to raise their own levels of capital investment and employment. Higher real national income can also lead to a higher level of savings which increases supply of loanable funds and can therefore keep market interest rates low.

Much depends on the extent to which government spending / investment is subject to rigorous cost-benefit analysis. Many investment projects have beenjointly financed by public and privatesectors. And open economies can attract loanable funds from overseas.