Crowding Out

Crowding Out

Crowding Out of Investment

• With expansionary fiscal policy the income (GDP)

  rises

  ---

  and the money demand (MD) will

  rise

  ---

  . This causes interest rates to

  increase

  ---

  which makes it more expensive to take loans. This causes Investment (I) expenditure by firms to

  decrease

  ---

  .

• Crowding-out effect on investment - the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

Crowding Out of Net Exports with a Flexible Exchange Rate

• When the interest rate rises from fiscal expansion (increase in government spending) it causes the domestic assets (bonds) to become

  more

  ---

  attractive so the domestic currency will

  appreciate

  ---

  . This causes net exports to

  decrease

  ---

  (get crowded out).
• In an open economy with flexible exchange rates, expansionary fiscal policy causes

  more

  ---

  crowding out since both Investment and Net Exports get crowded out so the expansionary fiscal policy is

  less

  ---

  effective.

Expansionary Fiscal Policy with a Fixed Exchange Rate

• When the interest rates rise higher than the world interest rate it causes domestic assets to become

  more

  ---

  attractive which causes

  more

  ---

  foreign currency to flow in to the domestic country.
• We exchange the foreign currency for domestic dollars at the central bank.
• This causes domestic money supply to

  rise

  ---

  and interest rate to

  fall

  ---

  back to the original level.
• Overall there is

  no

  ---

  crowding out of Investment or Net Exports.
• This is why fiscal policy is more effective with a

  fixed

  ---

  exchange rate.