Archive for the 'Crowding-out Effect' Category

Nov 06 2012

A closer look at the crowding-out effect

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.
To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occurred.
Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the government  now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
  • If the private demand for loanable funds is extraordinarily low, or
  • If the private supply of loanable funds is extraordinarily high.
When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

5 responses so far

Nov 06 2012

To continue stimulus or to pursue austerity, that is the question

Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.

In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 - Krugman argues for continued stimulus:

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Discussion Questions:

  1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
  2. What are three characteristics of an economy in a “depression” according to Krugman?
  3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
  4. Why is deflation dangerous according to Krugman?
  5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

Video 2 - Ferguson argues for austerity and “fiscal regime change”:

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Discussion Questions:

  1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
  2. Why would fiscal tightening “choke off the recovery”?
  3. How is the financial crisis in Europe a warning to the US?
  4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
  5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

6 responses so far

Oct 30 2012

Visualizing recession’s effect on government deficits and debt

Fiscal policy consists of the use of taxes and government spending in the economy to promote macroeconomic objectives such as full employment, economic growth, low inflation and reduced income inequality. When an economy is doing poorly, the government’s fiscal policies tend to result in large budget deficits, which occur when the amount of expenditures exceed the amount of tax revenue collected in a particular year.

When a government runs deficits year after year, each deficit is added to the nation’s debt. The charts below, created using Google’s Public Data Explorer, provide a snapshot of the deficit and debt situations experienced by the countries of Europe over the last couple of decades. Study the graphs closely with your class, then read the analysis and explanations that follow!

Automatic stabilizers in Fiscal Policy

When an economy is doing well, fiscal policy adjusts automatically to bring down deficits, and even allow a government to run a budget surplus if the tax revenues exceed government expenditures. When the economy slows down, output falls, and unemployment rises, government spending and taxation automatically adjust in ways that move the budget towards deficit, in which the government spends more than it collects in taxes.

These automatic adjustments to fiscal policy result from the effect growth or recession have on previously mandated government expenditures and tax receipts. For example, imagine the US economy slips into a recession:

  • As demand for the nation’s output falls, the incomes of producers and workers decline, therefore the amount of income tax received by the government decreases automatically
  • At the same time, more workers are becoming unemployed, making them eligible to receive unemployment benefits from the government. More people slip into poverty and begin to receive welfare and government health insurance, and perhaps even subsidized housing and food.
  • Revenues automatically decline while government spending automatically increases, moving the budget further into deficit.

Next imagine the US economy has recovered and is growing at rates above its long run average growth rate. During such “booms” in the business cycle, the following occurs:

  • Business and household incomes are rising, so more income tax is being paid, increasing government tax revenues.
  • Unemployment is falling, meaning fewer people receive government benefits. Fewer people are in poverty, meaning less spending on transfer payments that support the poor.
  • With tax revenues increasing and government transfer payments decreasing, the budget automatically moves towards surplus.

These “automatic stabilizers” should mean that as an economy experiences the normal fluctuations of its business cycle, the government budget fluctuates between surpluses and deficits, and over time, national debt is kept nice and low. But as we saw in the graphs linked in the top of this post, a sustained downturn in economic activity can lead to structural deficits that persist for years and years. Persistent budget deficits mean an ever ballooning national debt, as can be seen in this chart:

As the graph above shows, over time, large deficits lead to ever growing debts. Notice the general inverse relationship between the size of a country’s budget deficit and the size of its national debt. Countries in the upper left hand corner of the graph generally have low deficits (or budget surpluses) and enjoy relatively small national debts. In the lower right, on the other hand, large deficits have lead to levels of debt frighteningly large as a percentage of the countries’ GDPs.

Discretionary Fiscal Policy

What does all this mean for government policy makers? Let’s first distinguish between the automatic fiscal policy described above and discretionary fiscal policy. Much of the increase in budget deficits and national debts seen in the charts in this post can be explained by European governments’ initial responses to the economic downturns first seen in 2007 and 2008. When unemployment began to rise and output began to fall across Europe, the first response of many governments was to intervene to try to stimulate aggregate demand  beyond what was provided automatically through increased transfer payments and decreasing tax receipts. Discretionary fiscal policy refers to deliberate changes to overall tax rates and government spending aimed at directly or indirectly stimulating (or contracting) demand in the economy to help move an economy back to its full employment level during a recession (or, in some cases, during a period of high inflation).

Discretionary fiscal policy, when used during a recession, will drastically increase the size of a budget deficit (and therefore, the national debt). Why do it, you ask? Advocates of such policies (often known as Keynesians, after John Maynard Keynes, whose theories formed the basis for such policies) argue that a recession must be reversed as soon as possible, or else the burden of a nation’s existing debt will grow (as a percentage of its GDP) as the country’s GDP falls. More importantly, of course, is the human and social cost of a recession, as workers become unemployed and hardship spreads among the nation’s households.

A short-term increase in the budget deficit may pay for itself if the subsequent increase in overall demand is mulitplied throughout the economy and overall GDP increases by more than it would have with only automatic stabilizers to rely on. Government spending on infrastructure, education, health, and other public goods creates jobs, increases household income, provides the economy with new capital and infrastructure, increasing the nation’s production possibilities and boosting demand to move the economy closer to full employment. Higher incomes among those employed in government projects will be spent, creating even more new jobs in the private sector.

Discretionary fiscal policy aimed at stimulating demand requires a government borrows money, increasing the national debt. But if such policies are successful, the debt burden will be smaller over time since economic growth may return, increasing the GDP and thus allowing the budget to move back towards surplus sooner, as automatic stabilizers once again kick in.

Evaluating the use of Fiscal Policy for managing the economy

Understanding the difference between automatic and discretionary fiscal policy, and the impact that expansionary policies have on budget deficits and national debt, provide us with tools for evaluating its use during recessions or periods of high inflation. However, we need to know more about the impact of deficits and debt in order to fully evaluate its use. For that, you’ve got to read some more posts and watch some videos. Here are some key resources that will help you evaluate the use of fiscal policy for fighting recessions.

After watching these two video lectures and reading the post, answer the discussion questions that follow:

  1. Explain the huge increases in national debts (both in Euros and as percentages of the countries GDPs) during the later part of the decade from 2000 to 2010.
  2. How does automatic fiscal policy differ from discretionary fiscal policy?
  3. How does the multiplier effect of fiscal policy provide support to the Keynesians’ views that tax cuts and increases in government spending can highly effective at getting and economy out of recession?
  4. How does the crowding-out effect of fiscal policy support the opponents of its use who argue that government spending and tax cuts will only make an economy less competitive and grow more slowly in the long-run?

No responses yet

May 08 2012

Loanable Funds vs. Money Market: what’s the difference?

Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.

*Click on a graph to see the full-sized version

Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the MoneyMoney Market Market diagram.

This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.

You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.

First watch this video lesson, which defines and introduces the money market diagram (skip ahead to 0:43 to hear the definition and explanation of the money market):

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Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.

When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.

However, since the money demand curve depends on the level of transactions going on in a nation’s economy in a particular period of time, an increase in government spending on infrastructure, defense, corporate subsidies, tax rebates or other fiscal policy initiatives will increase the demand for money, shifting the Dm curve rightward and driving up interest rates. The higher interest rates resulting from the greater demand for money reduces the quantity of private investment; in this way the crowding-out effect can be illustrated in the money market.

Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.

Watch this video for a clear explanation of the loanable funds market and how it can be used to illustrate the crowding-out effect (skip ahead to 3:18 for a definition and explanation of the loanable funds market):

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Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.

Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.

  • When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
  • The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
  • In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
  • As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
  • This causes crowding out of private investment.

Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.

  • Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
  • Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
  • This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.

What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.

On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).

It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.

57 responses so far

Mar 30 2012

Does expansionary fiscal policy “pay for itself”?

A theory of fiscal policy: Self-sustaining stimulus | The Economist

Expansionary fiscal policy is a tool governments often turn to when the economy is facing high unemployment and sluggish or negative economic growth. Cutting taxes and increasing government spending can contribute to the overall demand in the economy and thereby lead to job creation and economic growth.

One of the oldest arguments against stimulus, however, is that which says when a government borrows money to pay for such a policy, it can lead to a decrease in private investment and a decrease in future demand as the higher level of debt must be paid back in the future. Short-term stimulus, therefore, is counter-productive since any debts incurred must be paid back in the future, leading to lower levels of spending and therefore higher unemployment sometime down the road.

The crowding-out effect of fiscal policy is explained in detail in the following video from The Economics Classroom:

A recent study by two leading American economists provides an argument against this view of the crowding-out effect of fiscal policy:

In a new paper* written with Brad DeLong of the University of California, Berkeley, Mr Summers, now at Harvard after a stint as Barack Obama’s chief economic adviser, says that in the odd circumstances America faces today temporary stimulus “may actually be self-financing”…

Mr DeLong and Mr Summers are careful to say stimulus almost never pays for itself. When the economy is near full employment, deficits crowd out private spending and investment. In a recession the central bank will respond to fiscal stimulus by keeping interest rates higher than they would otherwise be. Both effects mean that in normal times the fiscal “multiplier”—the amount by which output rises for each dollar of government spending or tax cuts—is probably close to zero.

The “multiplier” referred to here is what economist refer to as the Keynesian spending multiplier, which is based on the theory that any increase in spending in an economy (say, through a new government spending package), will lead to further increases in spending (as households feel more confident and firms start to hire workers again), therefore the final change in national income resulting from a fiscal policy will be greater than the initial change in spending itself. This multiplier effect has formed the basis of the argument for expansionary fiscal policy since Keynes articulated it in the 1930’s.

The multiplier effect is explained in detail in the following video lesson:

If the multiplier is ZERO, there is no point in engaging in expansionary fiscal policies since there will be no additional increase in output as a government goes into debt to pay for a tax cut or an increase in spending. In the US today, argue Summers and Delong, the multiplier is probably not zero. Additionally, crowding-out is unlikely to occur.

Such constraints are not present now (meaning in the United States in 2012). Investment and demand are deeply depressed and the central bank, having cut interest rates to zero, is not about to raise them. The multiplier is higher than usual as a result…

Basically, Summers and Delong are trying to argue that the US government should engage in another round of fiscal stimulus, to offer additional support to the economy beyond 2009’s “Obama stimulus” and the current bill being debated in Washington, the American Jobs Act, a $470 billion tax cut and spending bill aimed at keeping unemployment from rising in America.

On one side of this debate are those like Summers and Delong who argue fiscal stimulus can pay for itself since it can leads to a larger increase in GDP than the increase in the government’s budget deficit needed to finance the stimulus. On the other side are those “deficit hawks” who believe that any increase in government debt will lead to a fall in current and future aggregate demand from the private sector, and therefore expansionary fiscal policies will just be crowded out by declining private sector spending.

By understanding the circumstances in which crowding-out is most likely and unlikely to occur, we should be able to make a more informed decision about future fiscal policy decisions. As these two economists argue, and as I have tried to present in this post and in a previous post A Closer Look at the Crowding-out Effect, today’s economy provides policy-makers with the perfect opportunity to stimulate aggregate demand by increasing the deficit and providing the US economy with the boost in demand it needs to get America back to full employment.

Discussion Questions:

  1. Why is crowding-out more likely to occur when an economy is already producing at or near its full employment level of output than when an economy is in recession?
  2. How are the theories of crowding-out and the multiplier effect used to argue for two different sides in the debate over the use of expansionary fiscal policy?
  3. Why might a government deficit, paid for with borrowed money, lead to an expectation of a future increase in taxes?
  4. Do you believe the government should take action during periods of economic hardship, or should it just get out of the way and let the economy “correct itself”?

One response so far

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