Question

Define and explain the crowding out effect. How does it impact the aggregate demand/aggregate supply model? Be specific

Answer 1

Crowding out effect is an argument that asserts that public sector spending drives out private sector spending. It means that when government increases its expenditure, it has its impact on privte investment.

When government increases its spendng, the multiplier increases aggregate output. Thus, demand for money increases more than the supply of money, leading to a rise in interest rates. This will discourage private investment, driving them out of the money market. The multiplier effect that should have increased aggregate demand, does the oppostie now as private investment is discouraged due to high interest rates. This is the effect of crowding out.