Question

explain the “crowding out” effect and how this effect might be the result of some specific stimulus to the economy such as a rapid increase in federal government expenditures (assuming the economy is at full employment). In the current U.S. economy, could you imagine a set of conditions where increased federal government spending actually caused private investment spending to rise (not fall)? Explain with an example, how this “crowding in” might occur.

Answer 1

Crowding out effect occurs where rise in interest rate reduces investment activities carried out by the private agents. Increase in government expenditure is funded through the borrowing from market. Borrowing from market reduces the availability of fund in market which increases interest rate. Rise in interest rate reduces investments by the private firms. This is called crowding out.

Crowding in is opposite to crowding out. During the financial crisis of 2008, Federal government increased expenditure. Rise in government expenditure increased demand in economy. rise in aggregate demand motivated private firms to make more investment to earn profits. Hence, rise in government expenditure ultimately leads to the rise in the private investments. This is an example of crowding in effect.