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4. Clearly explain what “crowding out” refers to, what would cause it to occur, and why...

4. Clearly explain what “crowding out” refers to, what would cause it to occur, and why this is viewed as a problem. Explain how the interest elasticity of investment affects the level of crowding out in the Keynesian model. Be sure to explain WHY this is the case. (10 pts.)

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Answer #1

Crowding out refers to the fall in private investment due to rise in rate of interest in the market. Rise in interest rate is caused by the significant uptick in government borrowings from market.

When government increases its expenditure, it resorts to market borrowing. Borrowing from market reduces availability of cash for other private investors. It increases interest rate in market. Rise in interest rate reduces private investments on account of rise in cost of production. hence, it is regarded as problem.

Interest elasticity of investment implies the degree of responsiveness of investment to change in interest rate. High interest elasticity of investment will cause higher crowding out effect and conversely, low interest elasticity shall cause low crowding out effect.

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