Intro to Crowding Out

AP Macroeconomics

Guiding Questions…

What are the sources of economic growth?

How do monetary and fiscal policies encourage economic growth?

Where did we come from?

In a previous lesson, we will discussed the lags associated with policy-making.

We talked about the inside lag and the outside lag. Which type of policy is associated with each of these lags (that is, monetary or fiscal policy?)

Where are we going?

In this lesson, we will discuss Crowding-out, or the decrease in private demand for funds that occurs when the government’s demand for funds causes the interest rate to rise.

That is, the demand by government for loanable funds decreases or crowds-out the private demand for loanable funds.

What is a loanable funds market?

According to Krugman, this market “brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects)…[and the] price that is determined in the loanable funds market is the interest rate…” (277)

Government Demand for Funds Increasesthe Demand for Money

Unit 5 Visual 5.1 Macroeconomics

Council for Economic Education

As the interest rate rises, so too does the demand for money, and vice versa. Investment decreases. As we know, a decrease in investment causes aggregate demand (real GDP) to decrease, as well. If the interest rate decreases, the opposite will happen.

Analyze this… So let’s say the government

implements expansionary fiscal policy. In turn, this increases aggregate demand (AD1). When aggregate demand increases, so too does money demand (MD1). This causes the interest rate to rise (which discourages investment) and AD to decrease because private businesses reduce investment. This is crowding-out!

Let’s also say that, to this point, monetary policy has not changed (MS). Could monetary authorities do anything to prevent the reduction in investment?

AD

AD1

MS MS1

MD

MD1

AD2

So…what is crowding out?

The effect on private investment when the government implements certain fiscal policy. When the government implements expansionary fiscal policy, this increases the demand for money which increases the interest rate causing private businesses to reduce investment.

SIGH!

And now…

Some resources:

Reffonomics:

http://www.reffonomics.com/

Morton workbook: Activity 44 Part A

Works Cited

Economics of Seinfeld. http://yadayadayadaecon.com/

Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York: Worth Publishers.

Morton, John S. and Rae Jean B. Goodman. Advanced Placement Economics: Teacher Resource Manual. 3rd ed. New York: National Council on Economic Education, 2003. Print.

Reffonomics. www.reffonomics.com.