An increasing interest rate will obviously discourage private sector investment due to their inverse relationship. (Economics, 1997) Entrepreneurs are unprepared to take high risks when interest rates are high. Consequently, there is a crowding out effect on the private sector, represented by the distance (Y - Y*) in Figure 1.
Crowding out occurs when an increase in government spending, aimed at increasing aggregate demand has the effect of reducing private spending (on consumption and investment) by the same amount, leaving total demand unchanged. (Economics, 2003) Although there are two forms of crowding out, financial crowding out and resource crowding out, both have the effect of reducing private expenditure. In the case of financial crowding out, government expenditure diverts funds away from the private sector reducing the level of private investment. On the other hand, resource crowding out involves government expenditure which leads to a reduction of private spending on resources. (Economics, 1997)
Determinants of the Degree of Crowding Out
The degree of financial crowding out which might occur in an economy is determined by two factors within the IS/LM framework. The first is the slope of the IS schedule and the second is slope of the LM schedule. However, the degree of resource crowding out is determined by the level of employment of output in the economy. (Economics, 1997)
1. The Slope of the LM Schedule
The more interest inelastic the LM schedule the greater the degree of crowding out. Conversely, the more interest elastic the LM schedule the smaller the degree of crowding out.
An interest inelastic LM schedule, shown in Figure 3 below, arises either due to money demand which is very responsive to changes in income or money demand which is not very responsive to changes in the interest rate. (Pratten, 2002)
When private investment is interest inelastic, an increase in government spending (shift from IS to IS) will bring about an income. Due to the highly responsive nature of money demand to changes in income, the rise in income will lead to an even larger rise in the demand for transactions and precautionary money. This would require that the speculative demand for money is lowered, which would result from a rise in the interest rate. Since money demand is interest inelastic, in other words, sincety money demand is not very sensitive to changes in the rate of interest, a large increase in the interest rate is required to restore equilibrium. This leads to a large reduction in investment demand (Y - Y*). Therefore there is a large degree of crowding out.
Figure 4, illustrated on the following page, represents the case where the LM schedule is interest elastic.
An interest elastic LM schedule exists either when money demand is very responsive to changes in the rate of interest or when it is not very responsive to changes in income.
In this case, as government spending and income increases, the transactions and precautionary demand for money increase. Due to the fixed supply of money, the interest rate rises. However, since money demand is interest elastic, only a small increase in the interest rate, shown by the distance (R - R) on Figure 4, is required to re-equilibrate the money market. Consequently, the level of private investment would decline. The small rise in the interest rate indicates that there will only be a small reduction effect on investment demand (Y - Y*). In other words, there is a small degree of crowding out, making fiscal policy more effective in a situation like this. (Pratten, 2002)
Another situation which is important to consider is when the LM schedule is perfectly elastic. This occurs when an economy is in recession and is characterized by a liquidity trap. In a situation like this, money authorities try to increase the money supply with the intention of reducing the interest rate and thus increasing demand for private investment. However the interest rate continues to fall until it stabilises at R, shown on Figure 5 below.
In this case, an increase in government spending would not have any crowding out effects. (Pratten, 2002)
The US economy faced a similar situation in the 1930s. The economy was in a liquidity trap during the Great Depression when interest rates fell below 1%. (Froyen, 2002) In this case, increasing government spending would not result in any crowding out effects.
Conversely, when the LM schedule is completely interest inelastic, there will be complete crowding out. (Froyen, 2002) This situation is presented in Figure 6 below.
2. The Slope of the IS Schedule
When considering the IS schedule, an interest inelastic curve would result in a smaller degree of crowding out and an interest elastic curve would result in a larger degree of crowding out.
When the IS schedule is interest inelastic, it means that investment demand is unresponsive to changes in the rate of interest. Therefore an increase in government spending would increase income causing the transactions and precautionary demand for money to increase. This would lead to agents needing to sell existing bonds, placing a downward pressure on bond prices. The interest rate would rise in order to keep the money market in equilibrium. Since investment demand is interest inelastic, a small rise in the rate of interest is require to re-equilibrate the market, causing only a small reduction in private investment. (Froyen, 2002) Therefore there is a small degree of crowding out is shown by the distance (Y - Y*) in Figure 7, on the following page.
However, in the case where the IS schedule is elastic, shown in Figure 8 below, an increase in government spending would require a large increase in the rate of interest to re-equilibrate the money market. (Froyen, 2002) This would have a large reduction effect on the level of investment demand. In other words, there would be a great degree of crowding out, shown by the distance (Y - Y*).
Effectively, in a situation where the IS schedule is completely interest inelastic an increase in government spending would have no crowding out effects, illustrated by Figure 9 on the following page. (Froyen, 2002)
3. Employment level of Output in the Economy
The third condition which is important to consider is the existence of full employment of ouput. In all the above situations, we are assuming that prices are fixed (that the aggregate supply curve is perfectly elastic). This is only valid if the economy is operating below full employment. In a situation of full employment or near full employment, an increase in government spending would as always, lead to an increase in the transactions and precautionary demand for money. However, when this spills over into the money market, the government tries to reach equilibrium by decreasing the money supply. (Economics, 2003) This shifts the LM schedule to the left (LM to LM) shown in Figure 10 below. This means that the new equilibrium at (R, Y) will be at a much higher interest rate (R). Full employment of output is achieved (Y). This results in a great degree of crowding out, which is shown by the distance (Y to Y*).
Conclusion
To conclude, an increase in government expenditure leads to higher interest rates, which in turn leads to the crowding out of private sector spending. The degree of financial crowding out, however may be determined by two factors; the slope of the LM schedule, the slope of the IS schedule. Finally, the degree of resource crowding out may be determined by the employment level at which an economy is operating.
Bibliography
Begg, D., Fischer, S., Dornbusch, R. (2003), Economics, McGraw-Hill Education, UK, 7th edition
Froyen, R. (2002), Macroeconomics Theories and Policies, Prentice Hall, New Jersey, 7th edition
Pratten, S. (2002) Keynesian Macroeconomics Lecture Notes
Sloman, J., Sutcliffe, M., (1997), Economics, Prentice Hall, UK, 3rd edition
