Crowding Out

What is it?

• A critique and flaw of Keynesian  policies that are applied to fight a recession. (An expansionary policy!)

Why does it happen?

• The policy of cutting Taxes and raising Spending will create a budget deficit.
• The budget deficit must be funded and to do this Congress orders the sale of US bonds.
• (This is NOT a Monetary Policy tool used by the Fed)

Where does the money come from?

• US citizens and companies, investment firms, foreign countries

therefore?

• Money that could be spent on Consumption or used for Private Savings is now being used to buy bonds.

On the money market graph

• This will cause the Money Demand curve to shift outward.  Remember this is a Fiscal event!

On the Loanable Funds Market

• This will cause the Supply  curve to shift inward  because we are not Saving money privately any more.
• This can cause the Demand  curve to shift outward because the private and public demand for $ increases_.

on both graphs

• The nominal and real interest rate will increase.

Therefore, on the Investment D graph

• The increase in nominal and real interest   rates will cause Ig to decrease.

Isn't this counterproductive?

• Fiscal Policy supporters (Keynesians) insist that gains in
• C and G will outweigh any loss in future Ig.

Why?

• C and G are greater than Ig and they are Short Run improvements.  
• Ig is longer run and Keynesians don’t worry about that.  
• In the long run we are all dead.

this is summarized on the Aggregate Model.  

• The AD will move outward due to the increases in C and G 
• then “maybe” move inward due to a loss of Ig, 
• but not as much as the increase.  
• Therefore the economy improves.