Crowding Out

i I +G S I +G’ Crowding Out Suppose that, contrary to Keynes, investment spending is sensitive to changes in the interest rate. I Now, add the debt-financed government spending to the private-sector demand for investment funds. I + G represents the demand (private and public) for loanable funds---onto which we can juxtapose the supply of loanable funds. The intersection of supply and demand gives us the market-clearing rate of interest. Suppose, now, that the government decides to spend more, but without raising taxes. It borrows, instead. The increase in the rate of interest discourages private-sector borrowing and reduces investment spending. Government spending, in effect, has “crowded out” private investment spending.

Y = C + I + G If the marginal propensity to consume is ¾, then the government spending multiplier is 4. An increase in government spending of 100 will cause income to spiral up by 400. And Consumption spending will rise by 300.

Y = C + I + G Suppose that there is “crowding out” in the amount of 70. That is, ΔI = -70. The stimulus, would be only 30, causing income to spiral up by only 120 and causing consumption to rise by only 90. The effective multiplier, then, is not 4, but rather is 1.2.

Y = C + ( I + G) Suppose that there is “crowding out” in the amount of 70. That is, ΔI = -70. The stimulus, would be only 30, causing income to spiral up by only 120 and causing consumption to rise by only 90. The effective multiplier, then, is not 4, but rather is 1.2. We see that, in effect, the sum (I+G) increased by 30. That is, Δ(I+G) = 30, causing Y to spiral up by 4 times that amount.

Crowding Out