Crowding Out Ct’d AP Macroeconomics

Where did we come from? In a previous lesson, we discussed 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.

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 MSMS1 MD MD1 AD2

Where are we going? We will further discuss the market for loanable funds, as well as the Barro-Ricardo effect. 19 th Century economist, David Ricardo, after whom the Barro-Ricardo effect is named.

For starters… Another way to think of the phrase “demand for [loanable] funds” would be to think of it as the demand for private sector investment. So, when we use this terminology during this lesson, try substituting it with the latter.

Loanable Funds Market D = private sector demand for funds (Investment) I and i are the initial equilibrium values. D + (G–T) = private + government demand for funds I1 and i1 are the new equilibrium values. I2 = new level of private investment I1 – I2 = government demand for funds (G–T) Note: The original curve is for private sector only with no borrowing or debt by the federal government. Also note: I1 is the new equilibrium interest rate, and I2 is the quantity of loanable funds demanded by the private sector at the new equilibrium. Visual 5.2 Unit 5 Macroeconomics

The Barro-Ricardo Effect An indirect effect of government budget deficits is the possibility that these deficits will lead to an increase in private savings and a decrease in consumption that offset the predicted expansionary fiscal policy. Why would this happen? Because people expect that when the government runs a deficit [the government takes in less than it puts out] it will increase taxes in order to repay the money being borrowed. Thus, people (possibly) save and consume less. This is called the Barro-Ricardo effect.

Who cares? We do! We do! The Barro-Ricardo Effect causes the supply curve for funds to shift outward (because there is less demand), thus reducing the increase in the interest rate and the decrease in private sector demand for funds. S2 Yipee! The Barro-Ricardo effect has saved the day! Visual 5.2 Unit 5 Macroeconomics

Why do we care? Although there’s no evidence that the Barro- Ricardo effect is significant, the effect of crowding-out can be particularly significant, depending on the following:  Elasticity of investment (that is, the responsiveness of investment to changes in the interest rate)  And interest-sensitive components of aggregate demand. your-why/

And now… Some resources: Reffonomics: Morton workbook: Activity 44 Part B

Works Cited Economics of Seinfeld. 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. 3 rd ed. New York: National Council on Economic Education, Print. Reffonomics.