Crowding Out (economics) - Is Crowding Out Likely?

Is Crowding Out Likely?

The question is how seriously we must take the possibility of crowding out? This is discussed in three points given below.

• Consider an economy with given prices, in which the economy operates below full employment. Under such conditions, when fiscal expansion increases demand, firms can increase their output by hiring more workers. But if the economy is at full employment level, crowding out becomes a much more realistic possibility because firms cannot increase their output through additional hiring. In this situation an increase in demand will lead to an increase in price level rather than an increase in output.

• In an economy with unemployed resources full crowding out will not occur because the LM curve is not vertical. A fiscal expansion will raise interest rates, but income will also rise depending on the slope of the LM curve. Crowding out, if it occurs, is thus a matter of degree.

• Monetary authorities can accommodate a fiscal expansion by increasing the money supply, thus dampening any rise in interest rates. This monetary accommodation is referred to as "monetizing the deficit", where the central bank prints money to buy bonds issued by the government to pay for its expansionary deficit. In this case, both IS and LM curves shift to right, resulting in increased output at the same interest rate. Thus with an appropriate monetary policy complementing fiscal policy, there need not be any crowding out of private investment.