The Crowding-Out Effect

The multiplier effect Opens in new window seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in aggregate demand is necessarily larger than $20 billion.

The crowding-out effect works in the opposite direction of the multiplier effect.

The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

While an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rate to rise, reducing investment spending and putting downward pressure on aggregate demand.

The crowding-out effect consists in the reduction in aggregate demand that results when a fiscal expansion raises the interest rate.

To see why crowding out occurs, let’s consider what happens in the money market when the government buys planes from Boeing. This increase in demand raises the incomes of the workers and owners of this firm (and, because of the multiplier effect, of other firms as well).

As income rise, households plan to buy more goods and services and, as a result, choose to hold more of their wealth in liquid form. That is, the increase in income caused by the fiscal expansion raises the demand for money.

The effect of the increase in money demand is shown in panel (a) of Figure V.

chiasmus diagram showing abba pattern Figure V, The Crowding-Out Effect | Source: SlideToDoc Opens in new window
Panel (a) shows the money market. When the government increases its purchases of goods and services, income increases, raising the demand for money from MD1 to MD2 and thereby increasing the equilibrium interest rate from r1 to r2. Panel (b) shows the effects on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand curve from AD1 to AD2. Yet because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD3.

Because the Fed has not changed the money supply, the vertical supply curve remains the same. When the higher level of income shifts the money demand curve to the right from MD1 to MD2, the interest rate must rise from r1 to r2 to keep supply and demand in balance.

The increase in the interest rate, in turn, reduces the quantity of goods and services demanded. In particular, because borrowing is more expensive, the demand for residential and business investment goods declines.

In other words, as the increase in government purchases increases the demand for goods and services, it may also crowd out investment. This crowding-out effect partially offsets the impact of government purchases on aggregate demand, as illustrated in panel (b) of Figure 5.

The increase in government purchases initially shifts the aggregate-demand curve from AD1 to AD2, but once crowding out takes place, the aggregate-demand curve drops back to AD3.

To sum up:

When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion depending on the sizes of the multiplier and crowding-out effects.