Answer to Question #276536 in Macroeconomics for Sujana

Question

Drawing diagram explain the process of crowding out. Also explain why the private sector might find budget deficit detrimental to their business planned projects.

Answer 1

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.

Figure(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. Figure(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.

The private sector might find budget deficit detrimental to their business planned projects since increased government borrowing causes a decrease in the size of the private sector. The government borrow by selling bonds to the private sector. Therefore, if the private sector (banks/private individuals) buy government bonds, they have less money to invest in private sector projects.