What is "crowding out"? Why is it important in discussions of fiscal policy? Use an appropriate diagram to illustrate your answer

Answer 1

Crowding out occurs when deficit spending by the government forces up interest rates and causes investment spending to contract. Some private parties who might have spent money choose instead to lend it to the government by buying bonds. If crowding out occurs, the expansionary effect of a budget deficit is substantially reduced. The crowding-out effect is based on the assumption that the total volume of private saving is fixed. If the government borrows more, private businesses must necessarily borrow less. The appropriate diagram should resemble Figure 16-10, emphasizing the interest rate effect of an expansionary fiscal policy.