Crowding Out of Private Investment and Activity

There has been substantial analysis in the academic literature on the “crowding out” aspects of debt-financed fiscal policy. The link between fiscal deficit and growth, saving and investment and debt and interest rates have also been examined throughout economic history. It has assumed greater significance in the recent past when public debt has surpassed the nation’s threshold limit in many cases.

The advocates of fiscal policy as an instrument of economic revival suggest that an economy with unemployed resources can stimulate economic activity through government investment in productive capacity and thereby can increase real private investment also.

This is explained with the help of the diagram below:

The Keynesians have emphasized the expansionary effect of debt financing of government expenditure. The increase in government expenditure through borrowed money causes an upward shift in the aggregate demand (IS curve) schedule.

An economy with less than fully employed resources will witness a corresponding increase in output and income. With an increase in income, tax revenue will rise, and ultimately, a balanced budget can be achieved.

In the case of an economy with less than full employment, with an expansionary fiscal policy through public borrowings, IS curve will shift to the right. Thus, real income and output will rise along with the rise in the rate of interest.

However, there is another aspect of government spending. This is related to an economy with full employment of resources and a fixed supply of goods and services. In this case, the government can claim more of the economy’s output only by depriving the private sector of its use. The Crowding out of real private expenditure and private investment caused by price inflation and the rise of interest rates is a well-recognized concept.

The transactions crowding out associated with a budget deficit financed through the sale of interest-bearing bonds have been a standard part of the fiscal and monetary policy analysis through the IS-LM model.

When the government borrows funds to finance its deficit, there will be an increase in demand for loanable funds. Given the fixed supply of money, there must be an offsetting reduction in demand for money for markets to clear.

If the demand for money balances is sensitive to the rate of interest, the required offset for demand for money is brought about by an increase in the interest rate. However, since the investment responds negatively to a rise in interest rates, there will be a decline in private investment.

We know interest rate is inversely related to Investment, so the investment schedule is downward sloping. So with an increase in interest rate, investment will fall, causing movement along the curve (I₁ to I₂).

Thus, debt-financed government expenditure crowds out private investment. Thus, due to the crowding out of private investment, the net effect of debt-financed expansionary fiscal policy will be negligible.

As pointed out earlier, the impact of public borrowings will depend on how the funds are utilized. If the debt is used to fund consumption, then the investment will be crowded, and the burden will be placed on future generations. They would inherit a small stock of capital, an economy with a smaller capacity to produce, hence a smaller real output. The expenditure includes transfer payments to individuals, administrative expenses etc.

Private investment is affected under the following conditions:

● As discussed earlier, an economy with full employment and with an unchanged monetary policy will witness a crowding-out effect when the government resorts to deficit financing, causing interest rates to rise and a corresponding reduction in investment.

● Secondly, the presence of existing debt will also affect investment. Government spending used to finance consumption expenditure will lead to a rise in consumption. Moreover, bondholders may consider bond holdings as part of their wealth. If the wealth effect of bond holding is taken into account, then it will exert an influence on economic behaviour.

When more bonds are issued and sold by the government, the wealth of individuals will increase, causing a rise in demand for money. With a fixed money supply, an increase in demand for money will cause a leftward shift of the LM curve (from LM₀ to LM₁).

Thus, Expansionary fiscal policy causes IS curve to shift rightwards to IS1, and real income rises to Y*. However, the wealth effect, causing a leftward shift of the LM curve, causes interest rates to rise and crowds out private investment.

● Moreover, higher taxes imposed by the government to raise funds for debt servicing will also exert some negative influence on investment.

● Finally, the existence of large debt may cause a loss of confidence on the part of businesses regarding the health of the economy. They may curtail their investment.

In case the aggregate supply is assumed to be fixed, an increase in aggregate demand (AD1 to AD2) caused due to expansionary fiscal policy financed through debt financing will lead to a rise in price level with real income and output remaining unchanged.

At an unchanged level of income, tax revenues will fall, exerting pressure on the government. Eventually, the budget deficit will persist and go on accumulating towards unsustainable levels.

If, however, the deficit spending is used for improving productive capacity, then future generations will have additional productive capital to increase real output. In this case, both consumption and investment will rise, and the positive effect of government spending may more than offset the crowding-out effect.

In the case of debt raised through external sources, heavy government borrowing inflicts substantial harm to the economy even if interest rates are steady and private investment is unaffected. In this case, foreign saving is imported to offset government dis-saving to sustain domestic private investment.

This implies the transfer of resources and output earned from domestic production to service foreign debt, leaving less domestic income available. Hence, external debt is also not cost-free.

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment