CROWDING OUT

Crowding Out

• Some economists are of the opinion that government spending would sometimes substitute private spending and when this happens the impact of government spending on aggregate demand would be smaller than what it should be and therefore fiscal policy may become ineffective.
•  An increase in the size of government spending during recessions will ‘crowd-out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic growth .
• Crowding out effect is the negative effect fiscal policy may generate when money from the private sector is ‘crowded out’ to the public sector. In other words, when spending by government in an economy replaces private spending, the latter is said to be crowded out. 
• For example, if government provides free computers to students, the demand from students for computers may not be forthcoming. When government increases it’s spending by borrowing from the loanable funds from market, the demand for loans increases and this pushes the interest rates up. 
•  Private investments are sensitive to interest rates and therefore some private investment spending is discouraged. Similarly, when government increases the budget deficit by selling bonds or treasury bills, the amount of money with the private sector decreases and consequently interest rates will be pushed up. 
• As a result, private investments, especially the ones which are interest –sensitive, will be reduced. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion in demand resulting from an increase in government expenditure. 
•  Nevertheless, during deep recessions, crowding-out is less likely to happen as private sector investment is already minimal and therefore there is only insignificant private spending to crowd out. Moreover, during a recession phase the government would be able to borrow from the market without increasing interest rates. 

 CONCLUSION

Well designed and timely fiscal responses are necessary for an economy which is either going through stages of recession or inflation or on a drive to achieve economic growth and/ or equitable distribution of income. During periods of recession when there are idle productive capacity and unemployed workers, an increase in aggregate demand will generally bring about an increase in total output without changing the level of prices. On the contrary, if an economy is functioning at full employment, an expansionary fiscal policy will exert pressure on prices to go up and will have no impact on total output. Fiscal policy is also a potent instrument for bringing in economic growth and equality in distribution of income.