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Crowding-in occurs when an increase in government spending leads to more private investment. It occurs because public investment makes the private sector more productive, as well as because government spending may have a stimulative effect on the economy. It is contrasted with crowding out, which occurs when government spending leads to less private investment.
While both crowding in and crowding out are observed empirically, there are long-standing debates over which effect tends to prevail, and under what circumstances. The theories of classical economists such as Adam Smith, J. B. Say, and Karl Marx are generally interpreted as being more consistent with crowding out. [1] [2] The crowding-in effect is generally associated with the economic theories of John Maynard Keynes and post-Keynesian economics. Presently, the crowding-out effect is generally associated with Neoclassical and New Keynesian economics. The crowding-in theory has gained popularity in the aftermath of the Great Recession of 2007–2009, when public spending in the United States occurred simultaneous to a drop in interest rates. [3]
The most well-known mechanisms for the crowding-in effect are based on public investment. The construction or improvement of physical infrastructure increases the productivity of the private sector. Examples of physical infrastructure investment that exhibit this property include transportation infrastructure such as roads and ports, health and sanitation infrastructure such as sewage systems, and communications infrastructure such as broadband networks. [4] The predominance of this effect is found robustly across developed and developing countries. [5] [6]
Nevertheless, there are also mechanisms by which even non-investment government spending can elicit the crowding-in effect. One proposed mechanism is via increased aggregate demand. Government spending or tax cuts can be used to increase aggregate demand. This rise in demand leads to more employment opportunities as businesses "crowd in" to take advantage of the opportunity. Another is based on the ability of the government to resolve deflation. In a situation of deflation, real interest rates may be high, inhibiting investment. Using targeted public spending to create inflationary pressure, real interest rates may be reduced, stimulating private sector investment. Government spending may also induce private sector investment via the multiplier effect. This is the ratio of change in national income arising from a change in government spending. As the government spends, the national income rises by more than what is spent, inducing more spending by the private sector. This additional demand stimulates investment.[ citation needed ]
Aschauer (1989) presents a neoclassical study of increases in the productivity of private capital resulting from the accumulation of public capital through public investment in the US. They find that nonmilitary spending, especially on core infrastructure, has a significant and positive relationship with private sector productivity. They propose that the slowdown in government spending in the early 1970s may have been an important factor in the private sector productivity decline that took place at that time. [7]
Toshiya Hatano (2010) presents a model which demonstrates the importance of considering the long-run stock of fixed capital (rather than just investment flows) in evaluating the presence of the crowding-in effect. [8]
Whether government spending causes crowding in or crowding out is generally considered to hinge on three main factors:
According to New Keynesian economics, the crowding-in effect via government spending is more likely to occur in transitional or developing countries. This is because New Keynesian theory, like neoclassical theory, considers developed economies to generally operate near full employment. In case of recession, there is unused private sector savings and production capacity (unemployed labor force, unused capital infrastructure, etc.). An increment in government expenditure significantly increases national income in developing countries due to the presence of relatively higher levels of unemployment factors of production. This increase in national income further increases the purchasing capacity and encourages the growth of private investment. At the same time, an increase in the budget deficit will have a very small influence on interest rate growth because of the high elasticity of speculative demand for money (horizontal LM curve). In transitional countries, national income is the most important factor influencing private influencing the private investment. The impact of the interest rate is much smaller.[ citation needed ]
The crowding-out effect may appear either directly or indirectly. Direct crowding-out occurs with the reduction of the physical resources available to the private sector. Indirect crowding-out takes place through an increase in interest rates and prices. [12]
Inflation may also limit the crowding-in effect. Inflation induces banks to increase interest rates.[ citation needed ] As interest rates increase, private investment tends to decline.
Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/GDP and national income, unemployment, price indices and inflation, consumption, saving, investment, energy, international trade, and international finance.
Public capital is the aggregate body of government-owned assets that are used as a means for productivity. Such assets span a wide range including: large components such as highways, airports, roads, transit systems, and railways; local, municipal components such as public education, public hospitals, police and fire protection, prisons, and courts; and critical components including water and sewer systems, public electric and gas utilities, and telecommunications. Often, public capital is defined as government outlay, in terms of money, and as physical stock, in terms of infrastructure.
The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic model which is used as a pedagogical tool in macroeconomic teaching. The IS–LM model shows the relationship between interest rates and output in the short run in a closed economy. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves illustrates a "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the money markets. The IS–LM model shows the importance of various demand shocks on output and consequently offers an explanation of changes in national income in the short run when prices are fixed or sticky. Hence, the model can be used as a tool to suggest potential levels for appropriate stabilisation policies. It is also used as a building block for the demand side of the economy in more comprehensive models like the AD–AS model.
This aims to be a complete article list of economics topics:
In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. In modern economies, inflation is conventionally considered "healthy" in the range of 2%–3%. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilise the economy over the course of the business cycle.
The Ricardian equivalence proposition is an economic hypothesis holding that consumers are forward-looking and so internalize the government's budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing such spending does not affect agents' consumption decisions, and thus, it does not change aggregate demand.
In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.
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In economics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amount of goods and services that will be purchased at all possible price levels. Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.
A tax cut represents a decrease in the amount of money taken from taxpayers to go towards government revenue. Tax cuts decrease the revenue of the government and increase the disposable income of taxpayers. Tax cuts usually refer to reductions in the percentage of tax paid on income, goods and services. As they leave consumers with more disposable income, tax cuts are an example of an expansionary fiscal policy. Tax cuts also include reduction in tax in other ways, such as tax credit, deductions and loopholes.
Underconsumption is a theory in economics that recessions and stagnation arise from an inadequate consumer demand, relative to the amount produced. In other words, there is a problem of overproduction and overinvestment during a demand crisis. The theory formed the basis for the development of Keynesian economics and the theory of aggregate demand after the 1930s.
In economic policy, austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spending, raising taxes while cutting spending, and lower taxes and lower government spending. Austerity measures are often used by governments that find it difficult to borrow or meet their existing obligations to pay back loans. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures. Proponents of these measures state that this reduces the amount of borrowing required and may also demonstrate a government's fiscal discipline to creditors and credit rating agencies and make borrowing easier and cheaper as a result.
Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting, the acquisition by governments of goods and services for current use, to directly satisfy the individual or collective needs of the community, is classed as government final consumption expenditure. Government acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending, is classed as government investment. These two types of government spending, on final consumption and on gross capital formation, together constitute one of the major components of gross domestic product.
In economics, crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.
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