A look at whether higher government (fiscal) spending causes crowding out?
Crowding out occurs when government spending leads to a corresponding fall in private sector spending, therefore the higher government spending has no overall increase in domestic demand.
Readers Question: Examine the way in which fiscal spending inflates prices and crowds out private spending.
Government spending is a component of AD. Therefore, if we have an increase in Government spending, we would get an increase in AD (AD=C+I+G+X-M)
If AD increased faster than Aggregate Supply, we are likely to get an increase in inflation. We can show this with a simple AD / AS diagram.
Diagram Showing Inflation
Note, if AS increased at same rate as AD, then prices may not rise. But, if the fiscal spending causes growth to be above the long run trend rate inflation is very likely.
Fiscal Spending and Crowding Out.
An increase in government spending can cause crowding out.
1. Resource Crowding out.
To finance the increased government spending, the government need to borrow from the private sector. The Bank of England (through DMO) sell bonds, gilts and other securities to the private sector. Therefore, the private sector lend their money to the government. Therefore, it is argued that the government is increasing their spending, but only by reducing private sector spending.
2. Financial Crowding Out.
The other argument is that government borrowing puts upward pressures on interest rates. To attract enough people to buy bonds, the government need to raise interest rates, to attract enough savers; this can put upward pressure on general interest rates. The higher interest rates can cause lower private sector spending and investment. Resulting in lower private sector output.
Why Crowding Out May Not Occur
However, it depends on the economic situation. For example, in a recession and liquidity trap, governments can often borrow more from the private sector without causing crowding out.
In a recession, there is a rise in private sector saving. Therefore there is higher demand for buying government bonds (rather than saying buying riskier shares)