Crowding Out

What is it?

•   A critique falls of Keynesian policies that are applied to fight a recession. (An expansionary policy)

Why does it happen?

·   The policy of cutting taxes and raising spending will create a budget deficit.

So?

•   The budget deficit must be funded and to do this Congress orders the sale of US bonds. (This is NOT a Monetary Policy tool used by the Fed)

This money comes from? 

•   Mostly from US citizens and companies and investment firms.

Therefore?

·      Money that could be spent on consumption or used for Private Savings is now being used to buy bonds.

On the Money Market?

·      This will cause the $ demand curve to shift outward. Remember this is a Fiscal event!

On the Loanable Funds Market? 

•   This will cause the supply curve to shift inward because we are not saving money privately anymore.

Also, on the Loanable Funds?

•   This can cause the demand curve to shift outward because the private and public demand for $ increases.

On both graphs?

•   The nominal and real interest rate will increase.

Therefore, on the investment D graph

•   The increase in nominal and real interest rates will cause Ig to decrease.

Isn't this counterproductive? 

•   Yes

Why do it? 

•   Fiscal Policy supporters (Keynesians) insist that gains in consumption (C) and spending (G) will outweigh any loss in the future Ig.

Why?

•   C and G are greater than IG and they are short run improvements. IG is longer run and Keynesians don't worry about that. In the long run we are all dead.

Anymore?

Yes, this is summarized on the Aggregate Model. The AD will move outward due to the increases in C and G and the "maybe" move inward due to a loss of IG, but not as much as the increase. Therefore, the economy improves.