What is the crowding out effect and what does it mean for how effective fiscal policy is?
the crowding out effect refers to the possible effect that a government deficit-financed fiscal policy may have on real interest faced by the private sector. Its effect is a reduction in the desired effect of expansionary fiscal policy.
To finance fiscal policy to improve the aggregate demand in a nation, the government will have to borrow by issuing government bonds (certificate of debt from government to investor) to provide external funds to finance current expenditures and it does so by increasing the interest rate on bonds to make them more appealing to investors. Investors in turn take finance out of commercial banks to buy bonds.
As seen in graph 1 this means the supply of loanable funds in commercial banks will decrease, shifting private spending from Qe to Q1. The gap indicates the private sector spending being crowded out by investment in government bonds.
On a macroeconomic scale this means, as shown in graph 2, that while the AD curve might still shift outward, it might not do so as much as expected due to the I (investment) variable decreasing while the G (government spending) variable increases.
