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Chapter 27: Problem 2

What is meant by "crowding out"? Explain the difference between crowding out in the short run and in the long run.

Short Answer

Expert verified
Crowding out refers to when government spending and borrowing reduces private sector spending and investment. The primary difference between crowding out in the short run and the long run lies in the immediacy and nature of effects. Short-term crowding out occurs immediately and is usually due to increased interest rates making borrowing more expensive for the private sector. Long-term crowding out occurs over a longer time frame and is characterized by reduced economic growth due to less private sector investment caused by high levels of government borrowing.

Step by step solution

01

Understanding Crowding Out

Crowding out is an economic theory stipulating that increase in public sector spending drives down or even eliminates private sector spending. This concept is based on the fact that when the government spends more, there's less money available for private sector investments, hence the term 'crowding out'. It can occur as a result of higher interest rates or when government borrowing reduces available financial capital for the private sector.
02

Exploring Short-Term Crowding Out

In the short run, an increase in government spending could lead to an immediate rise in interest rates due to higher demand for funds. This increase in interest rates could lead to a reduction in private sector investment as borrowing becomes more expensive. This immediate impact on the private sector due to changes in government spending is referred to as short-term crowding out.
03

Understanding Long-Term Crowding Out

In the long run, crowding out could have more indirect effects. When government spending remains high for prolonged periods, it leads to increased borrowing, which can reduce the savings available for private investment. Over time, this can lead to slower economic growth as private sector investment is key to driving innovation and efficiency.

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Most popular questions from this chapter

Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long-run growth rate of real GDP. a. Is this outcome most likely to occur if the private spending being crowded out is consumption spending, investment spending, or net exports? Briefly explain. b. In terms of its effect on the long-run growth rate of real GDP, would it matter if the additional government spending involves (i) increased spending on highways and bridges or (ii) increased spending on national parks? Briefly explain.

(Related to Solved Problem 27.6 on page 971 ) A 2015 article in the Wall Street Journal noted that an official of the European Union was forecasting that "Greece faces two years of recession amid sharp budget cuts." What typically happens to a government's budget deficit during a recession? Do governments typically respond with budget cuts as the Greek government did? Briefly explain.

Identify each of the following as (1) part of an expansionary fiscal policy, (2) part of a contractionary fiscal policy, or (3) not part of fiscal policy. a. The corporate income tax rate is increased. b. Defense spending is increased. c. The Federal Reserve lowers the target for the federal funds rate. d. Families are allowed to deduct all their expenses for day care from their federal income taxes. e. The individual income tax rates are decreased.

Why can a \(\$ 1\) increase in government purchases lead to more than a \(\$ 1\) increase in income and spending?

The federal government collected less in total individual income taxes in 1983 than in \(1982 .\) Can we conclude that Congress and the president cut individual income tax rates in 1983 ? Briefly explain.
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