While a fiscal expansion is unlikely to occur, given the continually growing economy, it is still important to understand how fiscal policy affects the economy as a whole. Expansionary fiscal policy can be wonderful and really helpful during economic downturns. In fact, lowering taxes and increasing government spending are pretty much the only two ways that the government affects GDP. So what exactly happens when the government increases spending above taxes? Well, we should see an increase in overall GDP and total income in the economy. The government’s initial injection into the economy is also amplified by a multiplier, as the people will continue to spend their income, thereby becoming someone else’s income. However, like most things in economics—and to some degree life—there must be a downside.
This brings us to the problem of crowding out. Crowding out is a concept in macroeconomics where an increase in government spending as a component of GDP “crowds out” investment spending from the market place. Expansionary fiscal policy causes an increase in output from the goods side of the economy. As the level of income in the economy expands, and the money supply stays constant, there is upward pressure on interest rates. Therefore, interest rates increase as the government engages in expansionary fiscal policy. With this in mind, it’s generally accepted that firms are sensitive to changes in the interest rate. If the interest rate goes up, it becomes more expensive for firms to take out loans to finance the purchasing of new plant equipment and capital. This increase in the interest rates leads to a “crowding out” effect, where government spending replaces private investment spending on new plant equipment.
Crowding out is problematic for a couple reasons. When the economy is at full employment, there is a maximization of the crowding out effect. If we look at the aggregate demand-supply schedule, an increase in GDP caused by expansionary fiscal policy will cause an expansion in aggregate demand and income. In addition to an increase in the interest rates, this fiscal expansion will cause the economy to move past potential GDP thereby increasing the price level. This increase in prices reduced real money balances causing a contraction in the money markets. Here, the crowding out effect is maximized, as both the price level and the interest rates. If the economy is not at full employment, there will still be an increase in the interest rate. However, income will rise without a rise in the prices. In addition, there is also a preference to the private sector and a notion that crowding out the private sector will stifle creativity.
Determining whether or not we are at full employment is tough. Recently the Fed chose to increase interest rates to a higher level due to key economic indicators hitting specific points. These include unemployment at 4.8 percent, and the consumer price index at 2.5 percent year-over-year. However, there are those who argue that we are not at full employment, as indicated by high levels of underemployment, low wage pressures, and low employment rates. While Classicals believe that we are always at full employment, it is tricky when to determine when the government can increase spending, as an increase in spending at full employment would be catastrophic to both prices and the interest rate. This would allow for a full crowding out effect.
Those who are fearful of crowding out ignore two important pieces of information and argument. One, proponents of the crowding out argument do not address the level of interest and believe that all government spending is treated equally. If interest rates are already at record lows—as seen for the past seven years following the recession—a minimal increase in interest rates may, in fact, be warranted. During times of low-interest rates, especially when yields on 10-year Treasury bonds is low, it is perhaps the perfect time for a fiscal expansion. Here, ultra-low interest rates have room to rise, and the government can borrow money at the most inexpensive rate possible. In this regard, the government can expand income, while not worrying too much about crowding out because interest rates are so low. In addition, debt incurred by the federal government will be minimized. Furthermore, crowding out can be minimized if the Federal Reserve enacts expansionary fiscal policy to accommodate the rise in the interest rate. If the Fed increases the money supply, the LM curve will shift to the right and intersect the IS curve at a lower interest rate.
The second important piece of information that is ignored by proponents of the crowding out argument is that historically, public sector spending has not stifled creativity. In The Entrepreneurial State: Debunking Public vs. Private Sector Myths, Mariana Mazzucato argues that the public sector has actually brought us some of the most influential pieces of technology. She cites the creation of the iPhone as a product of government grants and subsidies and notes the numerous consumer technologies that were created as a result of government spending, most notably the electric screwdriver and ballpoint pen. That noted, while government spending has helped to lay the groundwork for innovations in the private sector, government spending typically isn’t the genesis of these innovative ideas.
While government spending has the ability to decrease investment spending in the economy and push out the private sector, if done under the correct circumstances, it can expand income and have a minimal effect on the interest rate. The crowding out effect will be heavily minimized while the benefits maximized, so long as the economy is not at full employment, and the expansion is accommodated by expansionary monetary policy during a period when it is inexpensive for the U.S. government to borrow. Nonetheless, there are challenges to expansionary fiscal policy, some of which may stifle creativity and prevent the technological creations that a strong private sector has fostered.
Bernstein, Jared. 2017. “Three Reasons We’re Not yet at Full Employment.” Washington Post. Accessed April 5. https://www.washingtonpost.com/posteverything/wp/2017/02/09/three-reasons-were-not-yet-at-full-employment/.
Derby, Michael S. 2017. “Fed Officials: March Rate Increase ‘on the Table.’” Wall Street Journal, March 1, sec. Economy. https://www.wsj.com/articles/fed-officials-rate-increase-on-the-table-1488323157.
Dornbusch, Rudiger, Stanley Fischer, and Richard Startz. 2013. Macroeconomics. 12th ed. New York: McGraw-Hill Economics.
Harrison, David. 2016. “Government Spending Cuts Escalate Clashes Over Monetary Policy.” Wall Street Journal, April 10, sec. Economy. http://www.wsj.com/articles/government-spending-cuts-escalate-clashes-over-monetary-policy-1460312664.
Mazzucato, Mariana. 2015. The Entrepreneurial State: Debunking Public vs. Private Sector Myths. Revised Edition. New York: PublicAffairs.