170 Fiscal Policy, Investment, and Crowding Out
Learning Objectives
- Explain crowding out and its effect on physical capital investment
- Explain how economic growth is tied to investments in physical capital, human capital, and technology
Neoclassical economists believe we should focus attention on the long run (e.g. economic growth) and that the short run will take care of itself. We know that economic growth, defined as the percentage change in real GDP over time, comes about through increases in the quantity and quality of labor, physical capital, and technology—all set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. In this section, we will examine how fiscal policy can affect these variables.
Government borrowing can reduce the financial capital available for private firms to invest in physical capital. However, government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development that creates new technology.
Crowding Out Physical Capital Investment
When government conducts an expansionary fiscal policy (i.e. increases in government spending or decreases in tax rate, it may run afoul of the crowding out effect. Expansionary fiscal policy means an increase in the budget deficit. The government is spending more money than it has in income. Where does government obtain the necessary funds to cover it’s increased deficit? The answer is borrowing.
A larger budget deficit will increase demand for financial capital. The supply of funds in financial markets is the sum of private saving, government saving, and net investment by foreigners into domestic financial markets. If private saving and net foreign investment remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital (i.e. increased budget deficit means a reduction in government saving), the result is crowding out.
The Interest Rate Connection
Let’s look at the details of how crowding out occurs. A larger federal budget deficit requires increased government borrowing in financial markets. How will this affect interest rates in financial markets? In Figure 1, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.
Higher interest rates tend to reduce private investment in physical capital. The new factory that made sense when a company could borrow the necessary funding at 5%, no longer ma