Crowing Out of Investment Vs Crowing Out of Investment

Crowing Out of Investment Vs Crowing Out of Investment

Subject: Economy

Context: Concerns about high government borrowings crowding out the private sector’s fundraising efforts were misplaced and not based on evidence, Chief Economic Advisor Krishnamurthy Subramanian asserted on Thursday reacting to comments made by a member of the Securities and Exchange Board of India (SEBI)

Concept:

Crowing Out of Investment

• This refers to a phenomenon where increased borrowing by the government to meet its spending needs causes a decrease in the quantity of funds that is available to meet the investment needs of the private sector.

Factors which make crowding out more likely

1. Expansionary fiscal policy means an increase in the budget deficit. This will lead to increase in government 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.
2. Higher government borrowing increases the interest rates. Increased interest rates lead to a reduction in private investment spending.

Crowing in of Investment

• Crowding in occurs when higher government spending leads to an increase in private sector investment.
• The crowding in effects occurs because higher government spending leads to an increase in economic growth and therefore encourages firms to invest because there are now more profitable investment opportunities.
• Crowding in may prove to be a temporary effect.

Factors which make crowding in more likely

• Recession. If the economy is in recession, there are unused private sector savings. Therefore, if the government borrows from the private sector, then it doesn’t reduce private sector investment because there is still sufficient levels of savings.
• Induced saving. If expansionary fiscal policy leads to a significant increase in economic growth, then this will lead to higher incomes and higher level of savings. This growth and higher savings will increase private sector investment, at least in the short-term.
• High multiplier effect. If there is a high multiplier effect of increased spending, there will be more crowding in. The size of the multiplier effect depends on marginal propensity to consume (MPC)
• Deflation/liquidity trap. If there is deflation (fall in prices) and interest rates are at the zero bound rate, then higher government borrowing is unlikely to have any effect on pushing up interest rates. In a situation of deflation, real interest rates (nominal rates -inflation) may be quite high. Therefore, if government spending reduces deflation, it may actually help to reduce real interest rates and therefore increase private sector investment