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The Crowding-out Effect When public expenditure replaces private Critics of the use of government expenditure to stimulate output and employment often refer to the problem of crowding out. In its starkest form, the argument goes like this. There is no point in the government embarking on a programme of public works to bring the economy out of recession. If it attempts to spend more, it can do so only by reducing private expenditure. The effect on total spending will be zero. This crowding out can take two main forms. Resource crowding out This is when the government uses resources such as labour and raw materials that would otherwise be used by the private sector. If the economy is operating near full capacity, then if resources are used by the government, they cannot at the same time be used by private companies. The argument is far less convincing, however, if there is slack in the economy. If the government merely mobilises otherwise idle resources, there need be no reduction in private-sector output. In fact, if private-sector firms have spare capacity, they will respond to the higher demand by producing more themselves: aggregate demand will stimulate extra production. Financial crowding out This occurs when extra government spending diverts funds from private-sector firms and thus deprives them of the finance necessary for investment. If the government spends more (without raising taxes or printing more money), it will have to borrow more and will therefore have to offer higher rates of interest. Private companies will then have to offer higher rates of interest themselves in order to attract funds. Alternatively, if they borrow from banks, and banks have fewer funds, the banks will charge them higher interest rates. Higher interest rates will discourage firms from borrowing and hence discourage investment. The weakness with this argument is that it assumes that the supply of money is fixed. If the government spends more but increases the amount of money in the economy, it need not deprive the private sector of finance. Interest rates will not be bid up. But would that not be inflationary? Not if there are idle resources and hence the extra money can be spent on extra output. Only if resource crowding out takes place would it be inflationary. Question Could resource crowding out take place at less than full employment? Fiscal and monetary policy together If fiscal and monetary policies are used together, they are much more likely to be successful. For example, if there is a recession, the government may cut taxes or increase government expenditure in order to expand aggregate demand. This could lead to crowding out, however, unless the central bank simultaneously pursues an expansionary monetary policy, so that any increase in the public-sector deficit is financed by an expansion in the money supply. The central bank could go further and actively cut interest rates. The policies reinforce each other. The expansionary monetary policy helps to ensure that increased public borrowing is not at the expense of private-sector consumption and investment. The expansionary fiscal policy helps to ensure that increased money is actually spent.