Economics “Ask the Instructor” Clip 76 Transcript What is crowding out? Crowding out refers to the tendency for an increase in one sector’s spending to cause a reduction in another sector’s spending. Crowding out is most often discussed in the context of fiscal policy, particularly the effect that increased government spending has on the economy. Classical economists and Keynesian economists disagree about many things, and crowding out is one of them. However, there is substantial agreement today that an increase in government spending is likely to have little or no effect on the overall level of real economic activity in the long run. A given government expenditure might cause private-sector spending to decrease if what is provided by government is exactly what households or businesses had planned to purchase for themselves. For example, suppose that you were intending to buy a pair of brown shoes, and government buys the shoes and gives them to you. You would likely not buy them. In this case, complete crowding out would occur. Or, suppose that the private-sector utility industry had planned on investing in plant and equipment in order to provide electricity to a region of the rural South. But what if government got into the electricity generating and distribution business? The private investment would not occur. This is basically what happened in the Tennessee River Valley in the 1940s as a result of the creation of TVA. The type of crowding out in these examples is often called direct crowding out. It happens when government spends on the same kinds of goods and services that the private sector would have provided. A second kind of crowding out is less direct. It occurs as a result of government borrowing. When government increases its spending but does not raise taxes, it must borrow. This drives up interest rates, which discourages borrowing by households and businesses. For example, if government borrows to finance a missile defense system and interest rates increase, households finance fewer purchases of consumer durables such as new cars and refrigerators, and businesses cut back on their financing of new plant and equipment. The likelihood and magnitude of the crowding-out effect is controversial. Classical economists believe that it is likely to occur and that it weakens the ability of government to stimulate the economy using fiscal policy. Keynesians recognize that crowding out can occur, but they think it is unlikely to be complete.