Download Crowding Out Continued

Crowding Out Ct’d
AP Macroeconomics
Where did we come from?
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In a previous lesson, we discussed
Crowding-out, or the decrease in private
demand for funds that occurs when the
government’s demand for funds causes
the interest rate to rise.
That is, the demand by government for
loanable funds decreases or crowds-out
the private demand for loanable funds.
Analyze this…
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So let’s say the government
implements expansionary
fiscal policy. In turn, this
increases aggregate demand
(AD1). When aggregate
demand increases, so too
does money demand (MD1).
This causes the interest rate to
rise (which discourages
investment) and AD to
decrease because private
businesses reduce investment.
This is crowding-out!
Let’s also say that, to this
point, monetary policy has
not changed (MS). Could
monetary authorities do
anything to prevent the
reduction in investment?
MD1
MD
AD1
AD AD2
MS MS1
Where are we going?

We will further discuss
the market for loanable
funds, as well as the
Barro-Ricardo effect.
19th Century economist, David Ricardo, after
whom the Barro-Ricardo effect is named.
http://en.wikipedia.org/wiki/Political_economy
For starters…
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Another way to think of the phrase “demand
for [loanable] funds” would be to think of it
as the demand for private sector investment.
So, when we use this terminology during this
lesson, try substituting it with the latter.
Loanable Funds Market
D = private sector demand for
funds (Investment)
I and i are the initial equilibrium
values.
D + (G–T) = private + government
demand for funds
I1 and i1 are the new equilibrium
values.
I2 = new level of private
investment
I1 – I2 = government demand for
funds (G–T)
Note: The original curve is for
private sector only with no
borrowing or debt by the
federal government.
Visual 5.2 Unit 5 Macroeconomics
Also note: I1 is the new equilibrium interest
rate, and I2 is the quantity of loanable funds
demanded by the private sector at the new
equilibrium.
The Barro-Ricardo Effect
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An indirect effect of government budget deficits is the
possibility that these deficits will lead to an increase in
private savings and a decrease in consumption that offset
the predicted expansionary fiscal policy.

Why would this happen? Because people expect that
when the government runs a deficit [the government takes
in less than it puts out] it will increase taxes in order to
repay the money being borrowed. Thus, people (possibly)
save and consume less.
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This is called the Barro-Ricardo effect.
Who cares?

We do!

The Barro-Ricardo
Effect causes the
S2
supply curve for funds
to shift outward
(because there is less
demand), thus reducing
the increase in the
interest rate and the
decrease in private
sector demand for
Yipee! The Barro-Ricardo effect has
funds.
saved the day!
Visual 5.2 Unit 5 Macroeconomics
Why do we care?

Although there’s no
evidence that the BarroRicardo effect is significant,
the effect of crowding-out
can be particularly
significant, depending on the
following:


Elasticity of investment (that is,
the responsiveness of
investment to changes in the
interest rate)
And interest-sensitive
components of aggregate
demand.
http://www.worksmartmompreneurs.com/blog/inspiration/do-you-know-whyyour-why/
And now…
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Some resources:
Reffonomics:
http://www.reffonomics.com/
Morton workbook: Activity 44 Part B
Works Cited
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Economics of Seinfeld.
http://yadayadayadaecon.com/
Krugman, Paul, and Robin Wells. Krugman’s
Economics for AP. New York: Worth
Publishers.
Morton, John S. and Rae Jean B. Goodman.
Advanced Placement Economics: Teacher
Resource Manual. 3rd ed. New York: National
Council on Economic Education, 2003. Print.
Reffonomics. www.reffonomics.com.