In macroeconomics I came across two type of crowding out. First, in IS LM model where in classical case, when LM curve is vertical increase in government expenditures have no increase in output i.e. full crowding out. Secondly, in AS AD model due to increase in government expenditures when AD curve shift in classical case i.e. Vertical AS curve there is no effect on output. What's the difference between these two cases of full crowding out.
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$\begingroup$ Is the second a case of crowding out, or is it a case of an economy at its LRAS - in what case aggregate demand can only impact prices, not output? $\endgroup$– hehNov 19, 2019 at 20:11
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2 Answers
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A vertical LM curve means that any change in government expenditure will result in a change of the interest rate which exactly offsets the initial change of public demand (private demand increases/decreases).
A vertical AS curve indicates the level of long-run output. If AD shifts, all that this will create is a change in prices in the long-run. This is also called the Classical Dichotomy: real variables are independent of monetary variables.
So, both diagrams tell the same story about crowding out: changes of private expenditure offset changes of public expenditure. The diagrams just highlight different parts of the same mechanism.
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Repeating from another answer:
Can a fully-financially-sovereign central government use its monopoly power of currency insurance to purchase up a massive amount of real resources, therefore making it such that there are fewer available for the private (non-government) sector to purchase? Yes. That is possible. If you call that crowding out, then crowding out is possible.
If, however you’re talking about any and all government spending “crowding out“ private sector lending based on the assumption of “loanable funds,” then, no, this kind of crowding out does not exist. The idea of loanable funds assumes that there is only a finite pile of money available to both the government and private sector, from which they can “borrow.”
As long as the real resources are available for purchase, federal government spending crowds in (augments) private spending. This idea of crowding out is false and predicated on three other false ideas. Briefly, it incorrectly assumes that:
- the central government is a user of its own currency,
- banks are revenue/reserve constrained (loanable funds), and
- the interest rate is an axiomatic function of the free market.
The truth is that:
- the central government issues currency every time it spends (even when it sells bonds, which is very misleadingly called “borrowing”),
- banks issue credit every time they lend, and
- the interest rate is a policy variable of the Fed’s FOMC board. (They change it because they want to change it.) Further, since the central bank has the infinite capacity to purchase and sell bonds on the open market, they therefore have infinite control over the market interest rate.
In summary: Real crowding out is possible, financial crowding out is not.
