Question

The increase of budget deficit, decreases the supply of loanable funds and the supply curve shifts left. Discuss the possible effects of this crowding out effect in an open economy.

Answer 1

Let's see some of the effects of this crowding out in the economy:

• Increase in taxation. As the government budget deficit increases due to borrowing, we know that the loanable funds reduce. An increase in taxation leads to lesser savings and thus lesser consumption. Thereby a balance is achieved in the aggregate demand, as the rise in government spending is equalized by the fall in household consumption.
• Surge in government borrowing from private sector. The financing for the same is done by selling bonds to the private sector. After they buy these bonds, they are not allowed to use the money to channelize private investment. Thereby 'crowding out' of private sector investment occurs in a massive scale.
• Higher interest rates. This is similar to the first point. To offset the increase in government spending, the banks tend to higher the interest rates to reduce consumption.

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