ALL Crowding-Out FRQ's

ALL Crowding-Out FRQ's

Understand that the College Board doesn't use the phrase Crowding-Out 
in the FRQ's but when Government (Deficit) Spending increases
it reduces the SLF or increases the DLF driving up the RIR (Real Interest Rate)
Private Investment is Crowded-Out of the Loanable Funds Market
In essence, these investors can't get cheap loans to create factories, equipment etc 
all because of the government borrowing
also,, taking it a step further

In the Long-Run
when RIR's increase there is less investment
less capital formation and less LR Growth

2014 AP Macroeconomics Exam

2010 AP Macroeconomics Exam

2008 AP Macroeconomics Exam

2005 AP Macroeconomics Exam

2003B AP Macroeconomics Exam

Interest Rate Sensitivity

Money Demand & Investment Demand

Interest Rate Sensitivity and Money Demand

If people's need (Demand) for money is more sensitive (elastic) to price level changes,, then when the price level increases the Demand for Money curve will shift rightward more,, therefore the Nominal interest rate will increase at a greater rate than if people's need (Demand) for money is less sensitive (inelastic) to price level changes.

 Interest Rate Sensitivity and Investment Demand

If people's investment demand is more sensitive (elastic) to interest rates,, then when the interest rates increase investment demand will decrease by a larger amount (think full crowding-out),, if people's investment demand is less sensitive (inelastic) to interest rates,, then when interest rates increase investment demand will decrease by a small amount (think partial crowding-out)

Crowding-Out

Crowding-Out

Reffonomics on Crowding Out Video

Definition: A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.

Simply put, The Federal Government spends more money than they have as revenue and to keep spending must borrow from the banks. How do they borrow? They sell Government Bonds. In selling these bonds cash is sucked out of the banks. Interest rates rise as there is less cash in the banks coupled with a larger demand for this cash. Rising interest rates slow the amount of investment in the economy.

The government has an expansionary policy and with its spending is trying to push AD aggregate demand higher, taking advantage of the multiplier. Spending raises interest rates that slows or even decreases (I) investment spending thus decreasing the effects of the multiplier.

Fiscal Policy Cheat Sheet here.

Lets look at examples of multiple choice questions:

2008 AP Multiple Choice

Answer - (decrease in private investment due to increased borrowing by the government)

2000 AP Multiple Choice

Answer - (C) higher interest rates decrease private sector investment

2005 AP Multiple Choice

Answer - (B) The decrease in consumption or private investment spending caused by an increase in government spending.

2010 AP Multiple Choice

Answer - (B) government borrowing to finance its spending decrease private sector investment.

1995 AP Multiple Choice

Answer - (A)

Tricky!

A tax cut is an expansionary fiscal policy. If the government decreases tax rates then it has less revenue. Less revenue means it must borrow to keep spending. The borrowing raises interest rates. Raising of interest rates will slow the amount of (I) investment which will keep GDP from increasing as much as expected, but it will increase. Just less than the government would have liked.

(Practice Question)

Answer - (B) Increasing the real interest rate

(Practise Question)

Answer - (C) Budget deficit increases

2010 FRQ#1

2010B FRQ#1

2008 FRQ#1

Blog post for 2008 FRQ#1 here.