How does contractionary fiscal policy lead to the opposite of the crowding-out effect?

According to general equilibrium models in contemporary macroeconomics, expansionary fiscal policy could cause crowding out of private activity in the credit market. This argument also flows the other way: Contractionary policy could allow for increased private activity in the credit market. This phenomenon is sometimes referred to in the literature as “crowding in.”

Understanding Contractionary Fiscal Policy

Fiscal policy refers to a government’s spending and taxing habits. There are two kinds of fiscal policy direction: contractionary and expansionary. Think of contractionary policy as anything that directly reduces government deficits or increases surpluses. Expansionary policy involves activity that directly increases deficits or reduces surpluses.

After a tax increase, the government’s balance sheet shows more revenue. Similarly, a spending cut is contractionary because it reduces expenditures. According to standard measurements of gross domestic product (GDP), contractionary fiscal policy seemingly reduces total output. Taxes tend to reduce private consumption just as spending cuts reduce government consumption.

Understanding Crowding out and Crowding In

Suppose the federal government increases its fiscal expenditures by $100 billion in a given year. If taxes are politically unpopular, the government normally finances extra spending through borrowing. The federal government borrows money by issuing U.S. Treasuries. In this case, the government issues $100 billion worth of Treasuries. That directly absorbs $100 billion from the credit market, money that might otherwise have been spent on other investments or consumer goods. Public issues take place by crowding out potential private issues.

Moreover, an influx of government debt securities affects interest rates and asset prices. If private individuals are induced to increase their savings to purchase government debt, the real interest rate tends to rise. When real interest rates rise, it is more difficult for individuals and small companies to obtain loans.

In a similar fashion, a decrease in government borrowing could leave more money for private investments. Less pressure on interest rates means more room for small borrowers. In the long run, less government spending often means fewer taxes, further increasing the pool of available funds for private markets.

If the government’s contractionary fiscal policy leads to surplus, the government can act as a creditor rather than a debtor. The effects of this are no more certain than the effects from deficit spending, but all economists agree it will have some impact.

Two Types of Crowding In

Some economists have argued that, under the right circumstances, an expansionary government policy might produce crowding in instead of crowding out. If, as Keynesian economists propose, an increase in aggregate demand creates economic expansion, then businesses find it profitable to add to capacity. This boost to the markets, called induced investment, might be stronger than the crowding-out effect.

This is a very different argument than the traditional crowding-in effect, which results from a contractionary fiscal policy. Each argument has its proponents and critics. To further complicate things, some economists allow for a crowding-in effect but disagree about its magnitude and long-term effects.

(For related reading, see “What Is Fiscal Policy?“)