Principles of Macroeconomics / Unit 15 MAC 1415 worked example, 60 to 90 seconds
Severe or Slight
The idea
Given the economy's position and the central bank's response, say whether crowding out will be severe or slight, and why. Two questions settle it: where is output relative to potential, and is the bank leaning with the fiscal expansion or against it? The interest rate is where the two policies meet.
In practice
Output is near potential and the government borrows heavily. The bank, worried about inflation, sells bonds and raises rates. Government borrowing already pushed rates up and the bank pushes them further, so investment falls substantially: crowding out is severe. Now output is far below potential with rates near zero. The government borrows heavily and the bank holds rates down, buying bonds as needed. Rates barely move, investment barely falls, and crowding out is slight. The borrowing was the same in both cases.
Where people slip
Slight crowding out is not free. The identity still requires a margin to adjust, so if investment does not fall then saving must rise or the inflow from abroad must, and the inflow is a claim on future output. The bank changed which margin moved and could not change that one had to.
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