<p>Just to add some more besides the answers above:</p>
<p><em>Short answer: by influencing interest rate.</em></p>
<p>Explanation:
In the post Keynesian literature what has come to be appreciated a lot is that government purchases, <em>backed by increased government debt</em>, increases interest rate. Why? Well, that's in itself an interesting explanation and perhaps should be a separate question (interesting, because contrary to what people think that &quot;more govt borrowing means more govt bonds in the market, means lower bond prices and hence higher interest rates&quot; is not at all a satisfactory explanation).</p>
<p>Private investments are assumed to be a function of interest rate. So some of the investment projects (particularly, those at the margin) that were earlier profitable may not be anymore due to increase in interest rate.</p>
<p>This is what is essentially, <strong>crowding out</strong> of private investment.</p>
<p>This does not require the assumption that <em>Savings</em> have to be fixed. Instead, in Keynesian framework, what happens is that <span class="math-container">$Y, S, C$</span> all goes up (because crowding out is not necessarily full, depending on the interest elasticity of money demand - slope of LM curve). It's just the share of <span class="math-container">$G$</span> increases and that of <span class="math-container">$I$</span> decreases.</p>
<p>Coming to your assessment that historically, at least during some periods, <span class="math-container">$I$</span> and <span class="math-container">$G$</span> have been found to be positively correlated. Indeed, investment is not <em>just</em> a function of interest rate. It is also a function of sentiments of future of the economy. When govt's start building infrastructure or take measures to improve supply constraints it boosts the confidence in the economy and encourages investment.</p>
<p>That doesn't make concept of <em>crowding out</em> incorrect. Because the concept is applicable when, <em><strong>ceteris paribus</strong></em>, <span class="math-container">$G$</span> increases.</p>
<p>Lastly, your own idea that &quot;the capital and labor in the economy is limited, and if the government is spending more money to use capital goods and labor, then there are less capital goods to go around for the investment.&quot; is the somewhat closer to the <strong>classical</strong> view. This assumes that economy is at its full potential and there are no rigidities in the labour market. Without going into details, this view over the year has been seriously challenged. However, it should still be considered as an alternative explanation.</p>

CC BY-SA 4.0
2020-09-29T14:36:36.307Z
Federal spending influences the interest rate only as much as the voting members at the central bank want it to. The Fed’s target rate is a policy variable – meaning, it’s whatever they want it to be. https://www.dropbox.com/s/759h1yrxyxs2j56/Fullwiler-Interest%20Rate%20on%20the%20National%20Debt%20Is%20a%20Policy%20Variable.pdf?dl=0
aliteralmind
CC BY-SA 4.0
2020-09-29T15:20:55.870Z
One, what happens in US should not be generalized. Two, when federal spending is expanded by financing the deficit, in theory, it means it is accompanied by monetary expansion. So $G$ has not increased *ceteris paribus* and hence the concept is not directly applicable. Three, if voting members do decide to not monetize the increased spending then also the market interest rates will move. Fed having target rate does not mean interest rate cannot be moved by market forces, but just that Central bank can also influence it. The concept refers to impact of market forces.
Dayne
CC BY-SA 4.0
2020-09-29T15:29:04.370Z
FOMC members have no part in the decision whether to sell or purchase bonds, as it relates to accompanying new federal spending. They can only decide the target interest rate. The central bank, however, has the infinite capacity to purchase or sell bonds on the open market, so yes, in all but the shortest of terms, they do indeed have the infinite capacity to bend market rates to their will. As I understand it, everything I’ve said, both in these comments and in my above answer, is true for all [fully-sovereign](http://citizensmedia.tv/mmt-developing-nations) currency issuers.
aliteralmind
CC BY-SA 4.0
2020-09-29T13:47:37.313Z
2020-09-29T13:47:37.313Z
Dayne
<p>Can a <a href="http://citizensmedia.tv/mmt-developing-nations" rel="nofollow noreferrer">fully-financially-sovereign </a>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.</p>
<p>If, however you’re talking about <em>any and all</em> 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 <em>and</em> private sector, from which they can “borrow.”</p>
<p>As long as the real resources are available for purchase, <a href="http://citizensmedia.tv/mmt-crowding-out" rel="nofollow noreferrer">federal government spending crowds <em><strong>in</strong></em> (augments) private spending</a>. This idea of crowding out is false and predicated on three other false ideas. Briefly, it incorrectly assumes that:</p>
<ol>
<li>the central government is a user of <em>its own</em> currency,</li>
<li>banks are revenue/reserve constrained (loanable funds), and</li>
<li>the interest rate is an axiomatic function of the free market.</li>
</ol>
<p>The truth is that:</p>
<ol>
<li>the central government issues currency every time it spends (<a href="http://neweconomicperspectives.org/2010/11/yes-deficit-spending-adds-to-private.html" rel="nofollow noreferrer">even when it sells bonds</a>, which is <a href="http://citizensmedia.tv/mmt-securitization" rel="nofollow noreferrer">very misleadingly</a> called “borrowing”),</li>
<li>banks issue credit every time they lend, and</li>
<li>the interest rate is a <a href="https://www.dropbox.com/s/759h1yrxyxs2j56/Fullwiler-Interest%20Rate%20on%20the%20National%20Debt%20Is%20a%20Policy%20Variable.pdf?dl=0" rel="nofollow noreferrer">policy variable</a> 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.</li>
</ol>
<p>In summary: Real crowding out is possible, financial crowding out is not.</p>

CC BY-SA 4.0
2020-09-29T13:50:24.160Z
"the central government issues currency every time it spends," - doesn't it assume that govt *always* monetizes its deficit - which of course is not true. Most govts *borrow* to spend beyond its revenues.
Dayne
CC BY-SA 4.0
2020-09-29T14:25:18.373Z
The revenue from bond sales (very misleadingly called “borrowing”) is not ever collected and then used for future respending. It is destroyed, as all federal revenue is. Bond sales are only used for draining reserves, which is how the central bank manages their target rate. (With a side effect of providing risk-free interest income for the rich, and disemploying millions of poor people.) Bond sales are not at all borrowing in the sense meant by average people. This post contains several academic references: http://citizensmedia.tv/mmt-securitization
aliteralmind
CC BY-SA 4.0
2020-09-29T14:27:31.727Z
All federal spending is money creation. All federal revenue is money destruction. Bond sales occurring or not occurring don’t change this reality. Bond sales have NEVER changed this reality.
aliteralmind
CC BY-SA 4.0
2020-09-29T14:31:10.490Z
Federal spending adds net financial assets to the non-government sector even when bonds are sold: http://neweconomicperspectives.org/2010/11/yes-deficit-spending-adds-to-private.html
aliteralmind
CC BY-SA 4.0
2020-09-29T14:40:37.853Z
Links added to the post.
aliteralmind
CC BY-SA 4.0
2020-09-29T14:55:01.373Z
So, to be clear: No. I am not assuming anything regarding the government monetizing its deficit. Currency is issued in all cases, whether bonds are sold (or purchased) or not.
aliteralmind
CC BY-SA 4.0
2020-09-29T15:24:36.127Z
Ok I may be wrong. But just to understand properly, could you please explain how sale of new bonds by the govt creates money (or how is the revenue from bond sales destroyed)? Maybe there's something about the US economic system that is different. I happen to work in a country's Central bank and know for sure that it doesn't happen in most economies
Dayne
CC BY-SA 4.0
2020-09-29T15:38:16.273Z
The sale of new bonds does not create money. All federal spending is money creation, regardless of bond sales or purchases. The specifics of the case of the US can be found in [this 1998 paper by Stephanie Kelton](http://www.levyinstitute.org/publications/can-taxes-and-bonds-finance-government-spending) and this [2014 paper by Eric Tymoigne](http://www.levyinstitute.org/publications/?docid=2008). But as I understand it, this (everything in both my comments and answer) is indeed the case in all [fully-financially sovereign economies](http://citizensmedia.tv/mmt-developing-nations).
aliteralmind
CC BY-SA 4.0
2020-09-29T15:39:48.010Z
Fully-financially-sovereign economies include the US, UK, Australia, Canada, Japan, New Zealand, etc.
aliteralmind
CC BY-SA 4.0
2020-09-29T15:42:42.503Z
To put it succinctly, the revenue from federal bond sales and taxation is destroyed in exactly the same manner as the 100 is “destroyed” after doing 1000-100=900 on a calculator.
aliteralmind
CC BY-SA 4.0
2020-09-29T16:24:21.433Z
@Dayne you are actually correct that not all government borrowing creates new money. Aliteralmind is promoting MMT which is fringe and among most economists not accepted theory, that argues that government should fund all its spending with new created money and probably Aliteralmind confused that for saying that all government debt is actually funded that way which it is not in the US. https://scholar.harvard.edu/files/mankiw/files/skeptics_guide_to_modern_monetary_theory.pdf
WilliamT
CC BY-SA 4.0
2020-09-29T16:39:19.243Z
Brian Romanchuk, [A Skeptics Guide To Mankiw's Skeptic's Guide To MMT](http://www.bondeconomics.com/2019/12/a-skeptics-guide-to-mankiws-skeptics.html): "The most natural way to approach a body of new theory is to pick up a textbook. It is exactly my mode of operation. The only issue here is that Macroeconomics is an undergraduate textbook.... Correspondingly, I think the implied claim in the title ‘Guide To Modern Monetary Theory’ needs to be viewed to be closer to ‘A Discussion of the MMT Macroeconomics Textbook.’...
aliteralmind
CC BY-SA 4.0
2020-09-29T16:39:44.540Z
...Since the textbook is an academic work that needs to stand up to scrutiny, this narrowing of focus is legitimate.... I would paraphrase Mankiw's criticism of MMT as follows: if we assume that neoclassical theory is correct, MMT is either incorrect (where it contradicts neoclassical theory) or trivial.”
aliteralmind
CC BY-SA 4.0
2020-09-29T16:40:15.880Z
Original MMT developer, Australian economist Bill Mitchell. [A response to Greg Mankiw – Part 1](http://bilbo.economicoutlook.net/blog/?p=43900) "It says very little about MMT. It demonstrates how hard it is for someone deeply locked into a dominant but failing paradigm to think outside the ‘box’ for a while and try to understand that the ideas of a new and emerging paradigm cannot be meaningfully reduced back into the conceptual framework of the failing paradigm that the contender is seeking to usurp."
aliteralmind
CC BY-SA 4.0
2020-09-29T16:42:05.447Z
It’s so much easier to dismiss as “fringe” than to engage on the theory itself.
aliteralmind
CC BY-SA 4.0
2020-09-29T16:54:30.883Z
Here are some actual, good-faith criticisms with responses: https://citizensmedia.tv/mmt-criticism. The Mankiw piece isn’t one of them.
aliteralmind
CC BY-SA 4.0
2020-09-29T17:04:14.103Z
MMT “argues that government should fund all its spending with new created money...” That’s incorrect. MMT argues that all federal spending *already is* newly created money (issued currency), whether bonds are sold or not. In the US, this is the case since the first dollar was created in the 1790s. It’s the only possible way for the federal government to spend.
aliteralmind
CC BY-SA 4.0
2020-09-29T20:32:10.703Z
Important clarification: the government can of course buy up all the actual resources that it wants, which indeed would put pressure on the non-government sector regarding those same resources. That’s not what I’m referring to. There is no such thing as loanable funds, and therefore it is not *inherent* that *any* federal spending crowds out an existing pile of loanable funds, therefore crowding out non-government sector borrowing. The latter is what I’m referring to. It‘s possible that the question is more referring to the former. I’ve updated the post.
aliteralmind
CC BY-SA 4.0
2020-09-29T22:35:20.703Z
I’ve better rewritten the answer.
aliteralmind
CC BY-SA 4.0
2020-09-30T03:23:27.523Z
@WilliamT: thanks for this clarification. Didn't know about MMT. Will not bother to read the links shared now.
Dayne
CC BY-SA 4.0
2022-03-22T09:48:13.123Z
@Dayne - I think it's better to engage with the theory to decide on its validity. I think MMT has a lot of useful things to say. I wouldn't just dismiss it out of hand.
Studi
CC BY-SA 4.0
2020-09-16T13:11:19.803Z
2020-09-29T22:39:15.903Z
2020-09-29T22:39:15.903Z
aliteralmind
<p>I am curious about <em>how</em> government purchases crowd out the private sector (if it does). If we look at a graph of the composition of US GDP, it seems that government purchases and investment are somewhat negatively correlated. It's obvious during WWII that government purchases skyrocketed while investment shrank significantly.</p>

<p>I am wondering about the intuition behind why this happens. If I had to guess, it's because at a given snapshot in time, the capital and labor in the economy is limited, and if the government is spending more money to use capital goods and labor, then there are less capital goods to go around for the investment. Is that line of thinking correct?</p>

CC BY-SA 4.0
2019-01-24T09:41:35.327Z
Your question doesn't reflect a clear crowd out effect.  You can find the answer from this wikipedia page. 
https://en.wikipedia.org/wiki/Crowding_out_(economics)
mootmoot
<gdp><investment><government-spending>
How do government purchases crowd out the private sector?
Vasting
# How do government purchases crowd out the private sector?

(Asked by: username_0 on 2019-01-24)

I am curious about *how* government purchases crowd out the private sector (if it does). If we look at a graph of the composition of US GDP, it seems that government purchases and investment are somewhat negatively correlated. It's obvious during WWII that government purchases skyrocketed while investment shrank significantly.

I am wondering about the intuition behind why this happens. If I had to guess, it's because at a given snapshot in time, the capital and labor in the economy is limited, and if the government is spending more money to use capital goods and labor, then there are less capital goods to go around for the investment. Is that line of thinking correct?

**Tags:** gdp, investment, government-spending

> **Comments:**
> **username_1**: Your question doesn't reflect a clear crowd out effect.  You can find the answer from this wikipedia page.  https://en.wikipedia.org/wiki/Crowding_out_(economics)  

---

## 2 answers

### Answer by username_2 on 2020-09-29. Score: 2

Just to add some more besides the answers above:

*Short answer: by influencing interest rate.*

Explanation:
In the post Keynesian literature what has come to be appreciated a lot is that government purchases, *backed by increased government debt*, increases interest rate. Why? Well, that's in itself an interesting explanation and perhaps should be a separate question (interesting, because contrary to what people think that "more govt borrowing means more govt bonds in the market, means lower bond prices and hence higher interest rates" is not at all a satisfactory explanation).

Private investments are assumed to be a function of interest rate. So some of the investment projects (particularly, those at the margin) that were earlier profitable may not be anymore due to increase in interest rate.

This is what is essentially, **crowding out** of private investment.

This does not require the assumption that *Savings* have to be fixed. Instead, in Keynesian framework, what happens is that $Y, S, C$ all goes up (because crowding out is not necessarily full, depending on the interest elasticity of money demand - slope of LM curve). It's just the share of $G$ increases and that of $I$ decreases.

Coming to your assessment that historically, at least during some periods, $I$ and $G$ have been found to be positively correlated. Indeed, investment is not *just* a function of interest rate. It is also a function of sentiments of future of the economy. When govt's start building infrastructure or take measures to improve supply constraints it boosts the confidence in the economy and encourages investment.

That doesn't make concept of *crowding out* incorrect. Because the concept is applicable when, ***ceteris paribus***, $G$ increases.

Lastly, your own idea that "the capital and labor in the economy is limited, and if the government is spending more money to use capital goods and labor, then there are less capital goods to go around for the investment." is the somewhat closer to the **classical** view. This assumes that economy is at its full potential and there are no rigidities in the labour market. Without going into details, this view over the year has been seriously challenged. However, it should still be considered as an alternative explanation.

> **Comments:**
> **username_3**: Federal spending influences the interest rate only as much as the voting members at the central bank want it to. The Fed’s target rate is a policy variable – meaning, it’s whatever they want it to be. https://www.dropbox.com/s/759h1yrxyxs2j56/Fullwiler-Interest%20Rate%20on%20the%20National%20Debt%20Is%20a%20Policy%20Variable.pdf?dl=0  
> **username_2**: One, what happens in US should not be generalized. Two, when federal spending is expanded by financing the deficit, in theory, it means it is accompanied by monetary expansion. So $G$ has not increased *ceteris paribus* and hence the concept is not directly applicable. Three, if voting members do decide to not monetize the increased spending then also the market interest rates will move. Fed having target rate does not mean interest rate cannot be moved by market forces, but just that Central bank can also influence it. The concept refers to impact of market forces.  
> **username_3**: FOMC members have no part in the decision whether to sell or purchase bonds, as it relates to accompanying new federal spending. They can only decide the target interest rate. The central bank, however, has the infinite capacity to purchase or sell bonds on the open market, so yes, in all but the shortest of terms, they do indeed have the infinite capacity to bend market rates to their will. As I understand it, everything I’ve said, both in these comments and in my above answer, is true for all [fully-sovereign](http://citizensmedia.tv/mmt-developing-nations) currency issuers.  

---

### Answer by username_3 on 2020-09-16. Score: -4

Can a [fully-financially-sovereign](http://citizensmedia.tv/mmt-developing-nations) 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](http://citizensmedia.tv/mmt-crowding-out). This idea of crowding out is false and predicated on three other false ideas. Briefly, it incorrectly assumes that:

1. the central government is a user of *its own* currency,
2. banks are revenue/reserve constrained (loanable funds), and
3. the interest rate is an axiomatic function of the free market.

The truth is that:

1. the central government issues currency every time it spends ([even when it sells bonds](http://neweconomicperspectives.org/2010/11/yes-deficit-spending-adds-to-private.html), which is [very misleadingly](http://citizensmedia.tv/mmt-securitization) called “borrowing”),
2. banks issue credit every time they lend, and
3. the interest rate is a [policy variable](https://www.dropbox.com/s/759h1yrxyxs2j56/Fullwiler-Interest%20Rate%20on%20the%20National%20Debt%20Is%20a%20Policy%20Variable.pdf?dl=0) 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.

> **Comments:**
> **username_2**: "the central government issues currency every time it spends," - doesn't it assume that govt *always* monetizes its deficit - which of course is not true. Most govts *borrow* to spend beyond its revenues.  
> **username_3**: The revenue from bond sales (very misleadingly called “borrowing”) is not ever collected and then used for future respending. It is destroyed, as all federal revenue is. Bond sales are only used for draining reserves, which is how the central bank manages their target rate. (With a side effect of providing risk-free interest income for the rich, and disemploying millions of poor people.) Bond sales are not at all borrowing in the sense meant by average people. This post contains several academic references: http://citizensmedia.tv/mmt-securitization  
> **username_3**: All federal spending is money creation. All federal revenue is money destruction. Bond sales occurring or not occurring don’t change this reality. Bond sales have NEVER changed this reality.  
> **username_3**: Federal spending adds net financial assets to the non-government sector even when bonds are sold: http://neweconomicperspectives.org/2010/11/yes-deficit-spending-adds-to-private.html  
> **username_3**: Links added to the post.  
> **username_3**: So, to be clear: No. I am not assuming anything regarding the government monetizing its deficit. Currency is issued in all cases, whether bonds are sold (or purchased) or not.  
> **username_2**: Ok I may be wrong. But just to understand properly, could you please explain how sale of new bonds by the govt creates money (or how is the revenue from bond sales destroyed)? Maybe there's something about the US economic system that is different. I happen to work in a country's Central bank and know for sure that it doesn't happen in most economies  
> **username_3**: The sale of new bonds does not create money. All federal spending is money creation, regardless of bond sales or purchases. The specifics of the case of the US can be found in [this 1998 paper by Stephanie Kelton](http://www.levyinstitute.org/publications/can-taxes-and-bonds-finance-government-spending) and this [2014 paper by Eric Tymoigne](http://www.levyinstitute.org/publications/?docid=2008). But as I understand it, this (everything in both my comments and answer) is indeed the case in all [fully-financially sovereign economies](http://citizensmedia.tv/mmt-developing-nations).  
> **username_3**: Fully-financially-sovereign economies include the US, UK, Australia, Canada, Japan, New Zealand, etc.  
> **username_3**: To put it succinctly, the revenue from federal bond sales and taxation is destroyed in exactly the same manner as the 100 is “destroyed” after doing 1000-100=900 on a calculator.  
> **username_4**: @username_2 you are actually correct that not all government borrowing creates new money. Aliteralmind is promoting MMT which is fringe and among most economists not accepted theory, that argues that government should fund all its spending with new created money and probably Aliteralmind confused that for saying that all government debt is actually funded that way which it is not in the US. https://scholar.harvard.edu/files/mankiw/files/skeptics_guide_to_modern_monetary_theory.pdf  
> **username_3**: Brian Romanchuk, [A Skeptics Guide To Mankiw's Skeptic's Guide To MMT](http://www.bondeconomics.com/2019/12/a-skeptics-guide-to-mankiws-skeptics.html): "The most natural way to approach a body of new theory is to pick up a textbook. It is exactly my mode of operation. The only issue here is that Macroeconomics is an undergraduate textbook.... Correspondingly, I think the implied claim in the title ‘Guide To Modern Monetary Theory’ needs to be viewed to be closer to ‘A Discussion of the MMT Macroeconomics Textbook.’...  
> **username_3**: ...Since the textbook is an academic work that needs to stand up to scrutiny, this narrowing of focus is legitimate.... I would paraphrase Mankiw's criticism of MMT as follows: if we assume that neoclassical theory is correct, MMT is either incorrect (where it contradicts neoclassical theory) or trivial.”  
> **username_3**: Original MMT developer, Australian economist Bill Mitchell. [A response to Greg Mankiw – Part 1](http://bilbo.economicoutlook.net/blog/?p=43900) "It says very little about MMT. It demonstrates how hard it is for someone deeply locked into a dominant but failing paradigm to think outside the ‘box’ for a while and try to understand that the ideas of a new and emerging paradigm cannot be meaningfully reduced back into the conceptual framework of the failing paradigm that the contender is seeking to usurp."  
> **username_3**: It’s so much easier to dismiss as “fringe” than to engage on the theory itself.  
> **username_3**: Here are some actual, good-faith criticisms with responses: https://citizensmedia.tv/mmt-criticism. The Mankiw piece isn’t one of them.  
> **username_3**: MMT “argues that government should fund all its spending with new created money...” That’s incorrect. MMT argues that all federal spending *already is* newly created money (issued currency), whether bonds are sold or not. In the US, this is the case since the first dollar was created in the 1790s. It’s the only possible way for the federal government to spend.  
> **username_3**: Important clarification: the government can of course buy up all the actual resources that it wants, which indeed would put pressure on the non-government sector regarding those same resources. That’s not what I’m referring to. There is no such thing as loanable funds, and therefore it is not *inherent* that *any* federal spending crowds out an existing pile of loanable funds, therefore crowding out non-government sector borrowing. The latter is what I’m referring to. It‘s possible that the question is more referring to the former. I’ve updated the post.  
> **username_3**: I’ve better rewritten the answer.  
> **username_2**: @username_4: thanks for this clarification. Didn't know about MMT. Will not bother to read the links shared now.  
> **username_5**: @username_2 - I think it's better to engage with the theory to decide on its validity. I think MMT has a lot of useful things to say. I wouldn't just dismiss it out of hand.  

---

