Crowding in an Open Economy

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Crowdingin an Open Economy

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Crowdingin an Open Economy

Crowdingis a situation where the government raises the interest rate leadingto a decrease in private investment. In some instances, thegovernment uses the expansionary fiscal policy to improve the levelof its spending so as to boost economic activities in the economy. Inan open economy, crowding out occurs in a situation where the fiscalpolicy have expansionary effect in the short-run (Maravalle &ampClaeys, 2012). When this occurs, the savings in the private sectorget reduced to some degree that the accumulation of capital leads toa reduction of employment in the long run.

However,if capital is mobile at the international level, then it does notguarantee domestic savings to determine capital stock, therefore, inthe long run, crowding has an effect on GDP and employmentdiminishes. When there is more borrowing by the government and fixedprivate savings, then the private organization should be able toborrow less. But in a situation where deficit becomes successful inincreasing the output, then more income and savings is expected inthe economy thus both government and a private organization canincrease their borrowings.

Crowdingeffect leads to increase in government borrowing which further leadsto forcing out of the private borrowers due to high-interest rate andas a result, crowding out effect dominates (Guest &amp Makin, 2013).When the economy is faced with slacks, then it is likely to reducethe aggregate demand in the short-run. The supply side in an economydominates in the long-run because of the presence of theself-correcting mechanisms that tend to push the actual GDP towardspotential growth rate. When interest rates are high, the economy ischaracterized by low investment thus the slow growth of potential GDPand the capital stock.

References

Guest,R., &amp Makin, A. (2013). The Dynamic Effects of Fiscal Stimulus ina Two‐SectorOpen Economy.&nbspReviewof Development Economics,&nbsp17(3),609-626.

Maravalle,A., &amp Claeys, P. (2012). Boom–bust cycles and procyclicalfiscal policy in a small open economy.&nbspJournalof Policy Modeling,&nbsp34(5),735-754.