John Heim


John Heim

SA 3205

February 9, 2011 12:00 PM - 1:30 PM

ABSTRACT:  This paper examines whether government deficits financed by borrowing reduce credit availability, thereby "crowding out" business and consumer spending.  To test this hypothesis, deficit variables are added to consumption and investment models and tested to see if they negatively impact private spending in a statistically significant way, and if they increase explained variance.  U.S. data for 1960 - 2000 is used.  A demand-driven econometric model, patterned after the work of Klein and Fair and containing eight behavioral equations is used to estimate crowd out effects.  Demand models were used because of the importance ascribed to them by two recent chairs of the President's Council of Economic Advisors:( 1) Mankiw (2007), who notes they "provide the foundation of much of our current understanding of economic fluctuations" and (2) Romer (2010) who notes demand deficiencies appear to have caused the severity of the recent recession.  In addition, fiscal stimulus prescriptions for from such models lose effectiveness if private spending is reduced by deficits. This study finds strong statistical evidence deficits crowd out private consumption and investment.  It also finds consumption and investment functions which include crowd out variables generally predict "IS" curve coefficients more accurately than other models.  The actual sign of the tax variable coefficient in IS curve econometric tests was found to be positive, implying deficits generated by tax cuts actually reduce the GDP.  This directly contradicts the expected result in traditional Keynesian models.  However, this positive sign is well predicted from consumption and investment models containing crowd out variables.  Deficits caused by government spending also had offsetting crowd out effects reducing their stimulus effect, and in some models eliminating it.  The study concludes that scientifically testing for the crowd out problem, in demand driven models, indicates the crowd out problem exists.  Increases in the savings components of M2, in years preceding the deficit, were found to offset crowd out effects.  This occurred presumably because the savings provided an alternative source of funds to offset the reduced credit available due to government borrowing to finance the deficit.  JEL Codes: C50, C51, E12, E21, E22


Keywords:   Macroeconomics, Consumption, Investment, Government Deficits, Crowd Out

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