Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them?

Balcerzak, Adam P.; Rogalska, Elzbieta Working Paper Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them? Institute of Economic Research Working Papers, No. 2/2014 Provided in Cooperation with: Institute of Economic Research (IER), Toruń (Poland) Suggested Citation: Balcerzak, Adam P.; Rogalska, Elzbieta (2014) : Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them?, Institute of Economic Research Working Papers, No. 2/2014, Institute of Economic Research (IER), Toruń This Version is available at: https://hdl.handle.net/10419/219564 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Balcerzak, Elżbieta Rogalska Toruń, Poland 2014 © Copyright: Creative Commons Attribution 3.0 License Article published in Economics & Sociology 2014, Volume 7, No 2. Quoting: Adam P. Balcerzak, Elżbieta Rogalska, Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them?, Economics & Sociology, Vol. 7, No 2, 2014, pp. 80-93. DOI: 10.14254/2071-789X.2014/7-2/18 Crowding Out and Crowding in within Keynesian Framework. Do We Need Any New Empirical Research Concerning Them? ABSTRACT: Last global financial crisis resulted in common among developed countries implementation of expansionary fiscal policy as an anti-recession tool. This led to the renewal of academic discussion on stabilization effectiveness of fiscal policy. In this context, the main research goal of this paper is to give theoretical analysis of the determinants of countercyclical effectiveness of fiscal policy with special concentration on crowding out and crowding in effects. Methodologically the analysis is done within Keynesian IS-LM framework within the assumption of expectations of economic actors. The theoretical analysis is confronted with the review of empirical papers based on the experiences of developed countries. Keywords: fiscal policy, crowding out, crowding in, stabilization policy JEL classification: E62, H31, H32 Introduction Macroeconomics is the field of modern economy where the scientist and especially the political decision makers “voting” for a given theory are still far away from general consensus on real or just good enough model of economy. However, the end of XX century made a period when the scientific community seemed to agree on fundamental principles of gut applied macroeconomics that could be considered as textbook model and framework for practical policy. This consensus was close to neoclassic synthesis of Samuelson (see. Blanchard, 1997, pp. 244-246; Taylor, 1997, pp. 233-235; Solow, 1997, pp. 230-232, Blinder, 1997, pp. 240-243). From the perspective of day to day policy this general agreement concentrated on application of anti-cyclical monetary policy stabilizing business cycle, which complies with rules that are similar to Taylor’s rule, and fiscal policy was considered to be rather responsible for foundations of long term economic growth. As it was stated by Martin Eichenbaum: “In sharp contrast to the views that prevailed in the early 1960’s, there is now widespread agreement that countercyclical discretionally fiscal policy is neither desirable nor politically feasible. Practical debates around stabilization policy revolve almost exclusively around monetary policy” (Eichenbaum, 1997, p. 236). Last global financial crisis has completely changed that situation. From the practical point of view one could see massive fiscal stimulation packages that were supposed to counteract the crisis and stabilize the real economy. However, also the theoretical agreement among university researchers is not valid any more. This can be especially seen when one observes the massive discussion around three influential papers, two of Carmen Reinhart and Kenneth Rogoff (2011, 2010) who proof that expansionary fiscal policy leading over time to high level of debts (the breaking level of debt was estimated here as 90% of GDP) can be a significant factor negatively influencing GDP growth, and a critic article of Thomas Herndon, Michael Ash and Robert Pollin (2013) who argue that the estimations of Carmen Reinhart and Kenneth Rogoff are seriously influenced by methodological approach and are not valid. The practical return to fiscal massive stabilization policy during the last financial crisis and the growing theoretical controversies on factors concerning fiscal policy that used to be considered as explained and once set prove that there is a growing need for renewal of research and theoretical discussion on the determinants of counter-cyclical effectiveness of fiscal policy. The main research goal of this paper is to fulfill that need with concentration on two significant factors influencing effectiveness of fiscal stabilization action, which are crowding out and crowding in effects. From the methodological point of view the analysis is done within Keynesian IS-LM framework but within assumption of expectations. The main reason for this approach is the fact that it gives the advantage of analytical simplicity. Currently for the same reason many economists often use textbook AS-AD model. In this paper IS-LM framework was preferred due to some methodological problems and serious contradictions in the AS-AD model that were pointed by Robert Barro (1997, p. 611). Keynesian IS-LM perspective is also used here due to the growing theoretical and practical expansion of Keynesian economists in recent years. In the first part of the article the transaction crowding out is defined in the context of its influence on fiscal stabilization actions. The second part is devoted to the analysis of consequences of portfolio crowing out and crowding in effects. In the third part the review of empirical research is done and the article ends with conclusions and future research recommendations. Transaction Crowding out and Effectiveness of Fiscal Stabilization Policy In case of Keynesian model the effectiveness of fiscal stabilization policy that is aimed at stimulating aggregate demand is dependent on the size of fiscal multipliers, which in case of basic models are assumed to be positive and high. In reality there are many economic factors that may impact negatively on their size, starting with the institutional factors, macroeconomic situation of a given economy, foreign trade and ending with the actions of microeconomic market actors (see Hassett, 2009, p. 8). One of the most important factor, which has been the object of theoretical and empirical analysis for last few decades, is the crowding out of private spending by government spending associated with fiscal expansion, which directly leads to a decrease in the value of fiscal multipliers. Thus, limiting the effectiveness of the government's fiscal stabilization policy. The crowding out is a heterogeneous phenomenon, where the subject of scientific discussion is not only the possibility and scope of its existence, but also the transmission mechanisms leading to it . Willem Buiter proposed to introduce two basic distinction of the crowding out processes into two main categories: a) direct crowding out where the economic activities of the state interact in a direct way on the structure of private consumption and private economic activities, such as the situation when private consumption is directly replaced by the consumption of public goods, b) indirect crowding out, much more complex than the first one, where the reactions of economic actors are associated with the changes in the level of interest rates and their structure (Buiter 1976). In that case, one can talk about transactional crowding out and portfolio crowding out. This subsection is devoted to the effects of the transaction crowding out. The portfolio crowding out will be discussed in the next section. Effect of transactional crowding out is defined as the phenomenon of the decrease in private investment and private consumption resulting from an increase in the interest rates, which is the consequence of fiscal stimulus (see Keynes, 2003, p. 84, Wernik, 2011, p. 97). Transactional effect is associated with increased volumes of transactions in the economy resulting from the fiscal stimulus, which leads to an increase in the demand for money. In the conditions of the growth in the demand for money, an equilibrium in the money market is possible only if there is an appropriate interest rate increase, which would bring the demand for money to its original level. Assuming that the demand for money is a growing function of the product, fiscal expansion that is increasing aggregate demand in the product market must also lead to an increase in the transactional demand for real resources of money. When one assumes that supply of money is exogenous and constant, the increase in the transactional demand for money leads to an increase in the interest rate, which is necessary to maintain equilibrium in the money market. In the same time, both private investment and private consumption are negative functions of the interest rate. It means that the increase in the interest rate leads to decline in private investment and consumption. Thus, one observes the phenomenon of crowding out of private consumption and investment spending as a result of fiscal stimulus. This is shown in chart 1. First of all, assuming that one analyses only the market of products that is unrelated to the market of money, where change in the volume of transactions do not affect the transactional demand for real resources of money, and therefore it does not affect the interest rate, the change in the size of government expenditure ∆G increases aggregate demand and shift the curve from IS 1 to IS 2 , it means that it shifts the equilibrium level from Y 1 to Y 3 . However, including into the analysis the money market, after the fiscal stimulus for the size of product Y 3 and the interests rate r 1 money market is in a state of disequilibrium. Returning to the market equilibrium requires a transition to Y 2 product size and a higher interest rate r 2 (Friedman 1978, pp. 599-603, Spencer, Yohe 1970, p. 17). Thus, in this model the size of the effects of transaction crowding out is the difference between Y 2 and Y 3 . Chart 1. Fiscal expansion with the transaction crowding out effects in IS-LM model Source: based on Friedman (1978, p. 602, Spencer, Yohe 1970, p. 17). The phenomenon of transactional crowding out leads to reduced effectiveness of positive fiscal stimulus, but in the same time it can also mean smaller negative consequences of fiscal consolidation in the real economy. Along with a reduction in aggregate demand resulting from the reduction of the budget deficit there is a decrease in the transaction demand for real resources of money, which translates into lower interest rates needed to maintain equilibrium in the money market. The lower level of interest rates may be a source of positive impulse on the side of private investment and consumer spending. Thus, this effect may in part, or – in extreme cases – even entirely offset the negative impact of negative fiscal adjustment on economic activity. From the perspective of the effectiveness of expansionary fiscal policy, which is aimed at stabilization purposes, it is particularly important that the effect of transaction crowding out can occur not only in conditions of full capacity utilization, but also in the case of economy in the Keynesian situation of unused production capacity. In addition, a major practical problem associated with the effects of transaction crowding out is the potential reaction of investment demand that is highly sensitive to interest rate, which can seriously affect the development of new productive capital equipment. In that case of the short-term effectiveness of fiscal stimulus is limited as a result of the impact of the current transaction crowding out effect, but IS 1 LM Product T he level of interest rate IS 2 r 1 r 2 Y 1 Y 2 ∆ G Y 3 the fiscal stimulation can also have negative long-term impact on the growth rate of productivity of the economy, and hence the rate of long-term economic growth (Friedman 1978, p. 596). There are two main factors that determine the scale of the transaction crowding out. First it is the elasticity of the LM curve, which determines the response of demand for real resources of money associated with the changes in product size. The second one is the elasticity of the IS curve, which reflects the impact of interest rates on private consumption and investment. The first extreme case leading to full transactional crowding out effect is a situation of zero elasticity of demand for real resources of money, where the demand for money does not respond to changes in nominal interest rates. This is the “classical case” of a vertical LM curve (Figure 2a). In this situation, shifting the IS curve associated with fiscal expansion only results in changes in interest rates. However, it does not lead to changes in the size of aggregate demand, there is only a change in its structure (Carlson, Spencer 1975 , p. 5). The second extreme case leading to the full effect of the transaction crowding out is the situation with perfectly elastic IS curve (Figure 2b). This occurs when there is an assumption of constant returns from investment. It may result from the interaction between a large amount of capital accumulated in the economy, and its relatively small marginal values. Due to the relatively small marginal values of capital they should not affect revenue from all the accumulated capital. Another factor leading to the constant returns to scale from investment is the fact that investment spending is often accompanied by investments in knowledge and research and development. As a result the typical decreasing returns to scale from capital accumulation may be offset by technological progress. Based on this thesis in the middle of eighties the endogenous growth theory was developed. In the case of horizontal IS curve fiscal expansion cannot move the IS curve, for example the increase of government spending absorbs the private savings that is necessary for financing private investment, thereby reducing adequately their feasibility. Thus, in this case, fiscal expansions do not affect the size of aggregate demand, as their effect one can only expect the change in its structure (Carlson, Spencer 1975 , pp. 6-7) . a) The classical case b) The perfectly elastic IS curve Chart 2. Transaction crowding out full effect in IS-LM model: extreme cases Source: based on Carlson, Spencer (1975, p. 5, 7). On the other hand, extreme cases leading to a lack of transactional crowding out associated with the positive or negative fiscal adjustment is the cases of vertical IS curve. In this situation planned consumption and investment spending do not respond to changes in interest rates. The second possibility is the liquidity trap case with horizontal LM curve. LM curve has that shape when the demand for real resources of money is insensitive to changes in the product or strongly reacts to changes in nominal interest rates (Rzońca 2007, p. 64). However, the previously mentioned two “extreme” cases of full transactional crowding out are not the only possible conditions leading to full neutralization real effects of stimulation or fiscal consolidation. Keith Carlson and Roger Spencer present two more variants of the model with the so-called. conventional shapes of IS-LM curves, which can lead to the full effect of transactional crowding out, hence the neutrality of fiscal adjustment. Such cases are: a) the case of Keynes with expectations of private sector; b) the case of ultrarational households (Carlson, Spencer 1975, pp. 5-8). In the first case fiscal expansion may adversely affect the confidence of economic actors in the future, which may result in an increase in liquidity preferences or decrease of the marginal efficiency of capital, thereby reducing the level of investment. This mechanism is shown in chart 3a. Fiscal expansion initially leads to a shift of the curve from the position IS 1 to the position IS 2 , which causing the increase in liquidity preferences shifts LM curve from LM 1 to LM 2 , while the decline in the marginal efficiency of investment shifts IS curve from the AD AD Product IS 1 IS 2 r 1 r 2 Y ∆G Product T he level of interest rate P Y LM Price level T he level of interest rate LM IS 1 = IS2 After ∆G Product P Y r Product position IS 2 to IS 3 . In this model, there is a final solution of the model for which shifts of the IS and LM curves lead to no change in the size of the aggregate demand for a given price level (Carlson, Spencer 1975, pp. 5-6). In the second case of ultrarational households there is a departure from the assumptions adopted in the traditional Keynesian approach in the IS-LM model, where there is no possibility of substitution between public and private expenditure. When one assumes that private debt and public debt are close substitutes, an additional amount of expenditure increasing budget deficit replaces the analogous value of private investment, because the government deficit is treated by households as public investment constituting a substitute to private investment, where both types of investments are evaluated by households from the prospects for future growth in consumption. As a result, after the initial shift of IS curve from IS 1 to IS 2 , household can limited their private investment or private consumption, pushing the IS 2 curve to the starting position (Figure 3b). Such a solution of the model does not depend on the method of carrying out fiscal stimulus. It does not matter whether fiscal expansion is the result of increased budget spending or tax cuts. As a result, fiscal expansion leads only to the full transaction crowding out effect (Carlson, Spencer 1975, pp. 7-8). a) The case of Keynes b) Ultrarational case Chart 3. Full effects of transactional crowding out in IS-LM models: the case of Keynes and ultrarational case Source: based on Carlson, Spencer (1975, pp. 6, 8). An important issue in the context of the analysis of the consequences of the transaction crowding out effects on the effectiveness of fiscal stabilization policy is the time horizon of Product IS 1 IS 2 r 1 r 2 Y ∆G Product T he level of interest rate AD P Y LM 2 Price level T he level of interest rate LM IS 1 Product P Y AD r Product IS 3 LM 1 IS 2 ∆G Y the analysis. In the literature, there is no clear agreement on the possible extent of crowding out of private spending by government spending depending on whether the analysis concerns the short or medium time horizon. Empirical studies cited by Benjamin Friedman suggests that with prolongation of analysis the effects of transactional crowding out may have larger sizes, which negatively influences the effectiveness of fiscal stabilization policy (Friedman 1978, p. 607). Analogous conclusions can be drawn from the analysis of several econometric studies presented by Gary Fromm and Lawrence Klein (1973, p. 393). Portfolio Crowding out and Crowding in Transactional crowding out effect is not the only consequence of fiscal stimulation, which can affect the behavior of private consumption and investment. By modifying the assumptions of Keynesian IS-LM model with respect to the definition of consumption function, in particular assuming the relationship of private consumption not only with income and interest rate, but also with wealth of economic actors and also taking into account the wealth in the money demand function, one can talk about the possibility of portfolio crowding out or portfolio crowding in effects. This effects are also sometimes called wealth effects and are defined as a situation where the rising public spending leads to decrease in private spending (crowding out) or stimulate private spending (crowding in) through its impact on the value of the wealth of economic actors. Foundations of analysis of the impact of the wealth on the private consumption and investment can already be found in the classical works of Arthur Pigou, who analyzed the impact of the size of households wealth on their consumption, as well as John Maynard Keynes investigating the impact of wealth on investment activity of enterprises. Reflection of the wealth effect in the goods market is the fact that the growth of wealth held by private entities is accompanied by an increase in aggregate demand, which in the standard IS-LM model moves IS curve to the right. This is equivalent to the occurrence of a positive wealth effect. Assuming that the source of increased wealth of households is positive fiscal impulse, the positive wealth effect in the goods market may strengthen primary multiplier effects of fiscal expansion (Kosterna 1995, p 121 ; Friedman 1978, p 609). As mentioned earlier occurrence of the wealth effects is not limited only to the goods market. It may have also a very significant influence on the money market, where the consequences of changes in household wealth may be much more complicated. Extending the model analyzed so far, it is assumed that households and enterprises treat the debt (government bonds) used to finance the state budget deficit as the wealth which positively affects their consumption and investment decisions. In addition, the treasury bonds included in the portfolios of housholds and enerprises as assets increase the demand for real resources of money (Silber 1970, pp. 465-467). This is due to the willingness of households to diversify risk, prompting them to build a diversified and balanced portfolio (Rzońca 2005, pp. 7-8). Based on the above assumptions, in the case of a fiscal stimulus leading to the issuance of debt financed by issuing the government bonds, one can predict the occurrence of two opposite effects. One should expect an increase in aggregate demand associated with the growth of household consumption that finance the budget deficit through the purchase of government bonds, and consider it as an increase in wealth held by them. This is the equivalent of shifting IS curve to the right from IS 1 to IS 2 in Figure 4. However, due to increased wealth of households, one should also expect an increase in interest rates, which is necessary to maintain equilibrium in the money market when there is the increase in the demand for money (it makes effect of portfolio crowding out and this corresponds to a shift of Fisher s. 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