Northrise University
30029 Kitwe - Ndola Dual Carriage Highway, P.O Box 240271, Ndola, Zambia
ASSIGNMENT COVER SHEET
Student ID:
Student Name:
Course Code:
Course Title:
Instructor Name:
Essay/Assignment Title: Discuss the concept of crowding out and multiplier effect giving relevant
examples. What are the 3 demerits of each?
Due Date:
Declaration:
I acknowledge that submitting this document binds me to the following:
To the best of my knowledge, I assert that no part of this assignment has been copied from the work of anyone else, be it
another student or any other author or from any source except where due credit is given in the text below, or has been
written for me by someone else except where the relevant instructors and authorities have explicitly permitted such
collaboration.
Signature:
Instructor’s Comments:
GRADE [ ]
Discussing the concept of crowding out and multiplier effect, giving relevant examples what
are the 3 demerits of each?
1. Crowding Out Effect
Crowding out effect is when there is an increase in interest rates which could lead to the
reduction in private investments such that it diminishes initial upward increase in aggregate
investment spending (Friedman et al., 1963). On the other hand, crowding in effects is when
higher government spending results in the increase in economic growth which encourages
business to invest more as there is profitable investment opportunities.
In other circumstances, governments sometimes implement expansionary fiscal policies
by increasing its spending so as to boost economic activity. The resulting effect of this is an
increase in interest rates which in turn affects private investment decisions. If not properly
managed crowding out could even lead less income in the economy.
Debt financing ways becomes difficult to access when interest rates increase; this is so
because the cost for funds for the purpose of investing becomes expensive. In the long run there
is lesser investment in the economy, ultimately crowding out the impact of the first investment
(Lucas, Robert, 1972).
Disadvantage of Crowding-Out effect
- The cost of borrowing funds for investment increases, this affects accessibility to debt
funding mechanisms
- It crowds out initial investments previously done because of reduced investments.
2. Multiplier Effect
This is the measurement of how an initial injection of funds in the circular flow of the
economy could stimulate economic activity in surplus of first investment. The reason for this is
because it is expected that a portion of new funds injected will itself be spent resulting in the
creation income both for firms and individuals (Kydland et al., 1977). In turn the firms and the
individuals spend a portion of their income which again creates income for other; it becomes a
cycle until there is no more extra income to be spent.
For instance, let’s say a company makes K100, 000 worth of investment in order to
expand its output in the manufacturing section of the business. Then in a year’s time of
production with the new facility operating at optimum capacity, the business’s income increases
by K200, 000. This simply implies that the multiplier effect was (K200, 000/K100, 000).
Meaning every K1 of investment produced K2 extra income.
Advantage of positive Multiplier effect
- Consumer spending in theory is boosted as a result of tax cuts ultimately leading to
general rise in Aggregate Demand
- Additionally, firms have to increase their output, as customer are able more and more
products because of increase in disposable income. In turn firms are encouraged to hire
more workers so as to meet demand (Singh et al., 2012).
Disadvantage of negative multiplier effect
It could be a decrease in injections
- Fall in consumer spending
- Fall in investment
- Fall in exports
- Fall in government spending.
Conclusion
Crowding out effect is when there is an increase in interest rates which could lead to the
reduction in private investments such that it diminishes initial upward increase in aggregate
investment spending and multiplier effect is the measurement of how an initial injection of funds
in the circular flow of the economy could stimulate economic activity in surplus of first
investment.
References
Friedman, Milton and Schwartz, Anna J. (1963) A Monetary History of the United States, 1867-
1960, Princeton University Press, Princeton, New Jersey, pp 520-21 and 543-544.
Kydland, Finn E. and Edward C. Prescott (1977) “Rules Rather than Discretion: The
Inconsistency of Optimal Plans” Journal of Political Economy 85-3.
Lucas, Robert E. (1972) “Expectations and the Neutrality of Money”, Journal of Economic
Theory
Singh, Manmohan and Peter Stella (2012), “Money and Collateral”, IMF Working Paper 12/95
