The Crowding-In Effect

In contrast to the crowding-out effect, fiscal policy may crowd in private investment, resulting in positive externalities in some cases. For example, if an increase in public investment is so effective that people believe that a boom may come soon, many firms are likely to invest more. Consequently, other firms increase their investments. This is a desirable outcome of the crowding-in effect, which comes from the positive effect on people’s attitude about future economic conditions.

In the high-growth era of Japan in the 1960s, one reason why macroeconomic fiscal policy was so successful was the signaling effect of the government’s policy. Private investment requires suitable circumstances in order to make future profits. Uncertainty about future macroeconomic activities depresses private investment. If the government provides reliable and optimistic information on future macroeconomic activities and/or fiscal policy and private agents accept it, it stimulates private investment. Thus, if a private agent believes the optimistic government scenario and follows it, the scenario may become reality. This is an example of a self-fulfilling expectation.

It is important for the efficacy of fiscal policy that public spending, especially public investment, produces a profitable outcome for private agents. If a public investment project makes private firms more productive, the crowding-in effect occurs. In such a situation, the government may only stimulate a small number of private firms and/or industries. However, because of the crowding-in effect, this policy may produce more investment in the whole economy.

Thus, the government may make fiscal policy more effective by inducing a small but core number of firms and consumers to follow its lead. If the crowding-in effect is large, the size of the multiplier may become large even if fiscal policy initially targets a small part of the private sector.

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