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Understanding the Prime Causes of Crowding Out Effect in Economics

Understanding the Crowding Out Effect in Economics
'Crowding out' in economics is an impact of an increase in the government borrowing, which further leads to an increase in interest rates, making it difficult for the private sector to borrow from the market.
Neha B Deshpande
Last Updated: Feb 25, 2019
Great Recession
During the great recession of 2007, government deficits had increased a lot, since the government had to incur huge public spending for the masses. However, the ultimate result was that it did impact the business sector, and they ended up being crowded out. Thus, government spending does have a negative side too, though it has been overlooked.
The dictionary meaning of the term 'crowding out' is thrusting out, or forcing out of a small place. However, in economics, the crowding out effect is an interesting phenomenon that deals with the government spending. Government deficit is a situation when the government ends up spending more than the borrowing.
What does the government do when it is short of money? Simply mint money? Of course, not! Money circulation is not so easy, and the government cannot start printing money simply as per its wishes and whims. Too much circulation of money will not lead to an increase in the value of the goods or services, but it will increase the inflation rate in the economy.
Why does 'Crowding Out' occur?
Financial paper
To reduce the deficits, the government again borrows from the market. Since the fiscal policies of the government impact the economy on a much larger scale, it does affect the private sector of the market.
Due to the increase in government borrowing, the demand for investments in the market increases. Automatically, the price of funds increases. It implies that this increases the rate of interest in the market.
Hence, increased interest rates in the market again have an impact on the private sector. The private entrepreneurs cannot borrow much, once the interest rate of loan funds increases. In this case, they may stop or curb their growth or expansion plans.
Thus, the government sucks up or absorbs the money circulation in the market, thereby creating a crowding out effect in the market.

Interest rates and borrowings have an inverse relationship. Once the interest rates increase, the borrowings decrease and vice versa. The government can create a crowding out effect in many ways.
Issuing government bonds in the market
United States dollars
The government borrows from the market, by issuing bonds and securities. Other than that, there are compulsory savings in the form of pension funds and other security benefits.
When such bonds are circulated in the market, people tend to invest in them due to their high credit rating as compared to the private sector. Thus, much also depends on the mentality of the investors. If they prefer to have risk-less investments, most of them will divert their savings to the government.
Increase in public sector spending
Consider that the government spends on donating to a public institutional store. The goods are available at rationed and subsidized prices in that storeĀ as benefits given by the government. So, the customers will prefer to buy from the store than buying from private local stores. Thus, public spending leads to losses for private individuals in the market.
Increase in tax rates
When taxes rise, the savings of individuals in the market reduce, and hence, there is less money in the market to invest. Thus, the money is diverted to the government's funds, which they use for public spending. However, due to this the private entrepreneurs are at a loss, since, when supply is lesser than the demand, prices will ultimately increase.
Thus, it withdraws money out from the private market's pocket to the treasury of the government. Studies have also shown, that once taxes increase, private individuals tend to make less donations, since they have less savings and there are public contributions made by the government too.
Impact of the increase in government borrowing on the economy
Down arrow
The crowding out effect might not be too tough in the market, and may not impact the economy much.
However, much depends on the economic conditions during that time. Thus, if it is coupled with an increase in the savings of the individuals in the economy, its impact might be washed away.
If the increase in borrowing by the government is not too aggressive, and the economic conditions in the market are conducive, it might have a very subtle impact on the borrowings of the private sector. Much depends on the interest rates rather than the increase in government expenditure.
Thus, it can be said that increased government spending has its own set of pros and cons. Though the government spends on public welfare, the private sector does suffer in this bargain. Its impact might not be that harmful to the economy and is influenced by many other economic factors such as investor's psychology, technology, international trade, etc.