What is the Crowding Out Effect?

The crowding-out effect is an economic theory that states that increased government spending effectively reduces total private spending. 

What Causes the Crowding Out Effect?

Increase government spending causes higher demand for capital in the market. The higher demand for capital causes a rise interest rates (i.e., the cost of money). The rise in interest rates makes private borrowing more costly, thus reducing the amount of private borrowing for capital project. The result is a reduction in total, private, investment spending. 

How Does Crowing Out Effect the Economy?

The crowding out effect may cause reduced total income in the economy. This is when the increased public sector spending is less than the decreased spending in the private sector.

When Does the Crowding Out Effect Occur?

Crowding out effects is most common in those big governments that borrow heavily to cover government spending. A good example is the United States government. 

When government spending absorbs private lending capacity and increases the interest rate, it discourages private businesses from borrowing money to make capital investments.   

Further, the rise in government bond interest rates may incentivize private savings. Private savings reduces private spending on capital projects.

Is the Crowding Out Effect Common?

Crowding out depends on the prevailing economic situation. If the economy happens to be below capacity, then it may lead to increased spending by both the government and the private sector. 

However, when there is strong economic growth, the government faces more competition from the private sector for investment capital. As such, the yield on government bonds will rise in order to secure capital. 

What are theTypes of Crowding Out Effect

There are two types of crowding-out effects:

• Financial Crowding Out Effect
• Resource Crowding Out Effect

What is the Financial Crowding Out Effect?

Increased government spending may result in the Government borrowing more money. The increased demand for money increases interest rates (based upon simple principles of supply and demand). This will reduce the amount of demand for capital in the private sector, as the interest rates rise. 

The increase in government spending may also give rise to an increase in taxes to cover part of the spending. This leads to a reduction of the discretionary income of consumers and firms.

What is the Resource Crowding Out Effect? 

We also have resource crowding out where the private sector lends the government money through the purchase of Government bonds. This is a form of private savings that rises. Increased private savings leaves the private sector with less to invest in the private sector projects. 

There is generally more efficiency in private sector investment compared to the public. So, when the government borrows from the private sector, total productivity often decreases.

Related Topics

• What is Government Spending?
• Autonomous Spending
• Autonomous Consumption
• Fiscal Policy
• Expansionary Fiscal Policy
• Contractionary Fiscal Policy
• Progressive vs Regressive Tax
• Marginal Tax Rates
• Proportional Tax
• Trickle Down Theory
• Discretionary Fiscal Policy
• Automatic Stabilizers
• Effects of Discretionary Policy (Interest Rates & Lags)
• Crowding Out Effect 
• National Debt
• Government Borrowing
• Golden Rule
• Ricardian Equivalence
• Balanced Budget - Deficit and Surplus
• National Debt
• Standardized Employment Budget
• Deficit Hawk
• Austerity
• Twin Deficits
• Fiscal Policy and the Aggregate Supply and Demand Curve
• Stabilization Policy
• Robin Hood Effect
• Ricardo Barro Effect
• Automatic Stabilizers
• Standardized Employment Budget
• How Does Fiscal Policy Affect Interest Rates? 
• Crowding Out
• Types of Lag in Fiscal Policy
• Temporary and Permanent Fiscal Policy
• Limitations of Fiscal Policy?
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• Government Borrowing
• National Savings and Investment Identity
• Debtor Nation
• Fiscal Policy Affects Trade Balances
• Twin Deficits
• Exchange Rates Affect Budget and Trade Deficits
• What are the risks of chronic large deficits in the United States?
• How Fiscal Policy Can Affect Trade Imbalances
• Government Borrowing Affect Private Savings
• Ricardian Equivalence
• Fiscal Policy Affects Investment and Economic Growth
• Crowding Out of Physical Capital Investment?
• How Does Government Borrowing Affect Interest Rates in Financial Markets?
• Government Investment in Physical Capital
• Public Investment in Human Capital
• Fiscal Policy Can Affect Technology Development

• Economic Cycle or Business Cycle
• Business Cycle Indicator
• Peak and Trough
• Recession and Depression
• Hard Landing vs Soft Landing
• Economic Bubble
• Boom and Bust Cycle
• Great Depression
• Baby Boomer Age Wave Theory

• Skyscrapper Effect (Economics)
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• U-Shaped Recovery
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• Abenomics
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• Real Economic Growth Rate
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• Endogenous Growth Theory
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• Real Economic Growth Rate - Explained
• Plutonomy