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Crowding Out Effect Definition
The crowding-out effect refers to an economic theory that states that the rising interest rates decrease the initial private total investment spending. Note that an increase in interest rates impact the investment decision by investors.
When the crowding of effect becomes significantly high, it may lead to reduced income in the economy. This happens because when there is increased public sector spending, there is usually decreased spending in the private sector.
A Little More on What is the Crowding Out Effect
Crowding out effects is most common in those big governments that like to increase borrowing. A good example is the United States government. The scale of borrowing of such a government usually leads to a substantial increase in the interest rate. It, in turn, absorbs the lending capacity of the economy and discourages private businesses from making capital investments.
Note that projects are funded using finances, and since crowding out discourages it, the cost of borrowing goes up. So, those profitable projects funded using loans become cost-prohibitive.
Types of Crowding Out Effect
There are two types of crowding-out effects. They are as follows:
- Financial crowding out effect
During the process of transmission between increased government spending and reduced private sector investment, the interest rate is always involved. For example, if the government raises its spending and it requires to fund part or all from the sector of finance, the move will increase the demand for money. This, in turn, will lead to an increase in the interest rates.
Higher interest rates result in the fall in both investment and consumer spending. The aggregate economic effect is that resources from private firms will be diverted so that they are used in the public sector. When the government spends on aggregate demand, it leads to the following:
- Increase in tax: When a government increases a tax on the private sector, it leads to a reduction of consumers’ and firms’ discretionary income. They include income and corporation taxes. Note that there will be lower consumer spending when a government increases the tax on consumers.
- Increase in borrowing: When the government increases borrowing, it means that it has to get money from the private sector. And for it to be able to finance what it has borrowed, it is forced to sell bonds to the private sector such as pension funds, private individuals, or investment trusts. Such a move leads to the government crowding out private investment in the private sector.
Resource crowding out effect
We also have resource crowding out where the private sector lends the government money, leaving them with less to invest in the private sector projects. Note that there is more efficiency in private sector investment compared to the public. So, when the government borrows from the private sector, it worsens the economy.
The Bottom Line
Generally, crowding out doesn’t happen often. It usually 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 investment. It means that yields from the government bonds will rise hence attracting more savings from the various investment projects.