What is crowding out effect?

There is general consensus that excess government expenditure financed through borrowing creates many adverse effects in the economy. The concept of crowding out effect indicates one such negative effects of high level of government borrowing.

The crowding out effect refers to a situation of high government expenditure supported by high borrowing causes decrease in private expenditure. Or in other words, when the government is increasing its expenditure, private expenditure comes down.

Increased government expenditure and its causality with decreased private expenditure are connected through borrowing.

If the government is raising its expenditure, it will be indicated by a higher deficit in the budget. For example, in India such rising government expenditure raises fiscal deficit.

This increased fiscal deficit will be met through borrowing. Government’s borrowing is different individual/business borrowing in terms of size and impact. This is because government is a big entity and its borrowing will be huge. In effect, high level of government borrowing causes an increase in the market interest rate. Similarly, availability of funds for the private sector will be less due to high level of government borrowing.

Increased interest rate and reduced availability of funds discourages private spending. Or in other words, high government expenditure crowd outs private expenditure.