CROWDING OUT

Economics has been one of the most interesting practical subjects of study in most times, with its topics grabbing interest for most of the finance and commerce and economics student. One such topic of interest has been the concept of “crowding out.”

Imagine a situation- ‘The government spending during a period of time has increased beyond expectations, or its revenue through taxes and other modes has decreased, thus creating a deficit. During such situations, the government in need for more funds to carry on the economic activities and for financing the deficit so occurred, starts borrowing funds. Due to this increase in demand for borrowings, the interest rates start to increase. This increase in interest rates, makes borrowing expensive for private entities, thus thereby reducing the investments by the private players. Thus, this overall impact of increase in government borrowing that reduces investment is referred to as “crowding out of investments”.

Usually economists use the term ‘crowding out’ denoting the increase in government’s use of resources and finances to cover up their deficit, which could otherwise have been used by the private investors, for investment. The extent to which crowding out takes place is also determined by the economic situation prevailing in the country. By this we mean whether the economy is operating at a full employment situation or below full employment situation.

If increased borrowing leads to higher interest rates by creating a greater demand for money and loanable funds and hence a higher “price”(ceteris paribus order), the private sector, that is sensitive to interest rates, will certainly reduce their investment as they would now get lower rate of return from such investment. Thus it is this investment which is said to be crowded out.

This is something which can also be referred to as that- an adoption of expansionary fiscal policy which leads to a reduction in government spending.

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