The crowding out effect is a process where government fiscal policy causes private individuals and firms to reduce their planned investments. In this effect, the government engages in deficit spending (it spends more than it takes in in taxes) and has to borrow money. This causes interest rates to rise. When this happens, the private sector borrows less money than it otherwise would have.
Governments often engage in deficit spending. The US government, for example,...
The crowding out effect is a process where government fiscal policy causes private individuals and firms to reduce their planned investments. In this effect, the government engages in deficit spending (it spends more than it takes in in taxes) and has to borrow money. This causes interest rates to rise. When this happens, the private sector borrows less money than it otherwise would have.
Governments often engage in deficit spending. The US government, for example, has run a deficit almost every year for the last five decades. When the government runs a deficit, it has to borrow money from somewhere.
When the government has to borrow money, the demand for money that can be loaned increases. We know that an increase in the demand for something will (ceteris paribus) cause the price of that thing to increase. Therefore, the price of borrowing money (the interest rate) will rise when the government borrows money.
When the price of something rises, it becomes harder for buyers to afford it. They will, therefore, tend to buy less of it. In this case, the private sector will not borrow so much money because the price of borrowing that money (the interest rate) has risen. This is the crowding out effect. The government’s deficit spending has caused interest rates to rise, thus causing the private sector to reduce its planned investment.
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