Crowding-out effect happens when increased government spending leads to a decrease in private spending or investment (Mankiw, 2024). When the government spends more, it can “push out” private borrowers.
How It Works
- Government increases spending → needs to borrow more money
- Demand for loanable funds increases because the government is borrowing more
- Interest rates rise as the demand for loans increases
- Higher interest rates make it more expensive for businesses and consumers to borrow money
- Businesses may reduce investment, such as building new factories or buying equipment
- Consumers may also reduce spending on things that require borrowing, such as houses or cars
As a result, some private investment and spending decrease. This is known as the crowding-out effect
Example
The government decides to fund a large infrastructure project, such as building new roads and bridges.
To pay for the project, the government borrows more money
The increased demand for loanable funds causes interest rates to rise
A business planning to build a new factory may decide not to because the cost of borrowing is now too high
As a result, the government's increased spending may lead to less private investment
Key Takeaway
More government borrowing can increase interest rates, making it more expensive for businesses and consumers to borrow. This can reduce private investment and spending, which is called the crowding-out effect.
- Crowding out is stronger when the economy is near full capacity
- It is weaker or may not happen during a recession (when there’s unused resources and interest rates are low)
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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