What is the crowding out effect?
Crowding out is what happens when the government pursues a fiscal policy that forces it to borrow a great deal of money. This leads to increased interest rates and makes it harder for the private sector to borrow money. In this way, governmental borrowing is said to have “crowded out” private investment.
When the government wants to have an expansionary fiscal policy, it must often borrow so as to keep taxes low while still spending a lot of money. When the government has to borrow, it reduces the supply of money that is available to be borrowed. When there is less money to be borrowed, the price of borrowing money (the interest rate) goes up. When interest rates go up, it is more expensive for firms to borrow money that they can use to invest in their businesses. Thus, government borrowing has made it harder for the private sector to borrow and invest. This process is known as “crowding out.”