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What is the crowding out effect and what is an example of it?

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Ian Chege eNotes educator | Certified Educator

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The crowding out effect occurs when public sector spending reduces private sector expenditure. It is an economic principle that happens when a government borrows more money that it usually does to cater to its needs. Governments pay for this type of spending by increasing taxes or borrowing more money. Increased borrowing leads to a spike in interest rates resulting in private companies reducing their spending. The private sector will be hesitant to borrow money because of the costs associated with paying the loan; therefore, it will reduce its spending.

An example of a country experiencing the crowding out effect is Malaysia. The country’s government focused on making investments in a number of companies, which reduced private sector involvement in the economy. Increased government investments have seen the country having many debt obligations. As it stands, the government is working towards reducing this effect.

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pohnpei397 eNotes educator | Certified Educator

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The crowding out effect is usually used to refer to what happens when governments borrow lots of money to finance a deficit.  The government spends more than it takes in and has to borrow money to make up for it.

When the government borrows a lot of money, it crowds out private borrowers.  It does that in two ways.  First, it can just borrow up all the money until there is none left.  That usually doesn't happen.  What does happen is that the increased demand for loans drives up the interest rates.  Then individuals and businesses can't afford to borrow so much money.

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krishna-agrawala | Student

Crowding out effect, in economics, refers to reduction in private domestic or  foreign investment due to increase in government spending. This is due to many factors such as rise in interest rates and foreign exchange rates, which in turn are fuelled by increased output and inflation.

The implication of crowding out effects is that the effect of government spending to stimulate economy in short-run by increasing in short run does not give the full benefit as expected by the phenomenon of multiplier effect. However most of the economists believe that in spite of crowding out effect, the net benefit of stimulus given by government through deficit spending will be positive at least for 1 or 2 years.