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

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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...

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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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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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