Crowding Out Effect

The so-called “crowding out" effect refers to how increased government spending, for which it must borrow more money, tends to reduce private spending. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available.

 As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out.The crowding out effect suggests rising public sector spending drives down private sector spending.

This happens because when the government takes up the lion’s share of funds available in the banking system, less of it is left for private borrowers. This also impacts interest rates in the economy.

There are three main reasons for the crowding out effect to take place:

1. Economics calling for increased taxation& borrowing,

2. social welfare activities, and

3. infrastructure development

The phenomenon of crowding out of private investment is based on the notion that supply of savings in the economy is fixed. Therefore, higher fiscal spending may increase the demand for loanable funds and hence exert an upward pressure on interest rates, thereby discouraging private investment.

Let us understand these phenomena with the help of flow charts/block diagrams.

a. Increasing Tax

Let us understand this flow chart for making it easy to interpret the other charts.

1.     When government increases taxes on the business in the form of corporation and income tax and further on the sale goods and services, there is consequent reduction in discretionary income of the consumers.

2.     It discourages private consumption expenditure which leads to crowding out of private investment.

3.     Moreover, there will be adverse impact on the aggregate demand offsetting the rise in government expenditure.

b.     Increased Borrowing

Crowding In Effect

It is important to keep in mind that crowding out doesn’t always occur – it depends on the state of the economy.

In emerging economies such as India, an increase in public expenditure in areas that boost private sector’s propensities to save and invest, may enable private investment rather than crowding it out.In emerging economy, what occurs is crowding in effect.

Crowding in occurs when higher government spending leads to an increase in private sector investment.The crowding in effects occurs because higher government spending leads to an increase in economic growth and therefore encourages firms to invest because there are now more profitable investment opportunities.

This is due to the income effect of higher government spending.If the economy is in a recession or below full capacity, expansionary fiscal policy can increase the economic growth rate and create a positive multiplier effect, which leads to greater private sector investment.

In fact, if the public expenditure is directed to sectors where the fiscal multipliers are large – for instance for building infrastructure – such spending may significantly crowd in private investment as well.

Let us try to understand how crowding in affect occurs using Production possibility curve.

Looking at the PPC curve as given in below, if the economy is below full capacity (as in case of emerging economies) then we can have more government spending and more private sector spending simultaneously.

Keynesians argue that in a recession there is no crowding out because the government is merely spending unused resources.

Keynesians argue that in a recession there is no crowding out because the government is merely spending unused resources.Also, as Keynes argued – in a recession – the private sector has idle resources (due to more saving).

Therefore, government borrowing is effectively making use of these idle resources. Financial crowding out is more likely to occur when the economy is growing and is close to full capacity already.

Therefore, in case of emerging economies the government expenditure pushes thedemand even in private ancillary industries/sector to come forward for meeting the rise in aggregate demand (because of increased government expenditure).