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Crowding out is a term used in macroeconomics to describe the jump in interest rates associated with increased government debt. This occurs when the government increases borrowing and consequently increases the interest rates. Eventually, private borrowers, such as businesses and individuals, cannot afford to borrow at the high interest rates. The term could also refer to a phenomenon in which the government offers new services, thereby crowding out private companies who would have offered the same services.
When a government needs more money to spend, it can either increase taxes or increase borrowing from its citizens and other resources. Governments accomplish this by issuing bonds, or promises to repay loans with a predetermined interest rate. As governmental borrowing increases, so does the interest rate, because a higher interest rate is often necessary to entice lenders and to compensate them for the risk of their investment and any apparent lack of trustworthiness.
The government, in theory, should always be able to pay off these higher interest rates because it has the power to raise taxes or cut spending in other areas. Private borrowers are limited in their ability to pay off certain interest rates, especially if those borrowers are individuals buying a house, small businesses, or larger companies with necessary expenditures. Lenders will be much more likely to lend to those who can pay off the high interest rates, so as a result these parties are crowded out of the lending market.
Other more specific types of crowding out occur in the healthcare sector and abroad. In healthcare, the term refers to the phenomenon involving new programs and resources for those without health insurance. Instead of causing those in need to enroll, these programs often have high enrollment from individuals who had previously been covered by private insurance, thus they might not always be as effective as once believed. International crowding out is also possible. In this case, increasing domestic interest rates caused by government debt encourage the influx of foreign currency into the market, causing exchange rates to increase.
Crowding out can be avoided or mitigated in several ways. Printing more money is one way to reduce the effects and pay back debt, but this creates high inflation rates that cause other problems for a country’s economy. In some cases, crowding out can actually stimulate the growth of new goods or services in a process known as the accelerator effect. This effect is most noticeable during times of recession, but during times of productivity, crowding out has worse economic effects.