What is the Crowding out Effect?

Malcolm Tatum

The crowding out effect is a type of economic theory that is sometimes used to explain the occurrence of an increase in interest rates as a result of a government’s activity in a money market. Usually, this upward shift in the interest rate is connected with an increase in the amount of borrowing that the government conducts in the marketplace. Should this activity begin to make it more difficult for businesses or individuals to participate in the market, the phenomenon is usually referred to as crowding out, meaning that the government’s borrowing is making it hard for others to transact business on those markets.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

The underlying concept of the crowding out effect is that when a government engages in increased borrowing, it naturally has an impact on the interest rates that apply in the market where that borrowing takes place. Since one of the means governments use to borrow money is issuing bonds, this means that an increased amount of bond issues on the part of a government could have the effect of significantly increasing interest rates. That increase may reach a point where other entities that would normally issue bonds to raise money may find the higher interest rate prohibitive. As a result, they do not move forward with issuing bonds and are thus crowded out of the market.

In the broadest sense, a crowding out effect takes place any time an increase in government spending has the effect of reducing investment of consumption by private entities. This means that consumers may feel crowded out when a government chooses to raise taxes as a means of generating additional funds, and begin to curtail their consumption as a means of dealing with the higher tax burden. At the same time, if the government steps up its borrowing in order to generate revenue, this may mean that private investors begin to cut back on their activities due to the increases in interest rates. In both scenarios, government spending exerts a significant amount of influence on how private and corporate investors choose to participate in various markets and in the economy in general.

While many economists accept the idea of a crowding out effect, it is not considered a proven theory by everyone who studies contemporary macroeconomics. Some of the objections to the premise of this particular economic theory is that the data cited to establish the connection between interest rates and their effect on investment is subject to interpretation. Some economists object to the crowding out effect on the grounds that a number of other factors may come into play even as the government steps up its spending that make some difference in how much or how little individuals and businesses adjust their consumption habits.

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