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Crowding Out Effect

Why in news:

  • Recently, the Chief Economic Advisor has asserted that concerns about high government borrowings crowding out the private sector’s fund-raising efforts were misplaced and not based on evidence.

About Crowding Out Effect

  • This refers to a phenomenon where increased borrowing by the government to meet its spending needs causes a decrease in the quantity of funds that is available to meet the investment needs of the private sector.
    • In other words, when the government is increasing its expenditure, private expenditure comes down.
  • Sometimes, government adopts an expansionary fiscal policy stance and increases its spending to boost the economic activity. This leads to an increase in interest rates. Increased interest rates affect private investment decisions. A high magnitude of the crowding out effect may even lead to lesser income in the economy.
    • With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually the initial increase in government spending is funded using higher taxes or borrowing on part of the government.
  • Some believe that government spending does not always lead to a crowding out of private investment in the economy. They instead argue that government demand for funds can compensate for the lack of private demand for funds during economic depressions, thus helping to prop up aggregate demand.

Source: The Hindu