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What is the concept of crowding out in simple terms?

Relevant Topics

This question pertains to topics in Macroeconomics, such as Fiscal Policy and Public Finance

Definitions:

Crowding out is an economic concept that refers to a situation where increased public sector spending replaces, or drives down, private sector spending.

Detailed Explanation:

The crowding out effect often occurs when a government increases its spending to stimulate economic activity, and finances this spending through borrowing (by issuing government bonds). This increase in borrowing can lead to an increase in interest rates, as the government is essentially competing with private businesses and individuals for loans from banks and financial institutions.

Higher interest rates make borrowing more expensive for businesses and individuals, which can deter investment and consumption. Consequently, this may lower private sector spending. The increase in government spending is thus offset by the decrease in private spending, a phenomenon referred to as crowding out.

It is important to note that the extent of the crowding out effect can depend on the state of the economy. In a booming economy with high utilisation of resources, the crowding out effect can be substantial. However, in a recession, with excess capacity and low interest rates, the crowding out effect might be less pronounced.

Recent: 

In the late 1980s and early 1990s in the UK, there was an increase in government borrowing which led to higher interest rates. These higher rates were cited as a contributing factor to the recession of 1991, as they discouraged private investment.

During the Eurozone crisis in the late 2000s and early 2010s, countries with high public debt such as Greece and Italy experienced a crowding out effect. The high borrowing by these governments led to increased interest rates, which in turn reduced private sector investment in these economies.

Summary:

In simple terms, crowding out refers to the situation where increased government spending, often financed by borrowing, leads to a rise in interest rates. This discourages private sector borrowing and can result in reduced private sector spending. This means that an increase in public spending can sometimes be offset by a decrease in private spending. The extent of the crowding out effect can vary, however, depending on the state of the economy.

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