Crowding Out Effect

• Crowding out


  When increased government borrowing and spending leads to higher interest rates, which then reduces private investment and economic growth
• How government borrowing can lead to crowding out

  1. Government borrows money by selling bonds

  2. This increases demand for loanable funds in the market

  3. Increased demand for loanable funds raises interest rates

  4. Higher interest rates make it more expensive for private firms to borrow and invest

  5. Reduced private investment leads to lower economic growth
• Government increases borrowing and spending

  Demand for loanable funds increases
• Demand for loanable funds increases

  Interest rates rise
• Interest rates rise

  Private investment is reduced
• Private investment is reduced

  Economic growth is lower
• This is a key argument made by classical economists against the use of active fiscal policy to boost the economy