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All you need to know about crowding out effect

A direct impact of excessive government spending is crowding out of private investments. This simply means that private sector investment falls due to government spending.
Darshita Shah Oct 27, 2016

Every time the government prepares it budget, it decides whether it needs to spend money in order to stimulate the economy or curb its expenses.

If the government increases its spending by building roads, railways and other infrastructure, it boosts the growth of the economy by creating jobs and thereby boosting demand. But government spending also has a negative impact on the economy, especially if the economy is operating at a full capacity.  

A direct impact of excessive government spending is crowding out of private investments. This simply means that private sector investment falls due to government spending.

Here’s how it happens. The government has to borrow to spend. To attract investors, the government has to offer an attractive yield. Thus, investors and even companies invest in government bonds to earn an attractive risk-free return. As a result, the interest rate in the market goes up. Since companies fund their projects by borrowing from the market, they are deterred to make investments if interest rates rise. This is because higher interest rates increase their cost of funding.

Alternatively, the government can also increase taxes to fund its spending. If it does so, this has a direct impact on the net earnings of individuals and firms. If individuals are earning less post tax, they would lower their spending which could eventually decrease the aggregate demand in the economy. 

To sum up, government spending has its pros and cons. Some macroeconomic theories suggest that If the economy is operating at below capacity, government spending can actually help the economy by creating jobs and increasing demand. The increased demand eventually leads to an increase in private sector spending. This is known as ‘crowding in effect’.

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