what is the crowding out effect 
the crowding out effect is an economic theory that argues that rising public sector spending drives down or even eliminates private sector spending to spend more the government needs added revenue it obtains it by raising taxes or by borrowing through the sale of treasury securities higher taxes can mean reduced income and spending by individuals and businesses treasury sales can increase interest rates and borrowing costs that can reduce borrowing demand and spending all told these government activities are thought to result in the crowding out of spending by private individuals and companies investopedia nez riazunderstanding the crowding out effectthe crowding out effect is based on the supply of and demand for money according to the theory as the government takes revenue raising actions such as increasing taxes or debt security sales the consumer and business demand for resulting higher interest rate loans decreases so does their desire to spend a potentially reduced amount of income their desire to earn a higher rate of interest on their savings may also come into play thus the government crowds out their spending by increasing its own bear in mind that the crowding out effect theory runs counter to older well known economic theories that hold that government spending during periods of slowing economic activity actually increases spending by consumers and businesses by essentially putting more money in their pockets one of the most common forms of crowding out takes place when a large government such as that of the u s increases its borrowing and sets in motion a chain of events that results in the curtailing of private sector spending the sheer scale of this type of borrowing can lead to substantial rises in the real interest rate this can absorb the economy s lending capacity and discourage businesses from making capital investments companies often fund capital projects in part or entirely through financing the increased cost of borrowing money makes traditionally profitable projects that are funded through loans cost prohibitive increased borrowing by large governments is considered to be a common cause of crowding out the borrowing can force interest rates higher and dampen loan demand by those in the private sector types of crowding out effectsreductions in corporate capital spending can partially offset benefits brought about through government borrowing such as those of economic stimulus however this is only likely when the economy is operating at capacity in this respect government stimulus is theoretically more effective when the economy is below capacity if this is the case however an economic downswing may occur this can reduce the revenues that the government collects through taxes and spur it to borrow even more money theoretically this in turn can lead to a vicious cycle of borrowing and crowding out crowding out may also take place because of social welfare albeit indirectly when governments raise taxes to introduce or expand welfare programs individuals and businesses are left with less discretionary income this can reduce charitable contributions in this respect public sector expenditures for social welfare can reduce private sector giving for social welfare offsetting the government s spending on the same causes similarly the creation or expansion of public health insurance programs such as medicaid can prompt those covered by private insurance to switch to the public option left with fewer customers and a smaller risk pool private health insurance companies may have to raise premiums leading to further reductions in private coverage another form of crowding out can occur because of government funded infrastructure development projects these can discourage private enterprise from launching similar projects in the same area of the market because they re now perceived as undesirable or corporate number crunchers might indicate that such investments are projected to be unprofitable this often occurs with bridges and roadways as government funded development deters companies from building toll roads or other related infrastructure example of the crowding out effectsuppose a firm has been planning a capital project with an estimated cost of 5 million an assumed 3 interest rate on its loans and a projected return of 6 million the firm anticipates earning 1 million in net income ni due to the shaky state of the economy however the government announces a stimulus package that will help businesses in need this raises the interest rate on the firm s new loans to 4 because the interest rate that the firm originally factored into its accounting has increased by 33 3 its profit model shifts the firm now estimates that it will need to spend 5 75 million on the project in order to make the same 6 million in return its projected earnings drop by 75 to 250 000 therefore the company decides that it would be better off pursuing a different project or halting major projects for the time being crowding out vs crowding inchartalism post keynesian economics and other macroeconomic theories posit that government borrowing in a modern economy operating significantly below capacity can actually increase demand it does so by generating employment and thereby stimulating private spending this process is often referred to as crowding in the crowding in theory has gained some currency among economists in recent years after it was noted that during the great recession of 2007 2009 massive spending by the federal government on bonds and other securities actually had the effect of reducing interest rates 1