What is crowding out?
When the government spends more and finances it by borrowing, demand for loanable funds rises, interest rates rise and private investment falls. Public spending partly "crowds out" private spending.
📌 At a glance
- Trigger
- Expansionary fiscal policy
- Channel
- Borrowing ↑ → rates ↑ → investment ↓
- Result
- Smaller fiscal effect
- Counterpart
- The multiplier effect
When is it large or small?
| Condition | Crowding out |
|---|---|
| Investment sensitive to rates | Larger |
| Money demand insensitive to rates (steep LM) | Larger |
| Liquidity trap | Very small |
| Central bank holds rates steady | Smaller |
Classical economists stressed full crowding out at full employment; Keynesians argue it is small in a slump.
Frequently asked questions
- What is the crowding-out effect?
- Higher government spending raising interest rates and reducing private investment.
- When is crowding out small?
- In a liquidity trap or when the central bank keeps interest rates low.
References
- Blinder, A. S., & Solow, R. M. (1973). Does fiscal policy matter? Journal of Public Economics, 2(4), 319–337.
- Mankiw, N. G. (2022). Macroeconomics (11th ed.). Worth Publishers.