Crowding Out in Economics: Definition & Effects

Lesson Transcript
Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Expert Contributor
Joseph Shinn

Joe has a PhD in Economics from Temple University and has been teaching college-level courses for 10 years.

Financial resources are limited, and there isn't always enough to go around. In this lesson, you'll learn about the economic concept of crowding out, including what it is and its effect. A short quiz follows the lesson.

Definition of Crowding Out

Crowding out is a situation where personal consumption of goods and services and investments by business are reduced because of increases in government spending and deficit financing sucking up available financial resources and raising interest rates. Crowding out can be caused by an expansionary fiscal policy financed by increased taxes, borrowing, or both. Let's look at this in a bit more detail.

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  • 0:00 Definition of Crowding Out
  • 0:31 Effects of Crowding Out
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Effects of Crowding Out

Crowding out creates at least three problems. First, an expansionary fiscal policy means that the government is using financial resources that are no longer available for use by individuals and businesses. If the spending is financed through raising revenue through taxation, then that means there will be fewer dollars in the pockets of individuals and businesses to use for spending and investment. Additionally, if the government is competing for goods and services along with individuals and business, it may result in Increased prices because of the increase in demand.

The problem may be compounded if the government finances its spending through borrowing. The sheer size of a government's borrowing may create upward pressure on interest rates as the private sector and public sector compete for loans. This will make financing more expensive, which will have a negative effect on private economic growth. If it costs too much to obtain financing, individuals will decide not to purchase and businesses will decide not to invest.

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Additional Activities

Additional Questions

Consider the four examples below. For each of the examples, determine if "crowding out" is occurring. If the situation being discussed does not describe crowd out, explain why this isn't the case. If, on the other hand, the situation does describes crowd out, explain the private party (or parties) that is (are) being negatively impacted by government spending.

  1. A state's government is currently trying to decide if they should offer free college tuition to all in-state students for the first two years of their post-hight school education. If they decide to do this, some for-profit schools will go out of business because many students would choose the free state option than pay for two years of college.
  2. The Federal Government is currently discussing the possibility of offering all citizens government-run health insurance. If they do this, most private insurance carriers will be forced to close because the demand for their products will be extremely limited.
  3. A government agency currently has a contract with a tech company to fix government-issues when the breakdown. That agency is considering giving this contract to a different company. If they do, the current company will no longer be receiving the money from the government.
  4. The government is currently running a deficit, causing interest rates to be pushed up. These higher rates also lead to a decrease in private investment.

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