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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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.
The combination of the first two problems leads to the overarching problem with economic crowding out—dependency on government spending for economic stability and growth. If government spending takes up a sufficient amount of financial resources and constitutes a sufficient amount of the overall consumption and investment in a country, then the country's economy may become dependent upon it. The United States government, for example, spends trillions of dollars a year. What do you think would happen to the U.S. economy if the United States stopped spending tomorrow?
Crowding out is an economic concept that describes 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. The costs of resources and interests rates increase as the private sector competes with the public sector for the resources and financing. If public sector spending becomes significant enough, a country's economy may become dependent upon government spending to maintain economic stability and growth.
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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.
- 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.
- 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.
- 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.
- 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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Crowding Out in Economics: Definition & Effects
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