Definition: A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.
Description: Sometimes, government adopts an expansionary fiscal policy stance and increases its spending to boost the economic activity. This leads to an increase in interest rates. Increased interest rates affect private investment decisions. A high magnitude of the crowding out effect may even lead to lesser income in the economy.
With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually the initial increase in government spending is funded using higher taxes or borrowing on part of the government.
The crowding out effect is a prominent economic theory stating that increasing public sector spending has the effect of decreasing spending in the private sector. In other words, according to this theory, government spending may not succeed in increasing aggregate demand because private sector spending decreases as a result and in proportion to said government spending.
The government is effectively taking a greater and greater percentage of all savings currently usable for investment; eventually, when the interest rate gets high enough, only the government is able to afford the cost of borrowing–private firms are then “crowded out” of the market.
The crowding effect is a monetarist criticism of expansionary fiscal policy. (As a refresher, monetarists are those who primarily attribute shifts in the overall health of the economy to money supply changes; thus, in their eyes, improving economies’ performance is most effectively achieved when governments make smart adjustments to the monetary supply.) The idea gained popularity in the 1970s and 1980s, as economists who valued a free market above all else chose to raise warnings about the increasing portion of the GDP for which the public sector was becoming responsible.
As seen in the case of the multiplier effect, government spending will shift aggregate demand (AD) further than expected when an expansionary fiscal policy is implemented. However, monetarists believe that because of this expansionary fiscal policy, the government will need to borrow money by selling government bonds. This leads to a rise in interest rates, i.e. from R1 to R2. The increased borrowing ‘crowds out’ private investing.