Crowding Out

In terms of public expenditure, crowding-out effect implies?

Q. In terms of public expenditure, crowding-out effect implies:

A. Excess government subsidies distorting resource allocation

B. Excess private expenditure producing inflation

C. Market exploitation by the private sector due to reckless government expenditure.

D. Excess government expenditure, raising the interest rate and depressing the availability of funds.

Answer: D. Excess government expenditure, raising the interest rate and depressing the availability of funds.

Explanation

What is Crowding-out-Effect?

Crowding out is an economic term and is related to Government’s fiscal policy. 

It is a situation where to increase its spending Government increases the taxes thus reduces the private sector spendings.

 Why does it happen?

Let us understand the ‘crowding effect’ with an example. Suppose, there is a family of four persons. Also, suppose the family could afford to purchase only four eggs each day for each person.

If a guest comes by to stay with the family and her appetite for the eggs is too big. Some members (juniors) of the family may not get the egg. This is crowding out.

There are several causes of crowding out. 

1. When the government needs fund for fiscal expansion, it borrows from the market. Its lender could be private investment firms, individuals, Banks or Public Sector Undertakings such as LIC.

 The government sells Securities or bonds to fulfills its funding requirement.

The private firms which lent to the government could have invested in the private sector. 

Further, an expansionary fiscal policy of the government exhausted the lending capacity of the economy. The private firms find it hard to get funds for their investment and expansion.

Thus government borrowings crowd out private sector funding requirement. This is similar to our egg example.

2. When the government excessively borrows money from the economy, taxes also rise. The government increases various taxes to increase its revenue which it needs to fund its expenditure.

But, an increased tax rates lower the spending capacity of the consumer.

Private companies also find it costly to borrow money from the banks or investment firms with higher tax rates. In this case, they postpone their expansion plans. They forego their investment decisions.

This reduces the tax revenue for the government and thus increases the need for the government to borrow even more money. 

This situation again causes crowding out. 

3. An increase in government spending in activities, such as insurance,  which are traditionally carried by the private sectors, make it unprofitable for private firms to enter into those activities.

Thus reducing investment. 

In a nutshell

Crowding out effect occurs when government invests heavily to boost the economy. But the public investment creates unfavorable situations for private sector investment. 

A high magnitude of the crowding out effect may lead to lesser income in the economy and that may result in loss of jobs, etc.

Economists who suggested the term crowding out” 

The term “crowding out” was suggested by John M Keynes, Frank Knight and Milton Friedman.

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