There is tremendous role for government spending in every economy. During recession and even in normal times, the government makes significant level of expenditure on various heads. This goverment expenditure stimulates the economy as it adds to the demand for goods and services.
At the same time, higher level of government expenditure produces some adverse effects. Practically, higher government expenditure is financed out of borrowings. This higher level of borrowing often causes two adverse effects in the fianancial system.
(i) Higher borrowing pushes up market interest rate. Increased government borrowing in the market compells the private sector to compete with the goverment for money. As a result, market interest rate goes up.
(ii) Higher government borrowing reduces the funds available for the private sector in the market.
These two occurances reduces the level of private spending inccluding private investment. Here what actually happened is higher level of goverment expenditure crowd outs (or reduces) private investment. Such a reduction of private spending caused by higher government borrowing is called crowding out effect.
What is crowding out effect?
The crowding out effect refers to a situation of high government expenditure supported by high borrowing causes decrease in private expenditure. Or in other words, when the government is increasing its expenditure, private expenditure comes down.
Increased government expenditure and its causality with decreased private expenditure are connected through borrowing.
If the government is raising its expenditure, it will be indicated by a higher deficit in the budget. For example, in India such rising government expenditure raises fiscal deficit.
This increased fiscal deficit will be met through borrowing. Government’s borrowing is different individual/business borrowing in terms of size and impact. This is because government is a big entity and its borrowing will be huge. In effect, high level of government borrowing causes an increase in the market interest rate. Similarly, availability of funds for the private sector will be less due to high level of government borrowing.
Increased interest rate and reduced availability of funds discourages private spending. Or in other words, high government expenditure crowd outs private expenditure.