The crowding out effect is a term that it’s being used more and more on financial newspapers and other reports. But I do not want you to feel left out of the conversation every time someone brings it up – and it does happen quite often lately, no wonder why – so here’s a brief explanation.
Let’s take a random example, the English government. An increase in the English government’s expenditure may have to be financed by borrowing money. This would lead to an increase in interest rates, which would eventually result in higher borrowing costs for the private sector.
Higher borrowing costs for the private sector or else tighter bank lending terms would naturally lead to a reduction in demand. And if such a ‘hypothetical’ scenario was to take place, the government will have ‘crowded out’ the private sector due to its increase in spending.
Not to mention how bad that would be in terms of inflation…