Definition
The crowding out effect is the idea that larger government spending or borrowing can reduce private-sector spending and investment. In simple terms, when a government runs big deficits and finances them by issuing debt, it can push up interest rates or raise taxes — both of which make it harder or less attractive for businesses and households to borrow and spend.
Key terms (defined)
– Interest rate: the cost of borrowing money, usually expressed as a percentage of the loan.
– Real interest rate: the nominal interest rate adjusted for inflation; it measures the true purchasing‑power cost of borrowing.
– Disposable (or discretionary) income: income households have left to spend or save after taxes.
– Capital investment: spending by firms on long‑lived assets (factories, equipment, infrastructure) intended to produce future goods or services.
– Aggregate demand: total demand for goods and services in an economy (consumption + investment + government spending + net exports).
How crowding out works — main mechanisms
1. Loanable funds channel (direct): Government borrowing increases demand for loanable funds. If the supply of savings is limited, larger government demand raises real interest rates, increasing borrowing costs for private firms and households and discouraging loan‑funded investment.
2. Tax channel (indirect): If government finances spending by raising taxes, households and firms have less disposable