The Prime Causes of Crowding Out Effect in Economics

Great Recession
During the great recession of 2007, government deficits had increased a lot, since the government had to incur huge public spending for the masses. However, the ultimate result was that it did impact the business sector, and they ended up being crowded out. Thus, government spending does have a negative side too, though it has been overlooked.
The dictionary meaning of the term ‘crowding out’ is thrusting out, or forcing out of a small place. However, in economics, the crowding out effect is an interesting phenomenon that deals with the government spending. Government deficit is a situation when the government ends up spending more than the borrowing. What does the government do when it is short of money? Simply mint money? Of course, not! Money circulation is not so easy, and the government cannot start printing money simply as per its wishes and whims. Too much circulation of money will not lead to an increase in the value of the goods or services, but will certainly increase the inflation rate in the economy.
Why does ‘Crowding Out’ occur?

To reduce the deficits, the government again borrows from the market. Since the fiscal policies of the government impact the economy on a much larger scale, it does affect the private sector of the market. Due to the increase in government borrowing, the demand for investments in the market increases. Automatically, the price of funds increases. It implies that this increases the rate of interest in the market.

Hence, increased interest rates in the market again have an impact on the private sector. The private entrepreneurs cannot borrow much, once the interest rate of loan funds increases. In this case, they may stop or curb their growth or expansion plans. Thus, the government sucks up or absorbs the money circulation in the market, thereby creating a crowding out effect in the market.

Interest rates and borrowings have an inverse relationship. Once the interest rates increase, the borrowings decrease and vice versa. The government can create a crowding out effect in many ways.
Issuing government bonds in the market

The government borrows from the market, by issuing bonds and securities. Other than that, there are compulsory savings in the form of pension funds and other security benefits. When such bonds are circulated in the market, people tend to invest in them due to their high credit rating as compared to the private sector. Thus, much also depends on the mentality of the investors. If they prefer to have risk-less investments, most of them will divert their savings to the government.