Question

Using the national savings and investment indent, explain what crowding out is?  

Answer 1

The theory behind the crowding out effect assumes that governmental borrowing uses up a larger and larger proportion of the total supply of savings available for investment. Because demand for savings increases while supply stays the same, the price of money (the interest rate) goes up.

Crowding out begins to take effect when the interest rate level reaches a point at which only the government can afford to borrow. Unable to compete for loans under such circumstances, individuals and smaller-scale companies are forced (crowded) out of the market.

Because crowding out leads to decreases in private sector consumption and, therefore, slows economic growth, the crowding out effect should be a serious consideration for any government that plans to get an increasing percentage of its funding through the capital markets.