ECONOMICS (CBSE/UGC NET)

Detailed explanation-1: -Increased borrowing by large governments is considered to be a common cause of crowding out. The borrowing can force interest rates higher and dampen loan demand by those in the private sector.

Detailed explanation-2: -When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out.

Detailed explanation-3: -The crowding-out effect implies falling private investment due to rising public expenditure. If the federal government finances the deficit through borrowing, then the money supply would increase in the economy, as borrowed money would be in circulation. This also leads to an increase in interest rates.

Detailed explanation-4: -In the long run, crowding out can slow down the rate of capital accumulation which can cause a loss of economic growth. The loanable funds market model can be utilized to depict the effect that increased government spending has on demand for loanable funds thereby making borrowing more expensive to the private sector.