Question

Explain two ways crowding out may occur.

Short answer

Crowding out may occur via direct displacement (government purchases decrease availability of goods/services for private sector) or through the interest rate effect (increased government spending and borrowing causes higher interest rates, discouraging private investment).

Step-by-step solution

Understanding Crowding Out

Crowding out happens when government spending does not cause an increase in economic output, but instead decreases private sector spending. Therefore, in order to understand how crowding out occurs, it's crucial to get acquainted with this concept first.

First Method of Crowding Out: Direct Displacement

Direct displacement occurs when the government purchases goods and services which results in less of these goods and services available for the private sector to consume. For example, if the government decided to purchase a vast supply of a certain commodity for a public project, less of this commodity would be available for private companies, potentially leading to price increases and making it more difficult for private companies to afford this commodity.

Second Method of Crowding Out: Interest Rate Effect

The interest rate effect occurs when increased government spending leads to larger government deficits, and subsequently, higher interest rates. These higher interest rates can discourage private investment because borrowing money becomes more expensive and less feasible for businesses and individuals. Therefore, the higher interest rates caused by government borrowing can effectively 'crowd out' private investment.