Question

Does government borrowing crowd out public sector spending?

Answer 1

The crowding-out effect is a popular economic theory that increases in public sector expenditure are having the effect of rising private sector expenditure. In other words, according to this theory, government expenditure can not succeed in increasing aggregate demand because as a result and in relation to the said government spending, private sector spending decreases. The government is gradually taking a greater and greater portion of all the funds currently available for investment; finally, when the interest rate is high enough, only the government can absorb the borrowing costs – private companies are then "crowded out" of the market.

When governments increase their borrowing, they have to do the private sector borrowing. To fund the increased debt, a government ends up selling bonds through the central bank to the private sector. This practice is referred to as transparent operations on the sector. It is possible to sell these bonds to private individuals, mutual funds or investment trusts. If the private sector purchases certain government securities, they would not be able to invest in the private sector with the same funds. So government borrowing ends up crowding out private sector investment – thus using the phrase "crowding-out effect."

When a large country's government increases its total borrowing, this can have a significant effect on the economy in the form of a concomitant rise in the real interest rate of that economy. As a result, the lending potential of the economy is drained in such a way that firms are less likely to want to spend money in new projects. This is because businesses usually rely on finance to be able to fund these kinds of investments; as the opportunity cost of relying on funding (of borrowing money) rises, projects that would be financially worthwhile become overly costly and thus unprofitable.