Question

What is the crowding-out effect? Briefly explain and give an example

Answer 1

The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.

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Suppose a firm has been planning a capital project that with an estimated cost of $5 million and a return of $6 million, assuming the interest rate on its loans remains 3%. The firm anticipates earning $1 million in net income. Due to the shaky state of the economy, however, the government announces a stimulus package that will help businesses in need but will also raise the interest rate on the firm's new loans to 4%.

Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. Its projected earnings have now dropped by 75% to $250,000, so the company decides that it would be better off pursuing other options.