Business, Legal & Accounting Glossary
Crowding out effect is an economic concept. It explains how a rise in the rate of interest, due to increased government borrowing (in money market) drives away or ‘crowds out’ private investment (from the lending market). Government’s ability to crowding out private investment is primarily due to its high credit rating and its ability to pay market demanded interest rate. [Government can fund its spending by taxation or by printing money or by borrowing. Crowding out effect is associated with the option of government borrowing]. At times increased government borrowing has been held responsible for the sluggish economic growth of a country. However, with globalization firms have increased access to capital from foreign countries. [It is interesting to note that interest rates and bond prices are inversely related]. choices of others.
In recent times a new type of crowding has emerged in form of international fund flow. In a highly integrated global financial system markets are closely interlinked. Money flows in response to interest rate differentials. Economic agents invest in markets offering higher rates of interest. Futures market has emerged to take care of concerned complexities of this global financial market dealings. Now suppose, in this kind of integrated financial framework US government increases its spending and finances it through borrowing. This extra volume of government borrowing will drive up rates of interest in US in comparison to rest of world. As a response to high interest rates foreign savings will flow into US financial market. US dollars will face an increased demand. This will drive up price of dollars vis a vis that of other currencies. US goods will become dearer abroad. Foreign goods will become cheaper in US markets. US net exports will come down. [It may be noted that fiscal policy measures are effective if they are not crowded out. Also existence of a reliable multiplier is vital for effective functioning of fiscal policies].
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This glossary post was last updated: 26th March, 2020 | 1 Views.