Explain the concept of crowding out in relation to government spending.

Explain the concept of crowding out in relation to government spending.

Crowding out refers to the phenomenon where increased government spending leads to a decrease in private sector spending. When the government increases its spending, it often needs to borrow money by issuing bonds. This increases the demand for loanable funds, causing interest rates to rise. As interest rates increase, borrowing becomes more expensive for businesses and individuals, leading to a decrease in their spending and investment. This decrease in private sector spending offsets the initial increase in government spending, resulting in a limited overall impact on economic growth. Therefore, crowding out suggests that increased government spending can crowd out private sector investment and consumption.