Crowding out is a particular situation where private sector investments are influenced by the government expenditures. It has been noticed that whenever there is a hike in the government expenditures, there comes a major change in the market. The additional expenditures of the governments are balanced primarily by increasing the interest rates. At the same time, these expenditure hikes and increased interest rates may cause inflation. All these factors affect the private sector and private investment activities. Both private investment and the production capacity of the sector go down. On the other hand, by using the crowding out theory, a number of government ventures have been privatized. The theory of crowding out has also been used to reduce government intervention and to increase the production of the firms.
The crowding out theory explains that there are several situations where the national governments need extra money. For this purpose, the governments use several financial instruments like bonds and some others to arrange loans from the market. Now, if there are too many loans then the interest rates will also be an additional burden. To pay such a large amount, governments have to increase the national interest rate on several credit products. The main problem is that the government has the capacity to bear the market interest rate but the capacity of the corporations as well as the individuals are limited and cannot be stretched beyond a limit. Crowding out may also be caused by the floating exchange rates.
On the other hand, crowding out has some other faces also. Whenever the expenditures of the national government increase, the market is extended for different products so as to encourage fixed investments. These investments are very crucial at times when the economy is passing through a period of depression or some thing like that.
There are a few processes that are used to avoid crowding out or at least to reduce crowding out but at the same time, these methods can also cause serious inflation problem for the economy. Printing money can provide finance to the governments to fulfill the deficit but the consequences of such an action might be harmful.