A government decide to introduce a major increase in its spending

programmes. Explain how this may lead to crowding out effects.

(10 marks)
The crowding out effects on the other hand, refers to the theory that any increase in government
spending, when financed by a larger deficit, will lead to a net decrease in private expenditure, as firms
and households face higher interest rates due to the governments intervention in private financial
markets. Government spending will crowd out private spending thus any increase in spending will be
offset by a decrease in private spending, possibly even reducing overall income in the nation.
The effect that likely leading to crowding out to be occurred when the deficit-financed government
spending refers to any policy that increases government expenditures without increasing taxes, or one
that reduces taxes without reducing government expenditures. In either case, a government must
increase the amount of borrowing it does to pay for the policy, which means governments must
borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the
government to offer higher rates of return on its bonds. The impact is on the supply of the private
savings, which refers to the funds available in commercial banks for lending and borrowing in the
private sector, will be negative. In other words, the supply of loanable funds in the private sector will
decrease.

In the above figure, it will illustrate the consequences of this increase in the demand. There is a given
amount of savings in the economy and this is represented by the supply of loanable funds curve. The
price of these loanable funds is the interest rate. The increased demand from D1 to D2 for savings in
order to finance a deficit results in an increase