Crowding out effect and debt trap

Crowding out effect and debt trap

Subject :Economy

Context:

State has transitioned over the years from being “debt-stressed” to “debt-trapped”, generating a typical crowding out effect on private investment in Punjab.

Concept:

Debt Trap:

• The debt trap is a vicious cycle wherein one borrows new loans in order to clear the already existing borrowings. In other words, we incur in a debt to clear a debt, and in so doing fall into the trap.
• Such a situation arises due to the higher interest rates and most typically when our debt obligations exceed our capacity to repay.
• Individual households are not the only ones impacted by the debt trap; it is a distress that also affects the nations and their economies presumably because a household is the basic unit of an economy.

Crowding out effect:

• A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.
• Sometimes, the government adopts an expansionary fiscal policy stance and increases its spending to boost economic activity.
  • This leads to an increase in interest rates. Increased interest rates affect private investment decisions.
• A high magnitude of the crowding out effect may even lead to lesser income in the economy.
• With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually the initial increase in government spending is funded using higher taxes or borrowing on part of the government.