Crowding out occurs when increased government expenditure leads to lower private sector consumption and investment. This means to say that government expenditure crowds out the private sector. This occurs to the extent that there will be less boost to aggregate demand.

If the government has a large fiscal deficit it will have to raise money by selling bonds on the financial markets. The more bonds it sells, the more it will have to raise the coupon or interest rate to attract new buyers. Increase in long term interest rates will have an adverse impact on private sector consumption and investment.

The government could also finance its increased expenditures by raising taxes such as income and corporate taxes or indirect taxes such as value added tax (VAT). However, by doing so, it could curtail private sector consumption and investment.

If the government decides to finance the increased fiscal expenditure by selling bonds and widening the fiscal deficit, it is possible that economic agents will conclude that the higher fiscal deficits today will mean higher taxes in future. Therefore, they may save more today so as to not suffer when there are higher taxes in future. Large fiscal deficits may upset the financial markets raising long-term interest rates and the cost of raising capital.

There may be adverse supply side effects on the economy of increased government taxes to finance increased government expenditure on the labour market which lowers the incentive to work. If taxes drive up employers’ costs, these will directly reduce labour demand.

In an open economy, it is possible that an expansionary fiscal policy by raising the domestic interest rate may lead to a sharp appreciation of the currency which can reduce exports and increase imports. This is because the currency become more costly in terms of foreign currency and become cheaper in terms of domestic currency. This will mean a slow down in aggregate demand so to some extent offsets the effects of increased government expenditure.

Resource crowding out occurs when the increased government expenditure takes away scarce resources from the private sector, leading to lower activity by the private sector.