Final answer:
The crowding out effect occurs when government spending financed by borrowing leads to reduced financial capital availability for private sector investment, potentially impeding private investment in physical capital.
Step-by-step explanation:
The tendency for increases in government spending to cause reductions in private sector spending is known as the crowding out effect. When the government borrows funds to finance its spending, it increases demand for financial capital. If private saving and the trade balance remain unchanged, this increased demand can lead to a decrease in the financial capital available for the private sector to invest in physical capital. As a result, government borrowing can reduce the amount of money available for private firms to make investments, effectively crowding out private investment.
Additionally, if a government decides to finance investments in public physical capital through borrowing, there is a risk of increasing public physical capital at the expense of private physical capital, which might have been more advantageous for the economy. This effect can take place indirectly as well, for example, when higher taxes to fund government spending reduce private savings. While government spending on things like education or infrastructure can foster long-term growth, it is important to balance these benefits with the potential negative impacts of crowding out private sector investment.