Core Concepts & Learning Goals
This section explores the concept of crowding out, an important potential side effect of government fiscal policy. When the government increases its spending or cuts taxes to stimulate the economy, it often has to borrow money, which can have unintended consequences for the private sector.
The "big idea" is that government actions designed to solve short-run economic problems, like a recession, can inadvertently hinder long-run economic growth. By understanding crowding out, you can analyze the full impact of fiscal policy, weighing its short-term benefits against its potential long-term costs.
After studying this topic, you will be able to:
Define crowding out.
Use the loanable funds market model to explain how government borrowing leads to higher real interest rates.
Explain how higher real interest rates decrease, or "crowd out," private investment.
Describe the potential long-run impact of crowding out on capital accumulation and economic growth.
Key Concepts Breakdown
1. Fiscal Policy and Government Deficits
Governments use expansionary fiscal policy—increasing government spending or decreasing taxes—to boost aggregate demand during a recession. However, these policies often lead to a budget deficit, a situation where government spending is greater than its tax revenues in a given year.
To cover this shortfall, the government must borrow funds. It does this by selling government bonds to domestic and foreign savers. This act of borrowing places the government in direct competition with private firms and households who are also seeking to borrow money.
2. The Loanable Funds Market
The loanable funds market is the model used to illustrate the interaction between savers and borrowers in the economy. It determines the equilibrium real interest rate, which is the interest rate corrected for inflation.
Supply of Loanable Funds: Comes from private savings by households and businesses. The supply curve is upward-sloping because at higher real interest rates, the reward for saving is greater, leading people to save more.
Demand for Loanable Funds: Comes from private firms borrowing for investment (e.g., buying new machinery) and households borrowing for large purchases. The demand curve is downward-sloping because at lower real interest rates, the cost of borrowing is cheaper, encouraging more borrowing for investment.
When a government runs a budget deficit, it enters this market as a borrower. This adds to the total demand for loanable funds.
3. The Crowding Out Effect
Crowding out is the adverse effect of increased government borrowing that leads to a decrease in interest-sensitive private sector spending, particularly investment.
The process works as follows:
Government Borrows: The government's deficit spending increases the demand for loanable funds.
Real Interest Rate Rises: This increased demand pushes the equilibrium real interest rate higher.
Private Investment Falls: The higher real interest rate is the "price" of borrowing. For private firms, this higher cost makes some potential investment projects unprofitable. A firm that might have borrowed to build a new factory at a 3% real interest rate may decide against it at a 5% rate.
Result: Government borrowing effectively "crowds out" private investment. The government's spending is, in part, replacing private spending that would have otherwise occurred.
4. Long-Run Consequences of Crowding Out
The short-run decrease in private investment has significant long-run implications. Investment spending is crucial for the accumulation of physical capital, which includes the tools, machinery, and infrastructure used to produce goods and services.
Slower Capital Accumulation: When crowding out occurs, the rate of private investment falls. This means the nation's stock of physical capital grows more slowly than it would have otherwise.
Reduced Economic Growth: A smaller or less advanced capital stock reduces the economy's productive capacity. As a result, a potential long-run impact of significant and persistent crowding out is a lower rate of economic growth. The economy's long-run aggregate supply and production possibilities curve will shift outward more slowly.
Graphical Analysis (Text-Only)
The crowding out effect is best illustrated using the loanable funds market model.
Graph: The Loanable Funds Market and Government Borrowing
Vertical Axis: Real Interest Rate (r)
Horizontal Axis: Quantity of Loanable Funds (Q)
Initial State (Before Government Deficit Spending):
Supply Curve (S_LF): An upward-sloping curve representing savings.
Demand Curve (D1_LF): A downward-sloping curve representing private borrowing for investment.
Initial Equilibrium (E1): The intersection of S_LF and D1_LF. This establishes the initial real interest rate, (r_1), and the initial quantity of funds loaned for private investment, (Q_1).
The Change (Government Borrows to Finance a Deficit):
The government enters the market to borrow, increasing the overall demand for loanable funds at every real interest rate.
This action shifts the demand curve to the right, from D1_LF to a new curve, D2_LF. The horizontal distance between D1_LF and D2_LF represents the amount of government borrowing.
New State (After Government Deficit Spending):
New Equilibrium (E2): The supply curve (S_LF) now intersects the new demand curve (D2_LF).
Higher Interest Rate: This new equilibrium occurs at a higher real interest rate, (r_2).
Higher Total Borrowing: The total quantity of funds loaned in the market increases to (Q_2).
Crowding Out Analysis:
At the new, higher interest rate (r_2), private firms and households are less willing to borrow.
To find the new level of private investment, trace the new interest rate (r_2) back to the original private demand curve (D1_LF). This corresponds to a smaller quantity of private borrowing, (Q_p).
The decrease in private investment—the amount crowded out—is the difference between the original level of investment and the new level: (Q_1 - Q_p).
| State | Real Interest Rate | Private Investment | Government Borrowing | Total Borrowing |
|---|---|---|---|---|
| Before | (r_1) | (Q_1) | 0 | (Q_1) |
| After | (r_2) | (Q_p) | (Q_2 - Q_p) | (Q_2) |
The result is clear: while total borrowing in the market rises to (Q_2), the portion of that borrowing done by the private sector falls from (Q_1) to (Q_p).
Step-by-Step Example
Let's trace the effects of a government decision to increase spending on public infrastructure by $100 billion without raising taxes.
Step 1: Deficit is Created. The government's new spending creates a $100 billion budget deficit. To finance this, the U.S. Treasury must borrow $100 billion by selling bonds.
Step 2: Impact on the Loanable Funds Market. The government's demand for $100 billion in funds is added to the existing private demand from firms and households. In the loanable funds market graph, the demand curve shifts to the right. This increased competition for a limited pool of savings causes the equilibrium real interest rate to rise from, for example, 3% to 5%.
Step 3: Crowding Out and Long-Run Effects. The higher real interest rate of 5% discourages private investment. A corporation planning to build a new $50 million factory might cancel the project because the cost of borrowing is now too high. Consumers may delay buying new homes or cars. This reduction in private investment is the crowding out effect. Because less private investment occurs, the nation's stock of physical capital will grow more slowly, leading to a lower potential for long-run economic growth.
AP Exam Tips & Common Pitfalls
[FRQ Task]: A common FRQ will ask you to draw a correctly labeled graph of the loanable funds market and show how an increase in government borrowing affects the real interest rate. You will then be asked to explain how this change affects private investment and, potentially, long-run economic growth.
[MCQ Task]: Multiple-choice questions often test the causal chain of crowding out. Look for answers that connect deficit spending to higher real interest rates and lower levels of private investment.
[Common Pitfall ①]: Confusing Loanable Funds and Money Markets. The crowding out effect is analyzed in the loanable funds market, which determines the real interest rate. The money market determines the nominal interest rate. Do not use a money market graph to show crowding out.
[Common Pitfall ②]: Ignoring the Long Run. Crowding out is not just about a short-run increase in interest rates. The most important consequence, and one frequently tested, is its negative impact on the long-run growth rate of the economy due to reduced physical capital accumulation. Always be ready to connect the short-run market effect to the long-run growth trend.
Key Vocabulary
Crowding Out: The decrease in interest-sensitive private sector spending (especially investment) that results from increased government borrowing and the subsequent rise in real interest rates.
Budget Deficit: A situation in which government spending exceeds government tax revenues during a specific period, requiring the government to borrow to finance the difference.
Loanable Funds Market: The conceptual market where the supply of funds from savers and the demand for funds from borrowers interact to determine the equilibrium real interest rate.
Real Interest Rate: The interest rate adjusted for inflation, representing the true cost of borrowing and the true return to lending.
Physical Capital: The stock of man-made equipment, tools, factories, and infrastructure used in the production of goods and services.