Topic 5.5 Notes – Crowding Out

1. What Crowding Out Is

Crowding out happens when government borrowing increases real interest rates and reduces interest-sensitive private spending, especially investment (I).

Here’s the setup:

• Expansionary fiscal policy = ↑ government spending or ↓ taxes
• This often creates a budget deficit (government spends more than it collects in taxes).
• To cover the deficit, the government borrows in the loanable funds market.

That extra borrowing competes with businesses that want loans for factories, machines, and technology.

Higher government borrowing → higher real interest rates (r) → lower private investment (and sometimes lower consumption of houses and cars).

So part of the increase in aggregate demand (AD) from fiscal policy gets offset by falling private spending.

Short run: fiscal policy is weaker than expected.
Long run: less capital accumulation → slower economic growth.

2. The Loanable Funds Model and Government Borrowing

Quick refresher on the model:

• Supply of loanable funds (S) = national saving (households, firms, foreign sector).
• Demand for loanable funds (D) = private investment + government borrowing.
• The real interest rate (r) adjusts so that S = D.

Here’s what happens when the government runs a deficit:

1. Government increases spending or cuts taxes.
2. Budget deficit increases.
3. Government borrowing increases.
4. Demand for loanable funds shifts right.
5. Real interest rate rises.
6. Private investment falls.

On the graph below, the demand curve shifts right from L^D₀ to L^D₁, raising the real interest rate from r₀ to r₁. Quantity of loanable funds increases from L₀ to L₁.

Loanable funds market with deficit-driven demand shift

You should immediately think:

Deficit → D right → r up → I down.

That chain shows up constantly in multiple choice and FRQs.

Before vs After Deficit

The government is now absorbing more of the available savings.

3. How Crowding Out Reduces the Impact of Fiscal Policy

Imagine the economy is in a recessionary gap (output below LRAS), like during the Great Recession of 2008-2009.

The Chain Reaction

1. Government increases spending.
2. AD shifts right.
3. Output and income rise.
4. Government runs a larger deficit.
5. Borrowing increases.
6. Real interest rates rise in the loanable funds market.
7. Private investment falls.
8. AD shifts left slightly from its new position.

The graphs below show both markets adjusting at the same time. Focus on the left panel for the loanable funds market and the right panel for the AD-AS model.

In the loanable funds market, demand shifts right and the real interest rate rises. In the AD-AS graph, AD first shifts right, then shifts slightly left as investment falls.

The economy improves, but not as much as policymakers hoped.

On exams, they love asking you to show:

• Expansionary fiscal policy shifts AD right
• Crowding out reduces investment
• The final equilibrium output is lower than it would be without crowding out

The correct answer often mentions a leftward shift of AD caused by rising interest rates.

4. Short-Run vs Long-Run Consequences

Short Run Effects

• Higher real interest rates
• Lower private investment
• Smaller multiplier effect
• Weaker stimulus

Crowding out is more severe when:

• The economy is near full employment.
• The supply of loanable funds is inelastic.
• The demand for money is high.

It is less severe when:

• The economy is in a deep recession.
• There are large unused savings.
• Interest rates are already very low.

After the 2008 financial crisis, interest rates stayed near zero for years due to Federal Reserve policy. That limited crowding out because borrowing did not push rates up much.

Long Run Effects

Investment today builds tomorrow’s capital stock.

If investment falls:

• Slower capital accumulation
• Slower productivity growth
• Slower growth of LRAS

During the large federal deficits of the 1980s under Reagan, economists debated whether persistent borrowing would crowd out investment and slow long-run growth.

The key long-run idea is simple:

Less investment → less physical capital → slower economic growth.