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AP® Macroeconomics · Unit 5 · Topic 5.5

Crowding Out: Revision Notes (Macroeconomics 5.5)

One-page recap of crowding out: deficit borrowing, the loanable funds graph, the rise in the real interest rate, the smaller AD shift and the long-run cost to growth.

Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.

Recap

  • A government with a budget deficit usually borrows to pay for its spending.
  • Crowding out: extra government borrowing raises the real interest rate, which reduces interest-sensitive private spending (business investment, new housing, goods bought on credit).
  • In the loanable funds graph, government borrowing shifts demand right. The real interest rate rises; the total quantity of loanable funds rises; private borrowing falls.
  • Short run: the fall in investment offsets part of the fiscal stimulus, so AD rises by less than the simple multiplier suggests.
  • Long run: less private investment means less physical capital, lower productivity growth and a smaller rightward shift of LRAS.

Key relationships

Change Loanable funds market Private investment Long run
Larger deficit (more borrowing) D shifts right (or S shifts left); r rises Falls Slower capital accumulation and growth
Smaller deficit (less borrowing) D shifts left (or S shifts right); r falls Rises Faster capital accumulation and growth

Accounting check: government borrowing = extra saving + private investment crowded out.

Assumptions behind the model

  • The interest rate on the graph is the real rate.
  • Other things are equal: private saving and investment plans do not change for other reasons.
  • Saving responds to the interest rate. The less it responds (steeper supply), the bigger the crowding out.
  • Use one method for the shift: demand right or supply left, never both.

Mistakes to avoid

  1. Shifting demand left for more government borrowing.
  2. Saying the total quantity of loanable funds falls (with the demand-shift method it rises).
  3. Putting the nominal interest rate on the loanable funds axis.
  4. Claiming private investment falls by the whole amount borrowed.
  5. Saying crowding out makes fiscal policy have no effect on AD.
  6. Saying crowding out stops growth; it slows it.

Quick self-check

VD is the valda, the currency of the fictional country Valdoria used in the study guide.

  1. Private demand Qd = 240 − 10r, supply Qs = 60 + 20r. Find the equilibrium. (r = 6%, VD 180 billion)
  2. The government borrows VD 30 billion more. Find the new real interest rate and private investment. (r = 7%; private investment VD 170 billion)
  3. How much investment is crowded out? (VD 10 billion; the other VD 20 billion comes from extra saving)
  4. Why can this slow long-run growth? (Less investment → less physical capital per worker → slower productivity growth → LRAS shifts right by less.)

Next: practice questions.

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