Crowding Out: Study Guide (Macroeconomics 5.5)

Why a deficit means borrowing

In Topic 5.4 you saw that a government runs a budget deficit when its spending (government purchases plus transfer payments) is greater than its tax revenue in a year. The gap has to be paid for somehow. A government usually borrows the difference, mainly by selling government bonds to savers.

So expansionary fiscal policy that widens the deficit, such as a rise in government purchases or a tax cut, normally means more government borrowing. Borrowing takes place in the loanable funds market, where firms, households and the government compete for the same pool of saving.

Crowding out is the fall in interest-sensitive private spending, especially business investment, that happens because extra government borrowing raises the real interest rate.

The loanable funds market: a quick refresher

From Topic 4.7:

• The vertical axis shows the real interest rate (r). The horizontal axis shows the quantity of loanable funds.
• Demand for loanable funds comes from borrowers. It slopes down: at a lower real interest rate, more investment projects are worth borrowing for.
• Supply of loanable funds comes from savers. It slopes up: a higher real interest rate rewards saving.
• At equilibrium, the real interest rate makes the quantity demanded equal to the quantity supplied.

The real interest rate is the one that matters, because borrowers and savers care about what a loan costs, or earns, after inflation.

How government borrowing crowds out private investment

Follow the chain one link at a time.

1. The government runs a larger deficit and borrows to finance it.
2. The demand for loanable funds shifts right, because the government is an extra borrower at every interest rate.
3. At the old real interest rate there is now a shortage of loanable funds, so the real interest rate rises.
4. The higher real interest rate does two things. Savers supply more loanable funds (a movement up the supply curve). Private borrowers demand less (a movement up the original demand curve).
5. Private borrowing for interest-sensitive spending falls: business investment in machines and buildings, new housing, and consumer goods often bought on credit, such as cars.

Steps 4 and 5 are the crowding out. The government gets the funds it wants, partly from extra saving and partly by pushing private borrowers out of the market.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All data are fictional. In Valdoria’s loanable funds market (quantities in VD billion a year, r = real interest rate in %):

• Private demand for loanable funds: Qd = 400 − 20r
• Supply of loanable funds: Qs = 100 + 40r

At first the government’s budget is balanced, so all borrowing is private.

Worked example 1: measuring crowding out

Question. (a) Find the equilibrium real interest rate and quantity of loanable funds. (b) The government now runs a deficit of VD 60 billion and borrows the whole amount at any interest rate. Find the new equilibrium. (c) How much private investment is crowded out, and where do the government’s VD 60 billion come from?

(a) Set Qd = Qs: 400 − 20r = 100 + 40r, so 300 = 60r and r = 5%. Quantity = 100 + 40(5) = VD 300 billion, all of it private investment.

(b) Total demand is now Qd = 400 − 20r + 60 = 460 − 20r. Set it equal to supply: 460 − 20r = 100 + 40r, so 360 = 60r and r = 6%. Quantity = 100 + 40(6) = VD 340 billion.

Check the shortage. At the old rate of 5%, borrowers now want 460 − 100 = VD 360 billion but savers offer only VD 300 billion. The shortage of VD 60 billion is what pushes r up.

(c) Private borrowing at r = 6% is 400 − 20(6) = VD 280 billion. It was VD 300 billion, so VD 20 billion of private investment is crowded out.

The government’s VD 60 billion come from two places:

Source	Amount (VD billion)
Extra saving (340 − 300)	40
Private investment crowded out (300 − 280)	20
Total government borrowing	60

Interpretation. One-third of the government borrowing (20 of 60) is matched by lower private investment. Crowding out here is partial: private investment falls, but by less than the extra government borrowing.

Another way to draw it. Some teachers show the deficit on the supply side. A deficit is negative public saving, so national saving (private plus public saving) falls and the supply of loanable funds shifts left by VD 60 billion: Qs = 40 + 40r. Then 400 − 20r = 40 + 40r gives r = 6% again, and the equilibrium quantity is VD 280 billion, which is now the private investment. Same rise in r, same crowding out. Use either method in an exam, but label the shifted curve clearly and do not shift both.

Crowding out in the short run: a smaller AD shift

Expansionary fiscal policy is meant to raise aggregate demand (AD). Crowding out works against it, because investment is also part of AD. The rise in government purchases pushes AD right; the fall in private investment pushes it back to the left. The net shift is smaller than the simple multiplier predicts.

Worked example 2: the short run and the long run

Question. Valdoria’s deficit in Worked example 1 comes from an extra VD 60 billion of government purchases. The marginal propensity to consume (MPC) is 0.75. (a) Estimate the change in AD with and without crowding out. (b) Suppose the crowding out of VD 20 billion a year continues for five years, and all private investment adds to the capital stock (ignore depreciation). How much smaller is Valdoria’s capital stock after five years? (c) What does this mean for long-run growth?

(a) Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ 0.25 = 4.

• Without crowding out: 4 × VD 60 billion = VD 240 billion rise in AD.
• Investment falls by VD 20 billion, which on its own reduces AD by 4 × 20 = VD 80 billion.
• Net: 4 × (60 − 20) = VD 160 billion.

This is a simplified estimate. It treats the fall in investment as a single change in spending that has the same multiplier as government purchases. The point is the direction: crowding out makes the AD shift smaller.

(b) Investment without the deficit: 5 × 300 = VD 1,500 billion. With crowding out: 5 × 280 = VD 1,400 billion. The capital stock is VD 100 billion smaller.

(c) Fewer machines, buildings and equipment mean less physical capital per worker. Productivity grows more slowly, so the long-run aggregate supply curve (LRAS) shifts right by less than it would have done. The economy still grows, but at a slower rate. You will look at the link from capital to growth in detail in Topic 5.6.

What makes crowding out bigger or smaller

The size of the crowding out depends on how the market responds. In Worked example 1, two-thirds of the government’s borrowing came from extra saving. If saving responded less to the interest rate (a steeper supply curve), the real interest rate would rise further and more private investment would be crowded out. You will test this in Practice Question 7.

Two further points are useful background:

• What the government buys matters for the long run. If the borrowed funds pay for public capital, such as roads or broadband, that spending can itself raise future capacity and partly offset the lost private capital (Topic 5.7). Borrowing to pay for current spending has no such offset.
• The reverse also works. If a government cuts its deficit and borrows less, the demand for loanable funds shifts left, the real interest rate falls and private investment rises. Some textbooks call this “crowding in”.

You may also meet an explanation that uses the money market: higher income raises the demand for money and so the nominal interest rate. For this topic the course uses the loanable funds model and the real interest rate, so use that graph unless a question asks for another one.

Common misconceptions

• “Crowding out means the government takes money directly from firms.” It works through a higher real interest rate that makes private borrowers choose to borrow less.
• Shifting the demand for loanable funds left. Government borrowing adds a borrower, so demand shifts right (or, with the alternative method, supply shifts left). Never shift both curves for one change.
• “The quantity of loanable funds falls.” With the demand-shift method, the total quantity rises (300 to 340 in Valdoria). It is the private part that falls.
• “Private investment falls by the full amount the government borrows.” Usually not: extra saving supplies part of it. In Valdoria, 60 of borrowing crowded out 20 of investment.
• Using the nominal interest rate on the loanable funds graph. The vertical axis is the real interest rate.
• “Crowding out cancels fiscal policy in the short run.” It makes the AD shift smaller, not usually zero.
• “Crowding out stops economic growth.” It slows growth by reducing capital accumulation; LRAS still usually shifts right, just less.
• Confusing the deficit with the debt. The deficit is the yearly gap that must be borrowed; the debt is the total accumulated from past deficits (Topic 5.4).

Where this leads

In Topic 5.6 you will see why physical capital per worker matters so much for productivity and long-run growth: continue with the economic growth study guide. If the loanable funds graph is not yet secure, go back to Topic 4.7; for deficits and debt, see Topic 5.4.

Now try the practice questions, then use the revision notes and the checklist to consolidate.