When the government runs a deficit, it borrows in the The Loanable Funds Market market. That borrowing has a side effect on private investment.
Key idea
Crowding out: government borrowing raises the demand for loanable funds, which raises the real interest rate and reduces private investment. Some of the boost from deficit spending is offset by less private spending, and less investment means less capital for the future.
Why it works
Saving is a limited pool. When the government borrows more of it, the real interest rate must rise to bring supply and demand back together. At the higher rate, some private projects no longer pay, so firms borrow and invest less. How much is crowded out depends on how strongly saving and investment respond to the interest rate, and on the state of the economy: in a deep recession, with idle resources and weak demand for loans, rates may rise little; near full employment, borrowing competes harder for scarce saving. The size of crowding out in practice is debated.
Worked examples
Worked example: Crowding out with numbers
Supply: $r = 1 + 0.01Q$. Private demand: $r = 7 - 0.01Q$ ($Q$ in billions, $r$ in percent), so $r = 4\%$ and $Q = 300$. The government borrows \$100 billion at every rate. Find the new rate and the private investment crowded out.
- New demand: $r = 7 - 0.01(Q - 100) = 8 - 0.01Q$. Set equal to supply: $1 + 0.01Q = 8 - 0.01Q$, so $Q = 350$ and $r = 4.5\%$.
- Private borrowing at 4.5%: $7 - 0.01Q = 4.5$ gives $Q = 250$.
- Crowded out: $300 - 250 = 50$ billion dollars. Total lending rose by 50; the government got 100.
Answer: $r = 4.5\%$; \$50 billion crowded out
Worked example: Which curve?
In the loanable funds model where the government is a borrower, which curve shifts when the deficit grows?
- The government borrows more: demand shifts right.
- (Some textbooks show the same event as lower public saving, a leftward shift of supply. The real rate rises either way.)
Answer: Demand, to the right
Common mistake
Shifting the supply of loanable funds to the right when the government borrows. Government borrowing adds to demand (or, in the other framing, reduces national saving). Check: is the government lending or borrowing? It is borrowing, so the rate must rise.