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Lesson summary: crowding out

In this lesson summary review and remind yourself of the key terms and graphs related to the crowding out effect.

Lesson Summary

In a previous lesson, we learned that fiscal policy can be used to close a recessionary gap. This sounds like great news! A country could just engage in deficit spending and spend its way out of a recession, right?
Not so fast! When countries run budget deficits, they typically pay for them by borrowing money. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out.
Most economists agree that deficit spending is not in itself a problem. In fact, deficit spending might even be necessary during severe recessions. But most economists also recognize the possibility that there may be long-term consequences of deficits and debts. The reduced spending on investment means that a country’s capital stock will not grow as fast. As a result, crowding out can reduce a country’s future potential output.

Key Terms

Key termDefinition
deficitwhen government spending exceeds tax revenues
debtthe accumulated effect of deficits over time
crowding outwhen a government’s deficit spending, and borrowing to pay for that deficit spending, leads to higher real interest rates and less investment spending

Key equations

The government budget

Budget Balance=TG,whereT= tax revenueG=government spending
For example, if a country collects $100 million in taxes and spends $100 million, the budget balance is zero. Sometimes you will also see this referred to being “in balance” rather than “the budget balance is zero.” In either case, this is the formula:
$100 million$100 million=0
But, if a government spends more than it takes in, it has a deficit. So if tax revenue is $100 million, but government spending is $120 million:
$100 million$120 million=$20 million
The budget is short $20 million, so the government will need to borrow that money. If the government runs the same deficit every year for three years, it will accrue a debt of $60 million:
Debt=Deficityr1+Deficityr2+Deficityr3=$20 million+$20 million+$20 million=$60 million

Key graphs

Deficits, borrowing, and the market for loanable funds

There are two points of view on how deficits impact the market for loanable funds:
The assumption about the impact of deficitsImpact on the market for loanable fundsEffect on the real interest rate
Deficits increase the demand for loanable funds (government is a borrower)demand for loanable funds ↓real int. rate ↑
Deficits decrease savings available (government is a saver)supply of loanable funds ↓real int. rate ↑
We can show each of these assumptions graphically:
Figure 1: Deficits increase the demand for loanable funds
Figure 2: Deficits decrease the supply of loanable funds

Key Takeaways

Governments usually pay for deficit spending by borrowing

If you want to spend $50 on pizzas, but you only have $10, you can’t afford it unless you take out a loan. Governments have an advantage you do not, though, in that they can print money. However, this is a tactic that governments rarely take because it leads to inflation or even hyperinflation. Instead, just like you, governments borrow money.
What if you want to borrow $40 and the government wants to borrow $50, but there is only $60 available to borrow? Now you and the government are competing to buy something that is scarce, which will drive prices up. As the real interest rate goes up, you decide you don’t really need a pizza that much. As a result of the government competing with you, and with any other private borrower, the interest rate goes up, and there is less private spending.
Your pizza dilemma illustrates the crowding out effect: when governments borrow it crowds out private sector borrowing. Less of that borrowing means less investment spending and interest-sensitive consumption in the short run.
Ultimately, the extent of crowding out depends on whether the economy can accommodate additional borrowing. If an economy is in a recession, there is less private investment spending to compete with, and crowding out is less of a concern. On the other hand, if an economy is near full employment output, there is likely to be more private investment; as a result, there is more potential for crowding out.

Crowding out might have long-run effects

Long-run crowding out might slow the rate of capital accumulation. Recall that part of investment spending is businesses buying new equipment, and businesses usually borrow money to do that spending on new equipment. Therefore higher interest rates mean less borrowing, and less borrowing means less equipment (in other words capital) is purchased.
If there is less borrowing, less capital accumulation will occur. More capital contributes to an economy’s ability to produce goods and services in the long run. Therefore, a potential long-run impact of deficits and debts is a slower rate of economic growth because the deficit has crowded out private investment in capital.

Common misperceptions

Sometimes new learners confuse the terms deficit and debt. Deficits are a shortage of funds in any given year. Debts are shortages that have accumulated over many years. A mnemonic that might help keep them straight is that debt builds up but deficits are for right now.

Questions for review

Elistan is currently operating below full employment.
PART 1. Draw a correctly labeled graph of the aggregate supply-aggregate demand model and label i) current output as Y_1, ii) the current price level as PL_1, and iii) the potential output as Y_f
PART 2: Assume policymakers decide to use fiscal policy to close the output gap. The marginal propensity to consume is 0.75 and the output gap is $120 million. Calculate the minimum change in government spending required to close this output gap.
PART 3: If the government decides to lower taxes to close this gap, with the change in taxes be greater than, less than, or equal to the change in government spending? Explain.
PART 4: Suppose the government incurs a budget deficit as a result of the change in fiscal policy. Show the impact of the deficit on interest rate in the market for loanable funds.
PART 5: As a result of the change in the interest rate you showed in part 4, what will happen to Elistan’s production possibilities curve in the long run? Explain.

Want to join the conversation?

  • cacteye green style avatar for user Uma
    In Deficits, Borrowing, and the Market for Loanable Funds, one of the assumptions is that the deficit increases government demand for loanable funds. So, the overall demand for loanable funds should increase. However, in the impact on the market for loanable funds part of the section, it is given that the demand for loanable funds decreases. Even in the following graph, demand is shown to increase.

    Is this an error in the article or am I doing something wrong?
    (9 votes)
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  • blobby green style avatar for user samvitagarwal03
    Since governments often borrow from other nations, why does crowding out even occur in the first place?
    (2 votes)
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    • starky tree style avatar for user melanie
      They also issue government bonds, which are a form of debt. When the government sells bonds (*not to be confused with the central bank selling bonds!!*), it is becoming a demander of loanable funds.

      Remember how bond prices and interest rates are inversely related? If the supply of bonds in the bond market increases, the price of bonds decreases. When the price of a bond decreases, its return (increases), so people buy more bonds and less of other assets. Other issuers of assets have to offer higher interest rates to lure them back.
      (8 votes)
  • old spice man blue style avatar for user Liam Mullany
    Is this always a bad thing? Could crowding out be used as a technique to reduce a positive output gap? Also isn't the government also using the money to "invest" (in the non-economic sense of the word): Could it be used to prevent the private sector growing faster than government infrastructure can keep up? (by using the borrowed funds to invest in infrastucture)
    (4 votes)
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  • blobby green style avatar for user Zakariya  Gababa
    When the government chooses to participate in deficit spending, what impact does this have on the loanable funds market?
    (3 votes)
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  • purple pi teal style avatar for user varunsingh2519
    During a recession, the government sends $500 checks to every American family. 70% of American families save the money or use it to pay off their debt. *
    a. Expansionary fiscal policy.
    b. Contractionary fiscal policy.
    c. Crowding out.
    d. Fiscal multiplier.
    e. a and c only.
    f. a and d only.

    Answer on the website shows it to be (e) i.e expansionary fiscal policy and crowding out.
    My question is how is that even crowding out? Since the question make no reference to private investment and interest rates. It just talks about household behaviour.
    (1 vote)
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  • blobby green style avatar for user Thamir Aljobori
    Assume that the economy is initially in equilibrium at the level of real output (Y) of $5000 and an interest rate of 5%. If as a result of an increase in government spending of 500, the economy moves to a new equilibrium Y=$5750, r=6.5% (and given that the multiplier k=3), How much autonomous spending was crowded out due to increasing in interest rates?
    (1 vote)
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