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Main content
Current time:0:00Total duration:3:55
POL‑3.C (LO)
POL‑3.C.1 (EK)
POL‑3.C.2 (EK)
POL‑3.C.3 (EK)
POL‑3.C.4 (EK)

Video transcript

in this video we're going to use a simple model for the loanable funds market to understand a phenomenon known as crowding out and this is making reference to when a government borrows money to some degree it could crowd out private sector borrowing and investment and it could have negative consequences for the economy you might have less investment as a result and you could have less economic growth so let's see how the crowding out can happen using this loanable funds market model so just to be clear what's going on here horizontal axis the quantity of loanable funds the vertical axis you have your price of borrowing which is going to be our real interest rate and our equilibrium real interest rate and quantity is determined by the intersection between the supply of loanable funds curve and the demand of loanable funds curve so what happens if let's just say step one the government decides to borrow to fund some of its spending what is going to happen to these curves is one of them going to shift well sure if at any given interest rate all of a sudden you have a big borrower in terms of the government that now wants to enter the market for loanable funds at a given interest rate that's going to increase the demand for loanable funds so this step one right over here is going to shift the demand for loanable funds curve to the right I'll just call that step one right over there and so our new demand for loanable funds might look something like this and so let's call that demand for loanable funds prime so this is going to shift shift the demand for loanable funds to the right now what is that going to cause well that is going to cause our real interest rate to go up real interest interest rate is going to go up you see it right over here our new equilibrium you do have more loanable funds that are being supplied and demanded that are being borrowed so this is called this Q Prime but you see this happening at a higher cost at a higher real interest rate so we call that R Prime well what's going to be the impact in the private sector of a higher real interest rate let's imagine for a second this first blue curve was just the private sector let's say that the government just started to borrow in this video shifting the curve well if this was if the blue curve was just the private sector at this new interest rate the private sector is willing to borrow a lot less so we could say private sector private sector borrows less borrows less and so what could that result in well then you could have and this is the negative effects of crowding out you could have because they're borrowing less they're fueling less investment then you're gonna have less capital less productive capital that you can use to produce things so we could say less capital accumulation accumulation which is just another way of saying for example people are investing less because they're not borrowing as much investing less in factory or some other thing that might make people or in technology things that might make them more productive and so if you're having less capital accumulation that means that you're gonna have slower economic growth one of the ways that a country really pushes its production possibilities curve out or really pushes its long-run aggregate supply curve to the right and has true economic growth is through investment but if you have if you're borrowing costs are higher you're going to have less investment less capital accumulation and slower economic growth