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Deficits, Debt & Crowding Out

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Deficit vs. debt

A budget deficit is a flow: it is the amount by which government spending exceeds tax revenue in a single year (a surplus is the reverse). The national debt is a stock: it is the accumulation of all past deficits minus surpluses — the total the government owes at a point in time. Each year’s deficit adds to the debt; a surplus reduces it. To finance a deficit, the government borrows by selling bonds, which means it must compete with private borrowers for the economy’s pool of savings.

The loanable funds market

The loanable funds market determines the real interest rate through the supply of savings and the demand for borrowing. The supply of loanable funds comes from saving (households, firms) and slopes upward; the demand for loanable funds comes from borrowers who invest and slopes downward. The equilibrium real interest rate balances the two. This market is the setting for crowding out: when the government borrows heavily, it adds to demand for funds and drives up the real interest rate.

Crowding out

Crowding out is the reduction in private investment caused by government borrowing. When the government runs a deficit and borrows, the demand for loanable funds shifts right, raising the real interest rate. Higher interest rates make borrowing more expensive for firms, so private investment falls. Because investment builds the capital stock, sustained crowding out can slow long-run economic growth — one of the main long-run costs of persistent deficits. (Crowding out weakens, but usually does not fully cancel, the short-run stimulus of expansionary fiscal policy.)

Deficit, debt, and crowding out
Debt(this year) = Debt(last year) + Deficit(this year) · Gov’t borrowing ↑ ⇒ real interest rate ↑ ⇒ private investment ↓
The deficit is a yearly flow that adds to the debt stock. In loanable funds, government borrowing raises demand for funds, lifting the real rate and crowding out investment.
Worked example

A government runs deficits of $200B, $150B, and $250B in three consecutive years, starting from a national debt of $5,000B. Find the debt after three years, and explain the effect of this borrowing on private investment through the loanable funds market.

  1. 1.Add each year’s deficit to the running debt: 5,000 + 200 = 5,200.
  2. 2.Year 2: 5,200 + 150 = 5,350.
  3. 3.Year 3: 5,350 + 250 = 5,600. The national debt is $5,600B.
  4. 4.To finance these deficits, the government borrows, shifting the demand for loanable funds right and raising the real interest rate.
  5. 5.The higher real interest rate reduces private investment — crowding out.
Answer: The national debt grows to $5,600B (each deficit adds to the debt stock). The borrowing raises demand for loanable funds, pushing up the real interest rate and crowding out private investment, which can slow long-run growth.
Checkpoint

In the loanable funds market, an increase in government borrowing to finance a larger budget deficit will:

Watch out

Keep deficit (a yearly flow) separate from debt (the accumulated stock). Running a smaller deficit still increases the debt — the debt only falls when the budget is in surplus. This distinction is tested directly.

Checkpoint

A country reduces its annual budget deficit from $300B to $100B but still does not reach a balanced budget. What happens to its national debt?

On the exam

To show crowding out on the exam, draw the loanable funds market: government borrowing shifts demand right, the real interest rate rises, and investment falls. Then connect lower investment to slower long-run growth via a smaller future capital stock.

Answer the 2 checkpoints as you read.

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