Crowding Out, Shown Properly

You’ll be able to

Show crowding out in the loanable funds market and in the money market
Explain why crowding out reduces the effectiveness of fiscal stimulus
Identify the conditions under which crowding out is small

The same phenomenon, two graphs

Crowding out is the reduction in private investment caused by government borrowing. It can be shown two ways and both are acceptable. In the loanable funds market, government borrowing shifts demand right, raising the real interest rate and reducing private investment. In the money market, the fiscal expansion raises real GDP and therefore money demand, shifting money demand right and raising the nominal rate, which reduces investment. The first is the more direct story and the one most rubrics expect.

The chain

deficit ↑ → demand for loanable funds right → real interest rate ↑ → private investment ↓ → capital stock grows more slowly → LRAS shifts right more slowly

The last two links are what make crowding out a long-run problem rather than merely an offsetting short-run effect.

Why it blunts the multiplier

Fiscal stimulus raises AD by the spending change times the multiplier. But the higher interest rate it causes reduces investment, which is itself a component of AD — so part of the intended increase is canceled. The net AD shift is therefore smaller than the multiplier alone predicts. This is the standard evaluation point when a question asks whether stimulus will be as effective as calculated: the arithmetic gives a ceiling, and crowding out explains why reality falls short of it.

When crowding out is small

Three conditions weaken it. If the economy is deep in recession with idle saving and rates near zero, extra borrowing raises rates little. If investment is insensitive to interest rates — because firms see no demand regardless — then a higher rate does little damage. And if foreign capital flows in to meet the demand, supply of loanable funds expands and the rate rises less, though at the cost of a stronger currency and weaker net exports. Knowing these is what turns a mechanical answer into an evaluative one.

Worked example

A government funds a large stimulus entirely by borrowing while the economy is near potential output. Trace the effect on the real interest rate, private investment, and long-run growth.

1.Borrowing shifts loanable funds demand right; the real interest rate rises.
2.Higher real rates make marginal private projects unprofitable, so investment falls.
3.The net AD shift is smaller than the spending multiplier alone would predict.
4.Slower capital accumulation means LRAS shifts right more slowly than it otherwise would.

Answer: The real interest rate rises and private investment falls, partly offsetting the stimulus in the short run and reducing the growth of potential output in the long run. Near potential, this is the strongest case against deficit-financed stimulus.

Watch out

Crowding out is about private investment falling, not about the government "using up" money. The mechanism is the interest rate. An answer that says the government spent money that firms wanted describes a fixed pot of funds, which is not the model.

Checkpoint

Crowding out occurs when government borrowing:

Checkpoint

Crowding out is likely to be smallest when:

Checkpoint

The long-run cost of persistent crowding out is that:

On the exam

When a free response asks you to evaluate fiscal stimulus, name crowding out explicitly and show it on the loanable funds graph. Stating that the effect is "smaller than the multiplier suggests" without the mechanism rarely earns the point.

Answer the 3 checkpoints as you read.