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Crowding Out
Effect

Understand how government borrowing raises interest rates and reduces private investment: the key limitation of expansionary fiscal policy.

AP Macroeconomics

What Is Crowding Out?

When the government increases its spending through deficit spending (spending more than it collects in taxes), it must borrow money by selling bonds. This increased borrowing raises the demand for loanable funds, which pushes real interest rates higher. Higher interest rates make borrowing more expensive for private firms and consumers, reducing private investment and interest-sensitive consumption.

The Chain Reaction

1
Government runs a budget deficit: spending exceeds tax revenue.
2
Government borrows by selling Treasury bonds in the loanable funds market.
3
Demand for loanable funds increases: the demand curve shifts right.
4
Real interest rate rises: the equilibrium price of borrowing goes up.
5
Private investment falls: firms and households borrow less at higher rates, partially offsetting the fiscal stimulus.

Loanable Funds Market Diagram

Quantity of Loanable Funds Real Interest Rate
\( S \)
\( D_1 \)
\( D_2 \)
\( Q_1 \)
\( r_1 \)
\( Q_2 \)
\( r_2 \)

The Formal Mechanism

Recall the GDP identity:

$$Y = C + I + G + NX$$

When \( G \) rises through deficit spending, the government competes for savings. In the loanable funds market, higher government demand for funds pushes the real interest rate up. Since private investment is inversely related to the interest rate:

$$r \uparrow \;\Rightarrow\; I \downarrow$$

Investment Demand Curve

Quantity of Investment (\( I \)) Real Interest Rate (\( r \))
\( D_I \)
\( r_1 \)
\( I_1 \)
\( r_2 \)
\( I_2 \)
 Crowding Out

Partial vs. Complete Crowding Out

Partial Crowding Out
The rise in \( G \) exceeds the fall in \( I \). Real GDP still increases, but by less than the simple multiplier predicts. This is the standard case in most economies.
Complete Crowding Out
The fall in \( I \) exactly equals the rise in \( G \). There is no net change in real GDP. This occurs in the classical model where the economy is already at full employment.

What Makes Crowding Out Stronger or Weaker?

Stronger Crowding Out
Economy near full employment: limited idle savings, so government borrowing heavily competes with the private sector. Investment demand is interest-elastic.
Weaker Crowding Out
Economy in deep recession: ample idle savings, interest rates already near zero. Investment demand is interest-inelastic (firms won't invest regardless).
Open Economy Factor
Higher domestic \( r \) attracts foreign capital, which partially replenishes the loanable funds supply, mitigating crowding out domestically.

The Spending Multiplier Revisited

Without crowding out, the spending multiplier is:

$$\text{Multiplier} = \frac{1}{1 - MPC}$$

If \( MPC = 0.8 \), the multiplier is \( \frac{1}{0.2} = 5 \). A \$100 billion increase in \( G \) would raise GDP by \$500 billion.

How to Apply Crowding Out Analysis

1
Identify the fiscal policy: Is the government increasing spending or cutting taxes through deficit financing?
2
Trace the borrowing: Government sells bonds, increasing the demand for loanable funds.
3
Show the interest rate effect: Shift the demand curve right in the loanable funds market: \( r \) rises.
4
Show the investment effect: Move up along the investment demand curve: \( I \) falls.
5
State the net outcome: GDP rises by less than the full multiplier effect. Crowding out partially offsets the stimulus.

Example 1: Basic Scenario

Scenario: The government increases spending by \$50 billion, financed entirely by borrowing. The \( MPC = 0.75 \).

1
Simple multiplier: \( \frac{1}{1-0.75} = 4 \). Without crowding out: \( \Delta GDP = 4 \times \$50B = \$200B \).
2
Government borrowing increases demand for loanable funds. Real interest rate rises from 3% to 5%.
3
Private investment falls by \$20 billion due to the higher rate. The multiplied loss: \( 4 \times \$20B = \$80B \).

Example 2: AD-AS Impact

Real GDP Price Level SRAS
\( AD_1 \)
\( AD_2^* \)
\( AD_2 \)
\( Y_1 \)
\( Y_2 \)

Example 3: Open Economy Effects

Scenario: The U.S. government increases deficit spending. Real interest rates rise domestically.

1
Higher U.S. \( r \) attracts foreign financial capital. Demand for the dollar rises.
2
The dollar appreciates: U.S. exports become more expensive, imports become cheaper.
3
Net exports (\( NX \)) fall: this is sometimes called the international crowding out or exchange rate effect.

Crowding Out vs. Crowding In

Crowding Out Crowding In
Trigger Government deficit spending raises \( r \) Government infrastructure boosts private productivity
Effect on \( I \) Decreases Increases
Mechanism Higher interest rates deter borrowing Better infrastructure raises expected returns
Net Multiplier Reduced Enhanced
Time Horizon Short run Long run

Common Mistakes

✕ Crowding Out Eliminates All Growth
On the AP exam, crowding out is almost always partial. GDP still rises: just by less than the full multiplier predicts.
✕ Confusing Monetary & Fiscal
Crowding out results from fiscal policy (government spending/taxes), not monetary policy. The Fed controls the money supply, not loanable funds demand.
✕ Forgetting the Loanable Funds Graph
Students often jump to the AD-AS model without first showing the loanable funds market shift. Always start there to explain why \( r \) changes.

Summary of Key Relationships

Event Direction Market
Government deficit spending rises \( G \uparrow \) Fiscal policy
Demand for loanable funds shifts right \( D_{LF} \uparrow \) Loanable funds
Real interest rate rises \( r \uparrow \) Loanable funds
Private investment falls \( I \downarrow \) Investment demand
AD shifts right by less than expected \( AD \uparrow \) (smaller) AD-AS
GDP rises by less than full multiplier \( Y \uparrow \) (smaller) Real output

Question 1 of 5

When the government finances increased spending through borrowing, what happens in the loanable funds market?

Question 2 of 5

Crowding out causes the government spending multiplier to be:

Question 3 of 5

In an open economy, crowding out from deficit spending can also reduce:

Question 4 of 5

Crowding out is likely to be weakest when the economy is:

Question 5 of 5

Which of the following best describes the difference between crowding out and crowding in?