Crowding Out vs Crowding In
Crowding Out and Crowding In are two Fiscal Policy concepts in AP Economics that students often mix up. Crowding out is the fall in private investment that happens when government borrowing pushes up real interest rates. Crowding in is when government spending raises private investment, the opposite of crowding out, typically during a recession with idle resources. Here is how they compare side by side.
When the government runs a deficit it borrows in the loanable funds market, raising the demand for loanable funds and the real interest rate. The higher rate discourages private investment and interest-sensitive spending, partly offsetting the expansionary fiscal policy. It is a key limitation of deficit-financed government spending.
In a deep recession, expansionary fiscal policy can boost demand, output, and incomes without driving up interest rates much, because savings are ample and resources are idle. The resulting rise in sales and optimism encourages firms to invest, so public spending 'crowds in' rather than crowds out private investment. The accelerator effect (higher output raising desired capital) reinforces this. Whether crowding in or crowding out dominates depends on how close the economy is to full employment.
Crowding Out vs Crowding In: Which Way Private Investment Moves
| Crowding out | Crowding in | |
|---|---|---|
| What happens to private investment | Falls | Rises |
| Trigger | Government borrowing raises the real interest rate | Government spending raises expected demand, or repayment lowers rates |
| Loanable funds diagram | Demand for loanable funds shifts right | Supply shifts right, or investment demand shifts right |
| Real interest rate | Rises | Falls, or investment rises despite it |
| When it dominates | Near full employment, when resources are already in use | In a deep recession with idle capacity |
| Effect on the fiscal multiplier | Reduces it | Increases it |
| Long-run growth effect | Slower, since a smaller capital stock accumulates | Faster, if the investment is productive |
The standard chain, which you should be able to write from memory
Government runs a deficit, so it borrows. Borrowing increases the demand for loanable funds. Greater demand raises the real interest rate. A higher real interest rate makes some private investment projects no longer worth financing, so private investment falls. That fall partly offsets the increase in government spending, so aggregate demand rises by less than the multiplier applied to that spending alone would predict. It still rises, and by more than the spending itself, unless crowding out is close to complete. Each link is a separate rubric row on free-response questions, so write the chain out rather than jumping to the conclusion. Draw it at /sandbox/loanable-funds.
Crowding in is the same mechanism running backwards, plus one more
There are two distinct routes. The first is symmetric: if the government runs a surplus and repays debt, it adds to national saving, the supply of loanable funds increases, the real interest rate falls, and private investment rises. The second is not symmetric at all. In a deep recession, government spending raises expected future demand, and firms invest to meet demand they now expect to exist. Idle capacity means the borrowing does not push rates up much, so the interest rate effect is small and the demand effect dominates. This is why the crowding-out objection carries much less force in a slump than at full employment, and saying so is the sophisticated version of the answer.
How much crowding out happens depends on where the economy is
Crowding out is a matter of degree, not an on-off switch. At full employment, resources are fully used, so government use of them genuinely displaces private use and crowding out is strong. With substantial slack, both can expand at once and it is weak. The monetary response matters too: if the central bank holds interest rates steady while the government borrows, the mechanism is largely neutralised, which is why fiscal and monetary policy are often analysed together. When a question asks whether crowding out will be large, look for whether the prompt says the economy is at, above, or below full employment. That detail is there on purpose.
Frequently asked questions
What is crowding out?
Crowding out is the fall in private investment caused by government borrowing. Financing a deficit increases the demand for loanable funds, which raises the real interest rate, which makes some private projects unprofitable. The result is that expansionary fiscal policy increases aggregate demand by less than the spending alone would suggest.
What is crowding in?
Crowding in is the opposite: private investment rises alongside government action. It happens when the government repays debt, adding to national saving and lowering the real interest rate, or when government spending in a slump raises firms' expectations of future demand enough that they invest to meet it.
When is crowding out strongest?
Near full employment, when resources are already fully used, so government use of them displaces private use. In a deep recession with idle capacity, borrowing puts little upward pressure on rates and crowding out is weak. A central bank that holds rates steady while the government borrows also largely neutralises it.
Live Loanable Funds graph. Drag the curves, or open the full version.
Related comparisons
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