Crowding Out
What is Crowding Out?
Crowding out is the fall in private investment that happens when government borrowing pushes up real interest rates.
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.
Crowding Out: a worked example
Suppose the government adds $200 billion of deficit financed spending. Demand for loanable funds shifts right by $200 billion and the real interest rate climbs from 4 percent to 6 percent. Private investment in this economy falls by $30 billion for every percentage point the real rate rises, so the 2 point increase wipes out $60 billion of investment. Net new spending is $200 billion minus $60 billion, or $140 billion. With an MPC of 0.75 the spending multiplier is 1 ÷ (1 − 0.75) = 4. A student who ignores crowding out predicts 4 × $200 billion = $800 billion of extra real GDP. The honest figure is 4 × $140 billion = $560 billion, so crowding out costs $240 billion of output. Notice that the quantity of loanable funds still rises, because demand shifted and supply did not.
The mistake students make with crowding out
On the loanable funds graph most students shift the supply curve left, reasoning that government borrowing soaks up the pool of savings. It feels right because less is left over for firms. The correct move is to shift demand for loanable funds right, since the government is a new borrower competing for funds. Both shifts raise the real interest rate, but only the demand shift raises the equilibrium quantity of loanable funds, and graders check that quantity. A leftward supply shift also predicts less total lending, which contradicts the story being told.
Crowding Out questions
Does crowding out mean fiscal stimulus does not work?
Crowding out shrinks the effect of deficit spending rather than cancelling it. A $100 billion spending increase raises the real interest rate, and the higher rate trims private investment by some smaller amount, so aggregate demand still shifts right, just by less than the naive multiplier suggests. Complete crowding out, where the offset equals the stimulus, appears only in models where output already sits at full employment and the supply of loanable funds cannot expand.
Why does crowding out matter for long run growth?
Private investment builds the capital stock, so every dollar of investment lost to a higher real interest rate means slightly less equipment, software, and factory space in later years. A smaller capital stock means long run aggregate supply shifts right by less than it otherwise would, and potential output grows more slowly. Crowding out is therefore a cost paid in future productive capacity, not only a smaller multiplier today.
Can crowding out happen if the government raises taxes instead of borrowing?
A spending increase paid for entirely with higher taxes needs no new borrowing, so demand for loanable funds does not shift and the real interest rate does not rise through this channel. Crowding out in the interest rate sense is tied to deficits. Higher taxes still reduce private spending, but through lower disposable income rather than through a higher cost of capital, which is a different mechanism and a different graph.
Formula / Example
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated