Crowding Out: Government Deficit Borrowing

Crowding Out: Government Deficit Borrowing, step by step

1. 1

   Start at Equilibrium

   The loanable funds market begins in equilibrium where saving (supply) meets investment demand for funds. The intersection sets the real interest rate and the quantity of funds borrowed and lent.

2. 2

   Government Runs a Deficit

   The government spends more than it taxes and must borrow to cover the gap. Public borrowing adds to the total demand for loanable funds, so demand shifts right.

3. 3

   The Real Interest Rate Rises

   With more borrowers competing for a fixed pool of saving, the equilibrium moves up along the supply curve. The real interest rate rises and the total quantity of funds borrowed increases. This is a movement along supply, not a shift in saving.

4. 4

   Private Investment Is Crowded Out

   At the new higher real interest rate, borrowing is more expensive for firms, so the quantity of private investment demanded falls. This is a movement up along the demand curve, not a leftward shift, and it is the crowding out of private investment by public borrowing.

Where it ends up

Government deficit borrowing raises the real interest rate and increases the total quantity of funds borrowed, but the higher rate crowds out private investment.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• Financing the Deficit →
• Household Saving Behavior →
• Investment Tax Credit →

More Loanable Funds Market walkthroughs

• A Rise in National Saving →