AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/5/5-5)
Unit 5 · Topic 5.5
5.5 Crowding Out
Crowding out happens when government borrowing pushes up the real interest rate, so businesses and households borrow and spend less. It weakens the short-run effect of expansionary fiscal policy, and over time it can slow economic growth by reducing investment in physical capital.
Key terms
- crowding out
- loanable funds market
- real interest rate
- interest-sensitive spending
- physical capital
How crowding out happens
Crowding out is the drop in interest-sensitive private spending caused by more government borrowing.
- The government raises spending or cuts taxes and runs a deficit (or a bigger one).
- It borrows to cover the deficit, usually by selling bonds.
- That borrowing raises the demand for loanable funds. You can also see it as lower public saving, which reduces the supply of loanable funds.
- The real interest rate rises.
- Higher real interest rates lead firms to invest less and households to buy fewer interest-sensitive goods, such as cars and houses.
Showing it on the loanable funds graph
Draw the loanable funds market with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. A downward-sloping DLF1 and an upward-sloping SLF1 cross at r1 and Q1. Then use one of two methods.
Both methods, listed below, show a higher real interest rate. Textbooks use both, and AP scoring guidelines have accepted both. Pick one and label it clearly.
- Demand method: government borrowing adds to the demand for loanable funds, so DLF1 shifts right to DLF2. The real interest rate rises from r1 to r2. Total borrowing rises, but private borrowing for investment falls.
- Supply method: a deficit is negative public saving, so national saving falls and SLF1 shifts left to SLF2. The real interest rate rises from r1 to r2.
Short-run and long-run effects
In the short run, crowding out means a rise in government spending increases AD by less than the simple multiplier predicts, because the drop in private investment partly offsets it.
In the long run, less investment means firms add fewer machines, buildings and equipment. Physical capital per worker grows more slowly, so productivity grows more slowly and LRAS shifts right by less over time (5.6).
In an open economy, there's one more link. Higher real interest rates attract foreign financial capital, so the country's currency appreciates and its net exports fall (6.6). That also offsets part of the fiscal policy's effect on AD.
The reverse: lower deficits
If the government cuts its deficit or runs a surplus, it borrows less (or saves more). DLF shifts left, or SLF shifts right, so the real interest rate falls and private investment rises. This is sometimes called crowding in.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
A bigger deficit in the loanable funds market
The government increases spending without raising taxes, so its budget deficit grows. (a) Show the effect on the loanable funds market. (b) What happens to private investment? (c) What's a possible long-run effect on economic growth?
Show the solutionHide the solution
- Step 1: (a) The government borrows more, so DLF shifts right from DLF1 to DLF2. SLF stays at SLF1. The real interest rate rises from r1 to r2.
- Step 2: (b) At the higher real interest rate, fewer investment projects are worth doing, so private investment falls. That's crowding out.
- Step 3: (c) Less investment means a slower build-up of physical capital, so productivity and potential output grow more slowly. LRAS shifts right by less than it would have.
Answer: (a) DLF shifts right and the real interest rate rises. (b) Private investment falls. (c) Slower growth of the capital stock and of potential output.
- Example 2
Following a deficit through several markets
Country Z's government cuts taxes to close a recessionary gap and borrows to cover the lost revenue. Explain the effects on Z's AD, real interest rate, private investment and the value of Z's currency.
Show the solutionHide the solution
- Step 1: Tax cut: disposable income rises, so consumption rises and AD shifts right.
- Step 2: Borrowing: the demand for loanable funds rises, so Z's real interest rate rises.
- Step 3: Higher real interest rate: private investment falls (crowding out), which partly offsets the increase in AD.
- Step 4: Higher real interest rate: foreign investors want Z's assets, so demand for Z's currency rises and it appreciates. Z's net exports fall, which also offsets part of the AD increase.
Answer: AD increases, the real interest rate rises, private investment falls, and Z's currency appreciates.
- Example 3
Wrong graph (classic trap)
To show crowding out, a student shifts the money supply curve left in the money market. What's wrong with that?
Show the solutionHide the solution
- Step 1: Government borrowing doesn't change the money supply. Only the central bank's actions shift MS.
- Step 2: Crowding out is about the competition for saving between the government and private borrowers, so it belongs in the loanable funds market.
- Step 3: The correct graph shows DLF shifting right (or SLF shifting left) and the real interest rate rising.
Answer: The student used the wrong market; crowding out is shown in the loanable funds market with a higher real interest rate.
Common mistakes
- Saying crowding out is caused by the central bank. It comes from government borrowing in the loanable funds market.
- Saying the total quantity of loanable funds falls when DLF shifts right. Total borrowing rises; it's private investment that falls.
- Shifting a curve the wrong way for a deficit. A deficit shifts DLF right or SLF left; both raise the real interest rate.
- Stopping at 'investment falls'. Many questions also want the long-run result: a smaller capital stock and slower growth.
On the exam
- Free-response questions often follow one path: the government runs a deficit; show the loanable funds market; say what happens to the real interest rate and private investment; then give the long-run effect on growth. Answer each part with a direction and a reason.
- Questions may link crowding out to the foreign exchange market: a higher real interest rate brings in foreign capital and makes the currency appreciate.
Connected topics
Videos
Check yourself
4 questions on 5.5 Crowding Out. Pick an answer to see if you got it, and why.
Country L's loanable funds market is drawn with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis.
At first, the demand curve DLF1 and the upward-sloping supply curve SLF cross at a real interest rate (r1) of 3 percent and a quantity (Q1) of $600 billion, all of it borrowed by private firms and households.
The government then runs a larger deficit and borrows an extra $100 billion at every interest rate, shifting demand to DLF2. The new equilibrium is a real interest rate (r2) of 4 percent and a quantity (Q2) of $650 billion.
Hypothetical scenario
By how much does private borrowing fall after the government's extra borrowing?
The drop in private investment caused by the rise in the real interest rate is called
If this crowding out continues for many years, which long-run effect does the model predict?
Which of the following types of spending is most likely to be reduced by the higher real interest rate?
0 of 4 answered