AP® Macroeconomics · Unit 5 · Topic 5.5
Crowding Out and Long-Run Growth
Crowding out happens when government borrowing pushes up interest rates and squeezes out private investment, leaving a smaller capital stock and slower long-run growth.
When government runs a deficit, it borrows in the loanable funds market, competing with firms for the same pool of savings. More government demand for funds pushes interest rates up. Firms that would have borrowed to build factories or buy equipment now find borrowing more expensive, so some investment projects get cancelled. That's crowding out: public borrowing displacing private investment.
This matters beyond the current year because investment today is tomorrow's capital stock. Less investment now means fewer machines, factories, and technology accumulating over time, so long-run aggregate supply shifts right more slowly than it otherwise would. On a production possibilities curve, this shows up as a smaller outward shift over time, because the economy sacrificed capital goods for present consumption. Less capital per worker also means slower growth in potential output and living standards a generation later.
The twist is what the borrowed money buys. If government spends borrowed funds on transfers or current consumption, crowding out is a pure loss: less private capital with nothing built to replace it. But if the deficit funds productive public capital, like roads, bridges, or education, that spending can itself raise future productivity. The PPC still shows a tradeoff today, but the outward shift tomorrow can be larger, not smaller, because public investment substitutes for the private investment that got crowded out. This is why the source of deficit spending, not just its size, decides its effect on long-run growth.
Key terms
- Crowding out
- The reduction in private investment caused by government borrowing pushing up interest rates.
- Loanable funds market
- The market where savers supply funds and borrowers, including government, demand them, setting the real interest rate.
- Long-run aggregate supply (LRAS)
- The economy's potential output level, determined by the quantity and quality of resources like capital and labor.
- Production possibilities curve (PPC)
- A graph showing the maximum combinations of two goods an economy can produce, illustrating tradeoffs and future growth.
- Productive public investment
- Government spending on capital, like infrastructure or education, that raises future output rather than just current consumption.
Watch it explained
- How it worksHow does a smaller capital stock show up as a slower moving LRAS curve?
- Ties togetherHow does crowding out connect a budget deficit to the production possibilities curve?
- Common mistakeWhy isn't all government borrowing bad for long-run growth?
- Going furtherWhat happens to future potential output when a deficit funds new highways instead of transfers?
Check yourself
End of topic.