Crowding Out in the Loanable Funds Market

The loanable funds market has one supply curve, from savers, and one demand curve, from borrowers: households, firms, and the government. When the government runs a deficit, it has to borrow the difference, so it shows up as extra demand for loanable funds. Demand shifts right, and the equilibrium real interest rate rises. Firms that plan to expand a factory borrow at that real rate, so a higher rate makes fewer projects worth financing. Private investment spending falls. That drop in investment, caused by government borrowing pushing up the real rate, is crowding out.

Crowding out matters because it means deficit-financed stimulus does not deliver its full punch to aggregate demand. The government spends more, which pushes AD out, but the higher real rate it creates pushes some private investment back in, which pulls AD back a little. The two effects do not cancel because the size of the rate increase, and investment's sensitivity to it, are usually modest compared to the size of the spending injection itself. So output and AD still rise on net, just by less than the raw spending increase would suggest. This is the link between the deficit spending discussed earlier in the unit and long-run growth: less private investment today means a smaller capital stock later, which is part of the long-run cost of short-run stabilization policy. In a deep recession with idle resources, this cost shrinks or disappears, because borrowing to fund stimulus does not need to bid much away from a private sector that is not borrowing much anyway.