3.6.7 (HL)—Crowding out

Crowding out occurs when government borrowing raises interest rates or competes for resources, reducing private investment or consumption.

The effect is stronger near capacity or when money supply does not accommodate borrowing; in a slump, unused resources may make it small.

State the financing condition and compare private response with public spending.

A deficit-funded expansion raises rates and delays business investment when banks face limited funds.

Crowding out is conditional, not inevitable.

In the loanable-funds version, plot the real interest rate vertically and quantity of funds horizontally. Deficit-financed government borrowing shifts demand for funds right, raising the equilibrium rate and reducing interest-sensitive private investment—the crowding-out effect. Alternatively, show fiscal expansion raising AD and money demand, with higher rates weakening private spending. Crowding out is stronger near full capacity or with a fixed money supply, and weaker in a deep recession with idle resources or accommodating monetary policy.