Crowding out | AP Macroeconomics | Khan Academy

In this video, we're going to use a simple model for the loanable funds market to understand a phenomenon known as crowding out. This is making reference to when a government borrows money; to some degree, it could crowd out private sector borrowing and investment. It could have negative consequences for the economy. You might have less investment as a result, and you could have less economic growth.

So, let's see how the crowding out can happen using this loanable funds market model. Just to be clear what's going on here: on the horizontal axis, you have the quantity of loanable funds; on the vertical axis, you have your price of borrowing, which is going to be our real interest rate. Our equilibrium real interest rate and quantity is determined by the intersection between the supply of loanable funds curve and the demand for loanable funds curve.

So, what happens if, let's just say, step one, the government decides to borrow to fund some of its spending? What is going to happen to these curves? Is one of them going to shift? Well, sure. If, at any given interest rate, all of a sudden you have a big borrower, in terms of the government, that now wants to enter the market for loanable funds at a given interest rate, that's going to increase the demand for loanable funds.

So, this step one right over here is going to shift the demand for loanable funds curve to the right. I'll just call that step one right over there. Our new demand for loanable funds might look something like this, and so let's call that demand for loanable funds prime. This is going to shift the demand for loanable funds to the right.

Now, what is that going to cause? Well, that is going to cause our real interest rate to go up. The real interest rate is going to go up; you see it right over here. Our new equilibrium does have more loanable funds that are being supplied and demanded, that are being borrowed. This is called q prime, but you see this happening at a higher cost, at a higher real interest rate, so we call that r prime.

Well, what's going to be the impact in the private sector of a higher real interest rate? Let's imagine for a second that this first blue curve was just the private sector. Let's say that the government just started to borrow in this video, shifting the curve. Well, if this was just the private sector, at this new interest rate, the private sector is willing to borrow a lot less.

So, we could say the private sector borrows less. What could that result in? Well, then you could have, and this is the negative effects of crowding out, you could have, because they're borrowing less, they're fueling less investment. Then you're going to have less capital, less productive capital that you can use to produce things.

So, we could say less capital accumulation, which is just another way of saying, for example, people are investing less because they're not borrowing as much—investing less in a factory or some other thing that might make people, or in technology, things that might make them more productive.

And so, if you're having less capital accumulation, that means that you're going to have slower economic growth. One of the ways that a country really pushes its production possibilities curve out, or really pushes its long-run aggregate supply curve to the right and has true economic growth is through investment. But if you have, if your borrowing costs are higher, you're going to have less investment, less capital accumulation, and slower economic growth.