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Crowding Out

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Crowding Out

Did you know that governments need to borrow money from lenders too? Sometimes, we forget that not only do citizens and businesses need to borrow money, but our governments do as well. The loanable funds market is where both the government sector and the private sector go to borrow funds. What can happen when the government borrows the funds in the loanable funds market? What are the consequences for funds and resources for the private sector? This explanation on Crowding Out will help you answer all these burning questions. Let's dive in!

Crowding Out Definition

Crowding out happens when the private sector investment spending decreases due to an increase in government borrowing from the loanable funds market.

Just like the government, most people or firms in the private sector tend to consider the price of a good or service before purchasing it. This applies to firms that are thinking about purchasing a loan to finance their purchase of capital or other expenditure.

The purchase price of these borrowed funds is the interest rate. If the interest rate is relatively high, then firms will want to postpone their loan taking and wait for a decrease in the interest rate. If the interest rate is low, more firms will take loans and thus put the money to productive use. This makes the private sector interest sensitive compared to the government sector which is not.

Crowding out happens when the private sector investment spending decreases due to an increase in government borrowing from the loanable funds market

Unlike the private sector, the government sector (also referred to as the public sector) is not interest-sensitive. When the government is running a budget deficit, it needs to borrow money to fund its spending, so it goes to the loanable funds market to purchase the funds it needs. When the government is in a budget deficit, meaning it is spending more than it is receiving in revenue, it can finance this deficit by borrowing from the private sector.

Crowding out types

Crowding out can be broken into two: financial and resource crowding out:

  • Financial crowding out occurs when private sector investment is hindered by a higher interest rate due to government borrowing from the private sector.
  • Resource crowding out occurs when private sector investment is hindered because of reduced resource availability when it is acquired by the government sector. If the government is spending to build a new road, the private sector cannot invest in building that same road.

Effects of Crowding Out

The effects of crowding out can be seen in the private sector and the economy in several ways.

There are short-run and long-run effects of crowding out. These are summarized in Table 1 below:

Short run effects of crowding outLong run effects of crowding out
Loss of private sector investmentSlower rate of capital accumulationLoss of economic growth

Table 1. Short and long-run effects of crowding out - StudySmarter

Loss of private sector investment

In the short run, when government spending crowds out the private sector from the loanable funds market, private investment decreases. With higher interest rates caused by the increased demand by the government sector, it becomes too expensive for businesses to borrow funds.

Businesses often rely on loans to further invest in themselves such as building new infrastructure or purchasing equipment. If they cannot borrow from the market, then we see a decrease in private spending and a loss of investment in the short run which reduces aggregate demand.

You are the owner of a hat production firm. At the moment you can produce 250 hats per day. There is a new machine on the market that can increase your production from 250 hats to 500 hats per day. You cannot afford to purchase this machine outright so you would have to take out a loan to fund it. Due to a recent increase in government borrowing, the interest rate on your loan increased from 6% to 9%. Now the loan has become significantly more expensive for you, so you choose to wait to purchase the new machine until the interest rate decreases.

In the example above, the firm could not invest in expanding its production due to the higher price of funds. The firm has been crowded out of the loanable funds market and it cannot increase its production output.

Rate of capital accumulation

Capital accumulation happens when the private sector can continuously purchase more capital and reinvest in the economy. The rate at which this can happen is partially determined by how much and how quickly funds are invested and reinvested into a country's economy. Crowding out slows the rate of capital accumulation. If the private sector is being crowded out of the loanable funds market and can not spend money in the economy, then the rate of capital accumulation will be lower.

Loss of economic growth

Gross Domestic Product (GDP) measures the total value of all final goods and services a country produces in a given time period. In the long run, crowding out causes a loss of economic growth because of the slower rate of capital accumulation. Economic growth is determined by the accumulation of capital which allows more goods and services to be produced by a nation, thereby increasing GDP. This requires private sector spending and investment in the short run to move the cogs of the nation's economy. If this private sector investment is limited in the short run, the effect would be less economic growth than if the private sector had not been crowded out.

Crowding out pie chart studysmarterFigure 1. Government sector crowding out private sector - StudySmarter

Figure 1 above is a visual representation of what happens to the size of one sector investment in relation to the other. The values in this chart are exaggerated to clearly depict what crowding out looks like. Each circle represents the total of the loanable funds market.

In the left chart, the government sector investment is low, at 5%, and private sector investment is high at 95%. There is a significant amount of blue in the chart. In the right chart, government spending increases, causing the government to increase its borrowing resulting in interest rates increase. Government sector investment now takes up 65% of the available funds, and private sector investment only 35%. The private sector has been crowded out by a relative 60%.

Crowding Out and Government Policy

Crowding out can occur under both fiscal and monetary policy. Under fiscal policy we see an increase in government sector spending resulting in a decrease in private sector investment when the economy is at or close to full capacity. Under monetary policy the Federal Open Market Committee raises or lowers the interest rates and controls the money supply to stabilize the economy.

Crowding out in fiscal policy

Crowding out can occur when fiscal policy is implemented. Fiscal policy focuses on changes in taxation and spending as a way to influence the economy. Budget deficits happen during, but are not limited to, recessions. They can also occur when the government goes over budget on things like social programs or it does not collect as much tax revenue as expected.

When the economy is close to, or at full capacity, then the increase in government spending to cover the deficit will crowd out the private sector since there is no room for expanding one sector without taking away from the other. If there is no more room for expansion in the economy then the private sector pays the price by having less loanable funds available for them to borrow.

During a recession, when unemployment is high and production is not at capacity, the government will implement an expansionary fiscal policy where they also increase spending and lower taxes to encourage consumer spending and investment, which in turn should increase aggregate demand. Here, the crowding out effect would be minimal because there is room for expansion. One sector has room to increase output without taking away from the other.

Types of Fiscal Policy

There are two types of Fiscal Policy:

  • Expansionary fiscal policy sees the government reducing taxes and increasing its spending as a way to stimulate the economy to combat sluggish growth or a recession.
  • Contractionary fiscal policy sees an increase in taxes and a reduction in government spending as a way to combat inflation by reducing growth or an inflationary gap.

Learn more in our article on Fiscal Policy.

Crowding out in monetary policy

Monetary policy is a way for the Federal Open Market Committee to control the money supply and inflation. They do this by adjusting the federal reserve requirements, the interest rate on reserves, the discount rate, or through the buying and selling of government securities. With these measures being nominal, and not having a direct link to spending, it can not directly cause the private sector to be crowded out.

However, since monetary policy can directly affect interest rates on reserves, borrowing for banks could become more expensive if monetary policy increases interest rates. Banks then charge higher interest rates on loans in the loanable funds market to compensate, which would discourage private sector investment.

crowding out expansionary fiscal policy short run studysmarterFigure 2. Expansionary fiscal policy in the short run, StudySmarter Originals

crowding out expansionary monetary policy short run studysmarterFigure 3. Expansionary monetary policy in the short run, StudySmarter Originals

Figure 2 shows that when fiscal policy increases aggregate demand from AD1 to AD2, the aggregate price (P) and aggregate output (Y) also increase, which in turn, increases the demand for money. Figure 3 shows how a fixed money supply will cause crowding out of private sector investment. Unless the money supply is allowed to increase, this rise in demand for money will raise the interest rate from r1 to r2, as seen in Figure 3. This will cause a reduction in private investment spending as a result of crowding out.

Examples of Crowding Out Using the Loanable Funds Market Model

Examples of crowding out can be supported by taking a look at the loanable funds market model. The loanable funds market model demonstrates what happens to demand for loanable funds when the government sector increases its spending and goes to the loanable funds market to borrow money from the private sector.

crowding out effect loanable funds market studysmarterFigure 4. Crowding out effect in the loanable funds market, StudySmarter Originals

Figure 4 above shows the loanable funds market. When the government increases its spending the demand for loanable funds (DLF) shifts out to the right to D', indicating a total increase in demand for loanable funds. This causes the equilibrium to shift up along the supply curve, indicating an increased quantity demanded, Q to Q1, at a higher interest rate, R1.

However, the increase in demand from Q to Q1 is entirely caused by government spending while private sector spending has remained the same. The private sector now has to pay the higher interest rate, which indicates the decrease or loss in the loanable funds that the private sector had access to before the government spending increased its demand. Q to Q2 represents the portion of the private sector that was crowded out by the government sector.

Let's use Figure 4 above for this example!

Imagine a renewable energy firm that has been

Crowding out public bus StudySmarterPublic Bus, Source: Wikimedia Commons

considering taking out a loan to fund the expansion of their wind turbine production plant. The initial plan was to take out a $20 million loan at a 2% interest rate (R).

In a time where methods of energy conservation are at the forefront, the government has decided to increase its spending on improving public transportation to show an initiative towards emissions reduction. This caused the increase in demand for loanable funds that shifted the demand curve to the right from DLF to D' and the quantity demanded from Q to Q1.

The increased demand for loanable funds has caused the interest rate to climb up from R at 2% to R1 at 5% and decreased the loanable funds available to the private sector. This has made the loan more expensive, causing the firm to reconsider the expansion of its wind turbine production plant.

The funds now unavailable to the private sector is the portion from Q to Q2. This is the quantity lost due to crowding out.

Crowding Out - Key takeaways

  • Crowding out happens when the private sector is pushed out of the loanable funds market due to an increase in government spending.
  • Crowding out decreases private sector investment in the short run because the higher interest rates discourage borrowing.
  • In the long run, crowding out can slow down the rate of capital accumulation which can cause a loss of economic growth.
  • The loanable funds market model can be utilized to depict the effect that increased government spending has on demand for loanable funds thereby making borrowing more expensive to the private sector.

Frequently Asked Questions about Crowding Out

Crowding out happens when the private sector is pushed out of the loanable funds market due to an increase in government borrowing.

Crowding out is caused by an increase in government spending that takes up funds from the loanable funds market making them unavailable to the private sector.

Fiscal policy increases government spending which the government funds by borrowing from the private sector. This decreases the loanable funds available to the private sector and increases the interest rate which crowds the private sector out of the loanable funds market.

When a firm can no longer afford to borrow money to expand due to an increase in the interest rate, because the government has increased spending on a development project.

In the short run, crowding out causes a decrease or loss of private sector investment, which can lead to a decreased rate of capital accumulation and lower economic growth. 

Final Crowding Out Quiz

Question

What is crowding out?

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Answer

Crowding out happens when the private sector investment spending decreases due to an increase in government borrowing from the loanable funds market

Show question

Question

How can a government finance its budget deficit?

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Answer

When the government is in a budget deficit, meaning it is spending more than its budget, it can finance this deficit by borrowing from the private sector. 

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What is a short run effect of crowding out?

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Answer

A loss of private investment

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What are the long run effects of crowding out?

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A slower rate of capital accumulation and a loss of economic development.

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Question

What can cause a budget deficit outside of a recession?

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Answer

The government spending over budget

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How does fiscal spending affect government budget?

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Answer

It increases government spending.

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Why does an increased interest rate cause the private sector to be crowded out?

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The private sector investment is crowded out because they are relatively more interest-sensitive and borrowing has become more expensive.

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Question

In the loanable funds market model, what happens when the government sector decides to enter the loanable funds market?

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Answer

The demand curve for loanable funds  shifts to the right, indicating an increase in total demand for loanable funds, and the equilibrium quantity and interest rate increase.

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Question

What happens to the interest rate when the government increases its spending?

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Answer

The interest rate increases.

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Question

If the economy is in a recession, and fiscal policy is implemented, will there be crowding out? Why or why not?

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No, because in a recession the market is not performing at full capacity and an increase in government spending would fill the gap towards full capacity, and so would not crowd the private sector out.

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Question

What are two types of crowding out?

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Answer

Financial and resource crowding out.

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Question

What is financial crowding out?

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Answer

Financial crowding out is when private sector investment is hindered by a higher interest rate due to government borrowing from the private sector.

Show question

Question

What is resource crowding out?

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Answer

Resource crowding out is when private sector investment is hindered because of an increase in government spending. If the government is spending to build a new road, the private sector cannot invest in building that same road.

Show question

Question

Why could government spending in the short run cause a loss of economic growth in the long run?

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Answer

Because if government spending drives up the interest rate for the private sector, the private sector may choose not to invest in the market as they would have at a lower interest rate, which sets back economic growth.

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Question

This happens when the private sector investment spending decreases due to an increase in government borrowing from the loanable funds market.

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crowding out

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The purchase price of these borrowed funds is


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interest rate

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If the interest rate is relatively high, then firms will...


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postpone their loans

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True or False: The government is not sensitive to interest rate changes.

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True

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A short-run effect of crowding out is:

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Loss of private sector investment

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A long-run effect of crowding out is:

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loss of economic growth

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Crowding out can occur with fiscal policy when:

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expansionary fiscal policy occurs when employment is at full capacity

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Crowding out can occur with monetary policy by:

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expansionary monetary policy raising the demand for money and interest rates

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The government borrowing money to increase its spending, it will shift the _____ curve in the loanable funds market to the ______

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demand; right

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Contractionary fiscal policy ______ increase crowding out.

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does not

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Contractionary monetary policy _______ increase crowding out

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does not

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True or False: Crowding out decreases private sector investment in the short run because the higher interest rates encourage borrowing.

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False

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True or False: Crowding out happens when the private sector is pushed out of the loanable funds market due to an increase in government spending. 

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True

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True or False: In the long run, crowding out can slow down the rate of capital accumulation which can cause a loss of economic growth.

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True

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True or False: fiscal policy will always result in crowding out.

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False

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True or False: Monetary policy has no effect on crowding out.

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False

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True or False: firms are like the government — they are not affected by interest rate changes.

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False

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True or False: the loanable funds market does not supply an adequate graph for crowding out.

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Falser

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True or False: if the money supply can increase, expansionary monetary policy may not lead to crowding out.

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True

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True or False: When the government is in a budget deficit, meaning it is spending more than it is receiving in revenue, it can finance this deficit by borrowing from the private sector. 

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True

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