Crowding out on the loanable funds graph

The test says: "The government runs a bigger deficit. Show the effect on private investment." Most students know the word, crowding out, and write "the government takes the money, so there is less left for firms." That sentence gets half credit at best, because it skips the only thing the graph is about: the interest rate. The government does not take anyone's money. It borrows, like everyone else, and when a big new borrower walks into the market, the price of borrowing goes up. Some firms, at that higher price, decide their project is no longer worth it. That is crowding out, and here is how to draw it, step by step, with numbers.

The market where savers meet borrowers

Start with the price. The Coral Bank lends you $1,000 for a year at 7%, so you pay back $1,070. But if prices rise 3% during the year, the bank earns only 4% in what the money can buy. That 4% is the real interest rate, roughly the rate written on the loan minus inflation, and it is the price on this graph: savers care about what their money will buy, and firms compare it with what a machine will earn.

On the supply side are the savers: families with a deposit, a retiree buying a bond, a farmer putting a good year aside. The higher the real rate, the more they save, so S slopes up. On the demand side are the borrowers who want to invest, which in economics means buying machines, buildings and tools: a boatyard that wants a shed, a hotel adding rooms. A $100,000 shed that earns the boatyard $6,000 a year is worth a loan at 5% (interest $5,000) but not at 7% (interest $7,000). So the higher the rate, the fewer projects pay, and D slopes down. Where S crosses D the rate settles: on Coralia at 5%, with $150M of loans, all of it going to private investment.

The government borrows $50M

This year the government of Coralia spends $200M and collects $150M in taxes. The $50M gap is its budget deficit, and it covers it by selling bonds, IOUs that promise interest each year. At every interest rate it wants $50M more than before: the government is a new borrower in the same market, so the demand for loanable funds shifts right, from D₀ to D₁. Slide the deficit and watch the crossing.

Read it in order. First the shift: D₁ is D₀ plus the government's $50M at every rate. Second the new crossing: at the old 5% borrowers want $200M and savers offer $150M, so borrowers compete for the money and the rate climbs until, at 6%, savers are willing to lend $175M and that is exactly what is asked for. Third, and this is the step most answers miss, go back to the old curve. Private firms did not change their minds about any project; at 6% they borrow what D₀ says at 6%: $125M. The boatyard's shed, which paid at 5%, does not pay at 6% and is not built. The $25M between $150M and $125M is the crowding out: private investment pushed out by the higher rate.

Notice the two totals. Loans went up, from $150M to $175M, because the higher rate pulled $25M of extra saving in. But the government took $50M, so private firms got $25M less. On Coralia's curves half of every deficit is crowded out: double the deficit to $100M and the rate hits 7%, loans reach $200M, and private firms are down to $100M. The exact share depends on how steep the two curves are; the direction does not.

The same deficit, drawn on the supply side

Some books draw it the other way, and the AP exam accepts both. Families and firms save, and so does the government when taxes are higher than its spending: that is public saving, taxes minus spending. With taxes of $150M and spending of $200M, public saving is −$50M. National saving, the whole supply of loanable funds, is private saving plus public saving, so a deficit can be drawn as S shifting left by $50M instead of D shifting right. Check the crossing: the real rate rises to the same 6%, and private firms, reading D at 6%, borrow the same $125M. Loans fall to $125M in this version, because the government's borrowing is counted as missing saving rather than as extra demand, but the crowding out is identical. Whichever curve you move, say which one and why, and read the private investment off the demand curve at the new rate.

When crowding out is small: 2020

If a deficit always pushed rates up, 2020 would have been the clearest case ever. The US government borrowed about $3.1 trillion that year, about 15% of GDP, its biggest deficit since World War II. Yet interest rates fell: a 10-year government bond paid less than 1%. The graph is not wrong; two curves moved at once. Stuck at home in the pandemic, families saved far more, about a third of their income in April 2020, and the supply of loanable funds jumped right at the same time as the demand. Try it on Coralia: the government's $50M deficit is already drawn in; now slide how much more families save.

So the rule for two shifts: when S and D both move right, total loans surely grow, but the rate can rise, fall or stay put, depending on which shift is bigger. In 2020 the saving shift won. That is also why economists say crowding out is small in a deep recession: when output is falling and firms have shelved their projects anyway, there are idle savings looking for a borrower, and the government's bonds find them without pushing the rate up much. In a boom, with every saver's dollar already lent, the same deficit crowds out far more.

Why a test cares

Investment is how an island gets its capital: the machines, buildings and tools it will produce with next year. A shed not built is boats not built later, so crowding out is a cost paid in future growth, not just in today's interest. It also shrinks the spending multiplier: if $100M of government spending would add $500M of income with nobody else affected, a deficit that pushes out $25M of private investment adds less. It depends on what the borrowing buys, since a harbor or a school is capital too, and on how much saving was sitting idle. And keep two words apart: the deficit is one year's gap, spending minus taxes; the debt is everything still owed, all past deficits added up minus surpluses. Coralia's debt of $400M plus this year's $50M deficit makes $450M; a balanced budget next year leaves it at $450M, and only a surplus shrinks it.

The trap on tests

• Crowding out works through the rate. Not "the government takes the money": it borrows, D shifts right, the real rate rises, and firms drop the projects that no longer pay.
• Read private investment off D₀ at the new rate. Firms stay on their old curve. At 6%, D₀ says $125M; the $25M below the old $150M is the crowding out.
• Loans rise, private investment falls. Total loans go to $175M because the higher rate pulls in more saving; firms still get less than before.
• Either curve is fine, if you say why. D right (the government borrows) or S left (public saving is negative): same 6%, same $125M for firms.
• Two shifts, two answers. With a deficit and more saving at once, loans surely rise; the rate depends on which shift is bigger, so say "it depends" and show both.
• Deficit is a flow, debt is a stock. A deficit of $50M adds to a debt of $400M; a balanced budget does not reduce it.

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