The Crowding Out Effect
Roshini Jagadam
Crowding Out
occurs when the government runs a deficit and is thereby pushed to borrow money from the Loanable funds market. This leads to the private sector being "crowded out" from the loanable funds market
Government deficit spending shifts the supply of loanable funds available to the private sector inwards. Higher interest rates in the bond market lead to investors taking money out of banks and buy bonds instead, reducing supply of loanable funds. With a reduced loanable funds available to the private sector, the real interest rate is driven up and the quantity of funds demanded by the private sector goes down.
The process of crowding out can cause the aggregate demand curve to shift left after it shifts rightward as a result of monetary policy to close the recessionary gap. The AD starts with a recessionary gap at point A. Through increased government spending the first shift (from point A to point B) occurs, effectively resolving the recession. However, the policies used to reach this point also increases interest rates and lead to crowding out of private consumption and/or investment. This decrease in private consumption leads to a leftward shift in the aggregate demand line (from point B to point C).
The intersection of the Supply for loanable funds and the demand for loanable funds is the Current Interest Rate. Ideally, with a balanced budget, the government should not have to borrow in the loanable funds market. Only the private sector (households and firms) should contribute to the demand of loanable funds. When the government has a deficit, it is pushed to borrow money thus leading to crowding out of the private sector due to higher interest rates and a smaller supply of loanable funds.