Answer to Question #29642 in Macroeconomics for dalmie
investment spending. The increased borrowing 'crowds out' private investing.
Originally, crowding out was related to an increase in interest rates from the
borrowing, but that was broadened to multiple channels that might leave total
output little changed or smaller.
One channel of crowding out is a reduction in private investment that occurs
because of an increase in government borrowing. If an increase in government
spending and/or a decrease in tax revenues leads to a deficit that is financed
by increased borrowing, then the borrowing can increase interest rates, leading
to a reduction in private investment. There is some controversy in modern
macroeconomics on the subject, as different schools of economic thought differ
on how households and financial markets would react to more government
borrowing under various circumstances.
Usually when economists use the term "crowding out" they are
referring to the government spending using up financial and other resources
that would otherwise be used by private enterprise. However, some commentators
and other economists use "crowding out" to refer to government
providing a service or good that would otherwise be a business opportunity for
The macroeconomic theory behind crowding out provides some useful intuition for
those trying to gain a tight grasp of the concept. What happens is that an
increase in the demand for loanable funds by the government (e.g. due to a
deficit) shifts the loanable funds demand curve rightwards and upwards,
increasing the real interest rate. A higher real interest rate increases the
opportunity cost of borrowing money, decreasing the amount of
interest-sensitive expenditures such as investment and consumption. Thus, the
government has "crowded out" investment.
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