AP Macroeconomics · Unit 5: Long-Run Consequences of Stabilization Policies

5.5 Crowding Out

What is Crowding Out?

Crowding out occurs when expansionary fiscal policy (increased government spending or tax cuts financed by borrowing) raises the government's demand for loanable funds. This drives up the real interest rate, which reduces private investment spending, partially offsetting the fiscal stimulus's effect on aggregate demand and real GDP.

The Loanable Funds Market Mechanism

When the government runs a budget deficit, it borrows by selling bonds, shifting the demand for loanable funds rightward. This raises the equilibrium interest rate. Higher interest rates make borrowing costlier for firms and households, decreasing investment (and interest-sensitive consumption), shrinking the capital stock available for future growth.

Effects on Long-Run Growth

Because crowding out reduces private investment, it can slow the growth of the capital stock, lowering long-run aggregate supply (LRAS) and future productivity and economic growth. This is why persistent budget deficits are a concern: short-run stimulus may come at the cost of long-run growth potential.

Key terms

Crowding out: A decrease in private investment caused by higher interest rates resulting from increased government borrowing.
Loanable funds market: The market where savers supply funds and borrowers (including government) demand funds; determines the real interest rate.
Effect of budget deficits on interest rates: Deficits increase government borrowing, raising demand for loanable funds and pushing interest rates up.
Long-run effect of crowding out: Reduced investment slows capital stock growth, lowering long-run aggregate supply and future economic growth.
Why crowding out matters for fiscal policy: It partially offsets the intended stimulus of expansionary fiscal policy by reducing private investment spending.

Try an AP-style question

Crowding out occurs when government borrowing…

lowers interest rates, raising investment
increases private saving
reduces the deficit
raises interest rates, cutting investment

Show the answer

D. Competition for funds.

Practice 8 AP-style questions with instant explanations, flashcards and spaced review.

Study 5.5 free in APrep