Crowding Out

What is "crowding out"? Crowding out is a term used to describe a situation when expansionary fiscal policies decrease or "crowd out" private spending.

Imagine an economy that's operating at full employment -- workers have jobs, and factories are operating near capacity. If the federal government tries to increase spending to, say, build a new road, then it necessarily has to take away some people and some capital from other sectors of the economy. GDP wouldn't increase because there's already full employment, so government spending would simply be crowding out private spending and investment and would not, in the short run, stimulate the economy. So when the government borrows to cover that additional spending, it affects the entire market for saving and borrowing.

Let's look at how the government affects the supply and demand for loanable funds. We'll use some numbers here for illustration. Imagine the government decides to borrow $100 billion dollars to build that new road. This shifts the demand for loanable funds up and to the right, increasing the equilibrium interest rate from 7% to 9%. A higher interest rate means that the quantity of savings supplied will increase -- in this case from $200 to $250 billion.

Now, remember that if savings increases by $50 billion that means that private consumption is falling by $50 billion. If we're saving more, we're consuming less. And because borrowing has become more expensive, due to that higher interest rate, private investment will also fall. At a 9% interest rate, we can see that the private demand for loanable funds is $150 billion -- 50 billion less than it was at an interest rate of 7%. We call these two effects "crowding out." So, when the government borrows $100 billion, it crowds out private investment and private consumption.

Now this assumes that the economy is operating at full employment. If the economy is in a recession, crowding out may not be an issue. Let's return to that original example, except this time the economy is in a recession, and workers and capital are underemployed. If the government wants to build that new road, it can hire those underused resources, and boost GDP, without crowding out private-sector spending. In this instance, government spending likely would increase GDP.