Crowding Out
When governments run budget deficits in order to finance government spending to boost the
economy a problem known as ‘crowding out’ can occur. To generate money for government
spending, governments sell bonds to financial institutions such as banks, who then sell these on
to consumers. What they are essentially doing to increasing demand for savings.
Here should have noticed a paradox as the government spends money to boost the economy, but
by selling bonds they are increasing demand for savings which leads to less consumer and
investment spending.
The given amount of savings in the economy is represented by the loanable funds curve. The
price of these loanable funds is the interest rate. The increased demand for savings from D1 to
D2 results in an increased interest rate from i1 to i2.
So even though the government wishes to increase aggregate demand (C+I+G+(X-M) by
increasing government spending, the higher interest rate causes interest-sensitive private
investment to fall, thus reducing aggregate demand.
Another way that the government can raise funds for spending is by raising taxes. As you know
this can lead to a reduction in consumer and business spending and therefore a decrease in
aggregate demand.
If the government raises the money for spending by taking out loans from banks then there will
be less credit available to firms for investment and thus a decrease in aggregate demand. Also,
the sheer amount of money the government is likely to borrow would have an upward pressure
on interest rates. Higher interest rates mean firms and consumers are less likely to borrow and
therefore spend.