How does the crowding out effect the economy?
1 Answer
Crowding out raises the real interest rate, which reduces funding levels for private sector projects.
Explanation:
Crowding out refers to the impact of government borrowing in the market for loanable funds. When governments run budget deficits, they increase their borrowing. This is how economists would show this problem graphically:
Note that private sector borrowing falls from Q* to Q2, as a result of the increase in government borrowing.
Note also that some economists (Paul Krugman, for example) do not believe crowding out is a significant problem during severe recessions, such as the Great Recession of 2008-2009. It may be impossible to resolve the politics of this issue, but clearly the demand for loanable funds contracted significantly before and during the Great Recession. The graph above focuses only on the shift caused by increased government borrowing and assumes (as in nearly all economic analysis) no other shifts.
