5 Steps to a 5 AP Macroeconomics 2019

130 ❯ Step 4. Review the Knowledge You Need to Score High

KEY IDEA

10.2 Difficulties of Fiscal Policy

Main Topics: Crowding Out, Net Export Effect, State and Local Policies

In theory, aggregate demand can be expanded or contracted, with government spending

and/or taxes, to move the economy closer to full employment. In practice, there are some

factors that lessen the effectiveness of fiscal policy. There are also some economists who

disagree on fiscal policy targets.

Crowding Out

If the government must borrow funds to pay for expansionary fiscal policy, the govern-

ment has an effect on the market for loanable funds. The market for loanable funds was

introduced earlier in this text, and you might recall that public borrowing (in the form of

a budget deficit) affects the demand for loanable funds. A government deficit increases the

total demand for loanable funds but, by raising the real interest rate, reduces the quantity

of loanable funds available to the private borrowers and investors. Less investment spend-

ing on capital goods is likely to reduce a nation’s growth rate, a topic we’ll explore at the

end of this chapter.

Figure 10.4 shows how a government budget deficit affects the demand for loanable

funds and how we see crowding out. At the initial equilibrium, the real interest rate is 5%,

the government has a balanced budget, and $100 billion is being saved by households and

invested by firms.

$20 of private investment

crowded out

$40 of government

borrowing S

120

5%

D1 D2

Loanable

Funds ($ bil)

Interest rate

80 100

6%

Figure 10.4

Now suppose that government fiscal policy creates a $40 billion budget deficit. To cover

the deficit, the government must borrow $40 billion in the market for loanable funds. The

new demand curve (D2) is simply the original demand curve, only it lays $40 billion to the

right of D1. The new market equilibrium interest rate is 6%, and $120 billion is saved and

invested. But remember that of this $120 billion, $40 billion is due to borrowing by the

government. That leaves $80 billion in private borrowing and investment. So the govern-

ment budget deficit caused private borrowing and investment to fall from $100 billion to

$80 billion, and that is where we see the crowding out of $20 billion in private investment.

“Crowding out

is an important

concept that

may get asked

more than once.”

—AP Teacher