5 Steps to a 5 AP Macroeconomics 2019

Fiscal Policy, Economic Growth, and Productivity ❮ 131

To see the full impact of crowding out, let’s go back to a horizontal SRAS curve that
depicts a severe recession. Ideally, expansionary fiscal policy would increase output from
GDP 0 to GDP 1. When the interest rate increases, households and firms are crowded out of
the market for loanable funds. This decrease in C and I dampens the effect of expansionary
fiscal policy. The crowding out is seen in Figure 10.5 as a movement from AD 1 to AD 2.
As we saw in Chapter 9, if increases in AD continue into the upward-sloping range of
AS, some of the multiplier effect of the fiscal policy is consumed by inflation, and thus it
is less effective.
When the government is fighting inflation with contractionary policy, we are likely
to see the opposite of the crowding out problem. If a budget surplus is the result of the
contractionary policy, and government debt is retired, the demand for loanable funds
decreases, interest rates fall and private investment increases (“crowding in,” perhaps), thus
lessening the impact of contractionary fiscal policy.

Figure 10.5

AD 0

Real GDP

Price

Level

PL 0

GDP 0 GDP 1

AD 1 (No crowding out)

AS

GDP 2

AD 2

Some crowding

out

Another Way of Looking at Crowding Out

There are two different ways to show how a government budget deficit

affects the market for loanable funds and crowds out private investment.

I know that can be frustrating, but, hey, that’s macro for you! Luckily, the

outcomes are the same, and each approach is considered correct on the

AP Macroeconomics exam.

The fundamental difference in these approaches is where the loanable

funds model places the government. In the model presented, government

borrowing (or saving, if there is a budget surplus) resides in the demand

curve. Most textbooks use this approach. The demand curve represents

the total of all of the private investing and borrowing (from firms) and

public borrowing (from government). When the government has a budget

deficit, the demand for loanable funds shifts to the right and the real inter-

est rate rises. Private investment, the other source of the demand for loan-

able funds, decreases and is thus “crowded out.”