A deficit crowds out investment

The chain in words

1. Step 1

   Before the deficit

   The horizontal axis is the quantity of funds borrowed and lent. The vertical axis is the real interest rate, the return after inflation. Savers supply funds, and firms and the government demand them. The market is at E₀.

2. Step 2

   Demand for funds shifts right

   The government issues bonds to fund its deficit. At every interest rate, more borrowing is wanted, so the demand for loanable funds shifts right. At the old rate, borrowers want more funds than savers offer.

3. Step 3

   The real interest rate rises

   Lenders can charge more, and the real interest rate rises. The higher rate coaxes out more saving, a movement along supply, and the market settles at E₁: a higher rate and more funds lent.

4. Step 4

   Private investment is crowded out

   At the higher rate, some private projects no longer pay. Firms borrow and invest less than before, a movement along their old demand. Government borrowing has crowded out private investment.

Takeaway. Government borrowing shifts the demand for loanable funds right, raising the real interest rate and crowding out private investment.

Draw it yourself

More on the loanable funds market graph