Chapter 30, Problem 4CYU

To determine

The graph of the loanable funds market that shows how a large government deficit can lead to crowding out and the effects of crowding out on short-run aggregate output and economic growth in the long run.

Explanation of Solution

When a government has a budget deficit and a consequent decline in private investment spending, this phenomenon is known as the crowding-out effect. The graph below illustrates how borrowing by the government raises the demand for the loanable fund:

  

The above graph shows that a budget deficit increases the demand for loanable money, raising the real interest rate in the process. Here, the limited quantity of savings that are available to governments must be shared with everyone else in the economy. Due to this rivalry, the real interest rate increases and private investment decreases, and the term for this phenomenon is crowding out.

Crowding out reduces or eliminates private sector investment over the short term, which means there is a slower rate of capital accumulation or lower aggregate output and slower economic growth in the economy. Furthermore, in the long run, slower economic growth results from crowding out since it lowers private investment because company tax cuts frequently encourage to decrease in government revenue that creates a budget deficit.

Economics Concept Introduction

Introduction: The loanable funds market provides an explanation of how savers and borrowers interact in an economy, and it is used to comprehend and analyze macroeconomic development.