Principles of Macroeconomics / Unit 15 MAC 1406 worked example, 60 to 90 seconds
Working the Crowding-Out Chain
The idea
Trace government borrowing to private investment through the market for financial capital, naming each link. The government adds to demand for borrowed funds, the interest rate rises, and investment projects that were worth doing at the old rate are not worth doing at the new one.
In practice
Take the course's economy with an interest rate of 5 percent and investment of 1,500. Government borrowing rises by 300. That shifts the demand for financial capital right, and the rate rises to 6 percent. At 6 percent some projects no longer clear their hurdle, and investment falls to 1,350. So 150 of private investment was crowded out by 300 of extra borrowing — a partial offset, not a complete one. The consensus estimate the anchor reports is that extra borrowing of one percent of output raises long-term rates by between half a point and a full point.
Where people slip
Note that the crowding out here was partial: 300 of borrowing displaced 150 of investment, and the rest came from saving or from abroad. Full crowding out, where every dollar borrowed displaces a dollar of investment, is the limiting case rather than the normal one, and treating it as normal overstates the effect by about double in this example.
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