When governments run budget deficits in order to stimulate an economy and reduce unemployment, there is a potential problem known as “crowding out”. to run a budget deficit, the government has to borrow money. this is done by selling government bonds, including treasury bills or treasury bonds. these are sold to financial institutions who then sell them on to people who want to increase their savings. essentially, the government is increasing demand for the savings, or loanable funds, that are in the economy. the consequences of the increase in demand is illustrated below.
there is a given amount of savings in an economy, which is represented by the supply of loanable funds curve. the price of these loanable funds is the interest rate. the increased demand from D1 to D2 for savings in order to finance a deficit results in an increase in the interest rate from i1 to i2. the higher interest rate may result in reduced incentive for businesses to invest, so investments may fall from I1 to I2. as a result, the government wishes to increase aggeregate demand by increasing government spending. however, the higher interest rate causes interest-sensitive private investment to all, thus reducing aggregate demand. the circumstances in which crowding out does occur, and those in which it does not is still being debated upon today. Keynesian economists argue that it will not occur if the economy is producing at less than full employment. neo-classical economists argue that crowding out results from increased government spending. these economists are also opposed to the use of demand management policies.
two other forms of crowding out have also been suggested. the first form is physical crowding out. this occurs if the economy is close to its productive capacity. increased spending on government projects could see resources, such as labour, being directed away form the private sector towards the public sector. the second type of crowding out is psychological crowding out. this occurs if the private sector worries about what it perceives to be too much intervention by the government in the economy. in this case, the private sector may delay or cancel investment projects.