Economics: Market for Loanable Funds, Crowding Out

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Government spending increases aggregate demand in the economy. Let's consider now how the government finances its spending, that is, how does it pay for the stuff that it buys? And how does the way in which the government finances its spending influence the effect that its spending has on the economy?
First of all, government revenue comes from taxes. That is, the money the government takes in in taxes in various forms is used to pay for the stuff that government buys. However, it's very rare that the amount of money collect in taxes would be exactly equal to the amount of money that the government spends. Typically then there would be difference between the amount of money that the government spends which we usually represent with the letter G and the amount of money that the government takes in in taxes, which we usually represent with the letter T. The difference between government spending and taxes is equal by definition to the government's budget deficit. If the government spends more money than it takes in taxes, we think the government has a budget deficit and that deficit then requires that the government do what any of us do when we run a deficit and that is to borrow money. The government borrows money by issuing treasury bills and whenever the government runs a budget deficit it has to issue treasury bills or debt equal to the amount of the budget deficit. Each year's government budget deficit then requires the issuing of additional treasury bills. And the total sum of outstanding treasury bills over all of the years that the government has run a budget deficit is called the national debt.
So here's the way the government runs a budget deficit. In some years, as in recent years, the government actually takes more money in in taxes than it spends. We've had a very good economy in the past few years and the government has actually seen a huge increase in tax revenue due to the way in which the government budget operates. When the economy booms, people move into higher tax brackets and therefore, they pay more in taxes. Because government spending has not increased at the same rate, tax collections have surpassed government spending and the government has a budget surplus. The government has a budget surplus any time the total amount of taxes collected exceed the total amount of government spending. Now surpluses then allow the government to retire debt, that is, whenever the government has extra savings, it does the same thing that you or I might do. It pays off some of its outstanding debt. So when the government runs a budget surplus, it can take the money and buy back treasury bills, which is a way of paying off its debt. Any time the government runs a budget surplus, the national debt is able to be decreased. So the first thing that we've done is define a government deficit is any time the government spends more than it takes in in taxes and the government finances it by selling treasury bills which is issuing IOUs. Any time taxes exceed government spending, the government has a budget surplus which allows it to reduce the national debt. The national debt is being retired right now as the government runs a series of budget surplus, but these budget surpluses are relatively new things. If we look at the economy over the past 30 years, what we see is we've got a history of federal budget deficits, that is, the government in Washington has been spending typically, in fact, exclusively more than it has taken in taxes. By a small amount in 1970 and then increasing in the later 1970's and running huge deficits in the early and mid 1980's as the economy was stimulated by a huge defense build up under President Reagan. Then the deficit shrank a bit in the late 1980's, but increased during the recession years of the early 1990's and then the budget deficit decreased. If we saw this line going on to 1997 through the year 2000, we would actually see that the deficit goes to 0 and then the government runs a surplus in the last couple of years. So the federal budget has been in deficit for more of the last 30 years. State and local governments, on the other hand, have run surpluses in most of these years, which to some degree offset the effect of government deficits on the economy.
Well, let's see now what happens theoretically whenever the economy experiences an increase in government spending or an increase in the government budget deficit. The effect on the economy can be seen, first of all, through the market for loanable funds, which we studied earlier. Here we have the demand curve for loanable funds, which is all of the people who are borrowing money. They want to borrow more money at low interest rates and less money at higher interest rates. The blue curve represents the behavior of lenders, people who are saving money who want to lend it in the economy. People are more interested in saving money when they get a high return at high interest rates and they want to save less money at lower interest rates. So here we have demand and supply interacting to give us the equilibrium interest rate in the economy and the total volume of lending that occurs. Now suppose the government borrows more money, that is, if the government runs a budget deficit, what's going to happen is the demand curve for loanable funds is going to shift outwards because the government has got to borrow funds in order to spend more than it's taking in taxes. If that occurs, then at the original interest rate we have excess demand for funds, that is, if the interest rate that we started with, the demand for funds is going to be much larger than the quantity supplied. Therefore the bidding mechanism pushes the interest rate up so that a larger quantity of funds is supplied by lenders and some borrowers, particularly businesses and consumers decide that they want to borrow less because of the higher rates. After everything is said and done, we wind up with a new equilibrium that involves a larger volume of finance at a higher interest rate. So the capital markets expand, that is, there's more IOUs floating around there because the government is issuing more treasury bills to borrow money. However the competition for loanable funds pushes up the interest rate and some suppliers respond to the higher rates by lending more money but some demanders or borrowers are pushed out of the market. And this is what we call in macroeconomics the phenomenon of crowding out. When the government decides that it wants to run a deficit, it's going to be taking a bigger share of the pool of savings available in the economy and that means there's less available for households and foreigners and businesses.
You'll remember an equation that we've used in macroeconomics and that is that the savings, that is the total amount of savings that households do plus the total amount of savings that the government does, plus the total amount of savings that foreigners do is equal to the amount of money that's available for businesses to borrow. You may recognize this equation by its representation in letters S + T - G - X = I. That is, think about all the sources of savings that there are in economy. There's the savings that households save. There's the money that the government saves by running a budget surplus and there's the money that foreigners save by buying less from us than we buy from them, that is, the negative of our net exports or the total that we're importing in excess of what we're selling to them. Here's the money that our households are saving, the money that the government is saving and the money that foreigners are saving in our economy. Well, that's the total pool of savings that's available to finance the investments that businesses want to do. Now what happens if the government decides to run a bigger budget deficit? Well, suppose the government decides to cut taxes? If the government decides to cut taxes, then the budget deficit will increase. The budget surplus will shrink, eventually go to 0 and then the government will start running a budget deficit as it spends more than it's taking in taxes. Well, something has to change in this equation to restore balance. One thing it could change is as the government starts borrowing more money because it's cut taxes and still needs money to finance spending, interest rates will be bid up and when interest rates are bid up, then businesses will decide that they can't afford to do as many investment projects as before so this is crowding out. A decrease in taxes leads to a decrease in business spending as interest rates rise pushing businesses out of the capital market. You get the same story if government spending increases because there's a negative sign here. If the government is going to take a bigger pool of the savings, it's going to do so by pushing businesses out. Another thing that could happen is if interest rates rise, it may be that households decide they want to save more. As government spending increases, more households enter the capital market because of the higher interest rate. But typically what's going to happen is you're going to get adjustment on both sides, both as the supply of funds increases and the demand for funds decreases to make room for what the government wants. This is called crowding out. We'll talk later about how foreign behavior influences this economy, but for right now understand that any the government increases its deficit, any time the government increases its spending relative to taxes, that means an increase in government borrowing or a decrease in government savings and that's got to have an offsetting effect somewhere else in the economy. Either households have to save more to provide what the government wants to borrow or businesses are going to be pushed out of the capital market by rising interest rates.
Let's look finally at some historical data and see what we can tell about the effect of budget deficits on interest rates. Here are the budget deficits for the years 1970 through 1996 and here's the real interest rate as a percentage during the same years. What could happen to the interest rate during the 1980's when the government budget deficit increased precipitously. The real interest rate went from a level that fluctuated around 0, that is, the nominal rate was about equal to inflation to historic highs of around 6, 7 percent in the mid 1980's. When the government deficit got so big so quickly, a lot of private spending was crowded out as the real interest rate rose. Now in the 1990's we had even bigger budget deficits, but the real interest rate came back down to its ordinary levels. This was in large part due to a huge influx of capital from abroad, that is, foreign savings offset the dis-savings that the government was doing so that our businesses were able to borrow at interest rates that were lower than before. Typically there's going to be a relationship between the government budget deficit and the interest rate. If households will save a lot more or if foreigners will lend us more during a period when the government wants to borrow, then there won't be so much crowding out, that is, the interest rate won't go so high pushing out businesses. However, a big government budget deficit during a period when foreigners don't want to lend us money, typically leads to high interest rates in order to attract additional savings from households and more importantly, pushing out investment spending.
So there you have it. Whenever the government spends more money, it competes in the capital market. It competes for the limited pool of savings and the way the government gets more of the economy savings is by competing it away from private businesses through a process called crowding out.
Monetary and Fiscal Policy
Fiscal Policy: The Mainstream
The Market for Loanable Funds and Crowding Out Page [2 of 2]