When the government borrows to cover a budget deficit, it competes with businesses for the same pool of saving. That pushes up the real interest rate and squeezes out some private investment. Less investment today means less capital and slower growth later. Use the lab to follow that chain from the loanable funds market to the long run.
Dashed grey lines show where the market started (5% real interest rate, 100 billion in private investment). Solid lines show where it is now.
Government borrowing raises the real interest rate, which reduces private investment spending. The government's spending partly replaces private spending instead of adding to it.
Savers supply funds and borrowers demand them. Supply comes from private saving, public saving (a budget surplus), and foreign saving. Demand comes from firms that want to invest and from a government running a deficit.
The loanable funds market sets the real interest rate: the nominal rate minus expected inflation. Firms compare it with the return they expect from new machines and buildings.
A deficit is negative public saving. You can show it as more demand for loanable funds (the government borrows) or as less supply (national saving falls). Both raise the real interest rate. AP graders accept either if you label it clearly.
Investment builds the capital stock. If deficits crowd out investment year after year, the economy has fewer machines and less technology later, so LRAS shifts right more slowly.
A budget surplus adds to the supply of loanable funds. The real interest rate falls, private investment rises, and long-run growth speeds up.
Each row is a chain you can write out on an FRQ: shift, then interest rate, then investment, then growth.
| Event | Loanable funds shift | Real interest rate | Private investment | Long-run growth |
|---|---|---|---|---|
| Government budget deficit increases | Demand right (or supply left) | ↑ | ↓ (crowding out) | Slower |
| Government runs a budget surplus | Supply right (or demand left) | ↓ | ↑ (crowding in) | Faster |
| Households save more | Supply right | ↓ | ↑ | Faster |
| Investment tax credit, business optimism | Demand right | ↑ | ↑ | Faster |
| Business pessimism | Demand left | ↓ | ↓ | Slower |
| Inflow of foreign financial capital | Supply right | ↓ | ↑ | Faster |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 5.5. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 5 terminology guide.