AP Macroeconomics

## Learning Outcomes

- Explain how crowding out is shown in the loanable funds market
- Identify why a budget deficit increases the demand for loanable funds
- Describe how a rightward shift in demand changes the equilibrium real interest rate and quantity of loanable funds
- Explain why higher real interest rates reduce private investment spending
- Distinguish crowding out of private investment from the broader effect of fiscal policy on aggregate demand
- Apply the full AP Macroeconomics causal chain in graph and FRQ answers

## AP Macroeconomics Syllabus

For the AP Macroeconomics, you are expected to understand how crowding out works in the loanable funds market, with a focus on the following syllabus points:

- Know that crowding out occurs when government borrowing raises the real interest rate and reduces private investment
- Identify the loanable funds graph with the real interest rate on the vertical axis and quantity of loanable funds on the horizontal axis
- Explain why a larger budget deficit increases the demand for loanable funds
- Understand that a rightward shift of demand for loanable funds raises the equilibrium real interest rate
- Explain how higher real interest rates discourage business borrowing for investment in physical capital
- Distinguish a budget deficit from the national debt
- Understand that crowding out reduces investment but does not mean all private investment disappears
- Connect lower private investment to slower capital formation and weaker long-run growth

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. Why does expansionary fiscal policy often increase the demand for loanable funds?
2. On a loanable funds graph, what happens to the equilibrium real interest rate when government borrowing rises?
3. Why does a higher real interest rate reduce private investment spending?
4. What is the difference between a budget deficit and the national debt?
5. How can crowding out weaken the effect of expansionary fiscal policy?

## Introduction

Crowding out is one of the most tested limits on expansionary fiscal policy. Students often remember that “government borrowing raises interest rates,” but AP questions usually require more than that. You need the whole chain: **budget deficit -> government borrowing -> demand for loanable funds increases -> real interest rate rises -> private investment falls**.

This topic matters because it connects Unit 5 fiscal policy to Unit 4 financial markets and, in some questions, to long-run growth and the open economy. If you can explain crowding out with clean graph logic, you can pick up points in both multiple-choice and free-response questions.

> **Key Term: crowding out**
> The reduction in private investment caused by government borrowing that raises the real interest rate in the loanable funds market.

### The loanable funds market and why government borrowing matters

Before you can explain crowding out, you need the loanable funds model clearly in mind. In this market, savers supply funds and borrowers demand funds. The “price” of borrowing is the **real interest rate**, not the nominal interest rate.

> **Key Term: loanable funds market**
> The market in which savers supply funds and borrowers demand funds, with the real interest rate adjusting to bring the market to equilibrium.

On the AP graph:

- the **vertical axis** is the **real interest rate**
- the **horizontal axis** is the **quantity of loanable funds**

That axis choice matters. Students lose points when they write only “interest rate” or accidentally switch to the money market, where the vertical axis is the nominal interest rate.

Who demands loanable funds? Households, firms, and governments. Firms borrow for investment spending such as factories, machines, and equipment. Governments borrow when tax revenue is not enough to cover spending.

> **Key Term: real interest rate**
> The nominal interest rate minus inflation; it is the inflation-adjusted cost of borrowing and reward for lending.

A key AP distinction is between a **budget deficit** and the **national debt**.

> **Key Term: budget deficit**
> The amount by which government spending exceeds tax revenue in a given year.

A deficit is a **flow** for one year. The national debt is the total accumulated borrowing over time. Crowding out is tied directly to the **deficit**, because the deficit is what forces the government to borrow more now.

Why does that matter in the graph? Because when the government borrows more, it enters the loanable funds market as a larger demander of funds. That is not a movement along the demand curve caused by the interest rate itself. It is a **shift** of the entire demand curve to the right because one of the non-price determinants of demand has changed: government borrowing has increased.

Students sometimes say that government borrowing “reduces the supply of loanable funds available to firms.” That idea points in the right direction, but for AP Macroeconomics the standard graph language is more precise: **the demand for loanable funds shifts right**.

> **Test Tip:** On an FRQ, always state the missing middle step: “Because the government runs a deficit, it must borrow more, which increases the demand for loanable funds.” If you skip that step, your answer often sounds incomplete.

### The crowding-out chain on the graph

Now apply the model step by step.

Suppose the government uses **expansionary fiscal policy** during a recession. It increases government spending, cuts taxes, or both. If this creates or enlarges a budget deficit, the government must borrow to finance it.

That borrowing increases the demand for loanable funds. Graphically:

- demand for loanable funds shifts from **D1** to **D2**
- supply of loanable funds stays the same in the basic model
- equilibrium moves up and to the right
- the **equilibrium real interest rate rises**
- the **equilibrium quantity of loanable funds rises**

The rise in quantity sometimes confuses students. If the government is borrowing more, why does quantity increase? Because at a higher real interest rate, savers are willing to supply more funds. The new equilibrium reflects both more borrowing and a higher cost of borrowing.

Here is the AP-style chain in full:

1. Government runs a larger budget deficit
2. Government borrowing increases
3. Demand for loanable funds increases
4. Demand curve shifts right
5. Equilibrium real interest rate rises
6. Private investment spending falls

That final step is the essence of crowding out.

> **Key Term: private investment**
> Business spending on physical capital such as factories, machinery, equipment, and other productive assets.

Why does private investment fall? Because firms compare the expected return on investment projects with the cost of borrowing. When the real interest rate rises, some projects that were profitable at the old rate are no longer profitable. A company might still build its most productive new factory, but it may cancel a smaller warehouse expansion or postpone equipment upgrades.

This is why crowding out does **not** mean investment becomes zero. It means **some** private investment is reduced.

A useful way to think about it:

- at a lower real interest rate, many investment projects clear the profitability test
- at a higher real interest rate, only the stronger projects still clear it
- weaker marginal projects are dropped first

That is classic marginal analysis. The government’s extra borrowing competes with firms for available saving, and the real interest rate adjusts upward.

### Worked AP-style example

Assume the economy is in recession and Congress passes a large spending package funded by deficit borrowing.

Initial loanable funds equilibrium:

- real interest rate = **3%**
- quantity of loanable funds = **$500 billion**

After the policy, government borrowing increases. Demand for loanable funds shifts right. New equilibrium:

- real interest rate = **5%**
- quantity of loanable funds = **$560 billion**

What should you conclude?

Step 1: Identify the policy effect  
Government borrowing increased because the deficit increased.

Step 2: Interpret the graph change  
The demand for loanable funds shifted right, causing the equilibrium real interest rate to rise from **3% to 5%**.

Step 3: Connect to firms  
Borrowing is now more expensive for businesses.

Step 4: State crowding out  
Some private investment spending decreases.

A strong exam sentence would be:

> Because the government is financing a larger deficit by borrowing, the demand for loanable funds increases, raising the equilibrium real interest rate from 3% to 5%, which discourages some private investment spending.

Notice what this answer does well:

- uses **real interest rate**
- names **government borrowing**
- identifies a **rightward demand shift**
- explains **why investment falls**

A weak answer would just say:

> Interest rates go up, so spending goes down.

That is too vague for AP standards.

> **Test Tip:** In graph questions, label the initial and new equilibria clearly. The scorer is often looking for three things: rightward shift of demand, higher equilibrium real interest rate, and lower private investment.

### Why crowding out can weaken fiscal policy

Expansionary fiscal policy is meant to shift **aggregate demand** to the right. Higher government spending directly raises AD, and tax cuts can raise consumption. But crowding out creates a partial offset.

Here is the logic:

- government spending rises, which pushes AD right
- but deficit borrowing raises the real interest rate
- higher real interest rates reduce private investment
- lower investment pulls AD back left relative to where it would otherwise be

The result is that fiscal policy may still work, but **less strongly** than students first expect.

This is an important evaluation point. Crowding out does not automatically cancel all stimulus. Its size depends on conditions in the economy.

If plenty of saving is available, the increase in government borrowing may have only a small effect on the real interest rate. In that case, crowding out is weak. If available funds are tighter, the interest-rate rise may be larger, and crowding out is stronger.

So the best AP phrasing is usually:

- crowding out **reduces** private investment
- crowding out may **offset part** of the increase in aggregate demand
- crowding out can make expansionary fiscal policy **less effective**

Avoid absolute claims like “fiscal policy never works” or “all investment is eliminated.”

### Long-run and open-economy implications students often miss

A strong answer can go one step beyond the immediate graph effect.

If private investment falls today, firms build less capital. That means fewer machines, less equipment, and less new productive capacity in the future. So crowding out can reduce **capital formation**.

> **Key Term: capital formation**
> The growth of an economy’s stock of physical capital through investment spending.

That gives crowding out a long-run cost:

- less private investment now
- slower growth of capital stock later
- weaker long-run economic growth

This point appears often in high-level explanations and is a good extension if the question asks about long-run effects.

In an **open economy**, there can also be another crowding-out channel. Higher real interest rates can attract foreign financial capital. Foreigners then demand the domestic currency to buy domestic assets. That tends to appreciate the currency, which can reduce net exports.

So in open-economy questions, higher interest rates may crowd out not only private investment but also **net exports**. Still, if the question is specifically about the loanable funds graph, keep your main focus on the standard chain through private investment unless asked to extend further.

### Common mistakes and how to avoid them

Students often lose easy points here because of avoidable errors.

Mistake 1: Using the wrong market  
Do not switch to the money market unless the question asks for it. The loanable funds graph has:

- vertical axis = **real interest rate**
- horizontal axis = **quantity of loanable funds**

Mistake 2: Forgetting government borrowing  
Do not jump straight from “fiscal policy” to “interest rates rise.” Explain that the **deficit requires borrowing**.

Mistake 3: Saying supply shifts left  
Some teachers mention “less loanable funds available to firms,” but AP scoring most often wants: **demand for loanable funds shifts right**.

Mistake 4: Confusing real and nominal interest rates  
In this model, use **real interest rate**.

Mistake 5: Overstating the effect  
Crowding out means **some** private investment falls. It does not mean all borrowing stops.

A model FRQ answer could be:

> An increase in the budget deficit causes the government to borrow more. This increases the demand for loanable funds, shifting the demand curve to the right. The equilibrium real interest rate rises, which makes borrowing more expensive for firms and reduces private investment spending.

That is short, direct, and earns points.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Crowding out is the reduction in private investment caused by government borrowing
- In the loanable funds market, the vertical axis is the real interest rate
- In the loanable funds market, the horizontal axis is the quantity of loanable funds
- A larger budget deficit usually means the government must borrow more
- More government borrowing shifts the demand for loanable funds to the right
- A rightward shift in demand raises the equilibrium real interest rate
- The equilibrium quantity of loanable funds usually rises as well
- Higher real interest rates make borrowing more expensive for firms
- More expensive borrowing reduces some private investment spending
- Crowding out weakens, rather than automatically destroys, expansionary fiscal policy
- A budget deficit is different from the national debt
- Lower private investment today can reduce future capital formation and long-run growth

## Key Terms and Concepts

- crowding out
- loanable funds market
- real interest rate
- budget deficit
- private investment
- capital formation


Crowding Out - Loanable funds shows crowding out