MAcro CHAPTER 5.5:

CHAPTER SUMMARY

You might remember the loanable funds market from Unit 4 (first graph below), where we saw that a shift in the demand for loanable funds can cause real interest rates to rise and also change the quantity of loanable funds borrowed.

This is closely connected to government spending, because often, governments have to borrow money in order to spend and invest. For example, because the United States has $30T of National Debt, they need to borrow money in order to spend. For example, if the United States government wants money to pay to build new roads, but doesn't have any money left, they must borrow that money. This increases the demand for loanable funds, resulting in a higher real interest rate (second graph above).

When the real interest rate rises, on the margin, some private sector businesses and consumers will stop borrowing, meaning that private sector spending goes down. This effect is called crowding out, because the government's additional borrowing has actually pushed some businesses and consumers stop borrowing - they are getting crowded out of the market.

This means that, if the government borrows and spends money as part of a policy that aims to increase aggregate demand by $10B, it might fall short, because the resulting rise in interest rates may cause Government Spending (G) to rise by $10B, but Consumer Spending (C) and/or Investment Spending (I) to fall by $4B, meaning that it actually only succeeds in increasing aggregate demand by $6B.

We can see how this works below. In graph 1, an economy is in a recessionary gap. In graph 2, the government increases spending to close the recessionary gap, shifting aggregate demand to the right (AD1) so that the economy reaches long-run equilibrium. However, in graph 3, because of rising interest rates, C and I have now fallen, causing AD1 to shift back to AD2, meaning the economy remains in a recessionary gap, although it is now smaller than before.

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