APMacro: Loanable Funds

crowding out
One potential problem of fiscal policy is the crowding-out effect. If government increases borrowing in order to conduct expansionary fiscal policy, the increased demand for funds in the loanable funds market can increase interest rates. Firms may respond by decreasing investment, reducing the effectiveness of the fiscal policy undertaken. Economists disagree about the strength of the crowding-out effect, as firms are already less likely to increase investment in a time of recession due to excess capacity.

The national debt is important primarily because of the effects of interest. Because ownership of the debt is concentrated in those with higher incomes, payment of interest increases the inequality of incomes. The payment of interest reduces government funds available to spend for other needs, and payment to foreigners who hold U.S. debt transfers those funds outside of the country. Crowding out is a much more important problem when the economy is at full-employment output, because increased government borrowing can reduce investment and compromise long-run economic growth. However, if the increased government spending is used for infrastructure improvements and research, long-run economic growth could be enhanced.



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