I n t h I s c h a p t e r y o u w I l L

crowding out
and is repre-
sented in the figure by the movement along the demand curve from a quantity of
$1,200 billion in loanable funds to a quantity of $800 billion. That is, when the gov-
ernment borrows to finance its budget deficit, it crowds out private borrowers
who are trying to finance investment.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
$800
$1,200
3. ...and reduces the equilibrium
quantity of loanable funds.
S
2
2. ...which
raises the
equilibrium
interest rate...
Supply, 
S
1
Demand
5%
6%
1. A budget deficit
decreases the
supply of loanable
funds...
F i g u r e 2 5 - 4
T
HE
E
FFECT OF A
G
OVERNMENT
B
UDGET
D
EFICIT
.
When the
government spends more than 
it receives in tax revenue, the
resulting budget deficit lowers
national saving. The supply of
loanable funds decreases, and 
the equilibrium interest rate rises.
Thus, when the government
borrows to finance its budget
deficit, it crowds out households
and firms who otherwise would
borrow to finance investment.
Here, when the supply shifts
from 
S
1
to 
S
2
, the equilibrium
interest rate rises from 5 percent
to 6 percent, and the equilibrium
quantity of loanable funds saved
and invested falls from $1,200
billion to $800 billion.
c r o w d i n g o u t
a decrease in investment that results
from government borrowing

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5 7 2
PA R T N I N E
T H E R E A L E C O N O M Y I N T H E L O N G R U N
C A S E S T U D Y
THE DEBATE OVER THE BUDGET SURPLUS
Our analysis shows why, other things being the same, budget surpluses are bet-
ter for economic growth than budget deficits. Making economic policy, how-
ever, is not as simple as this observation may make it sound. A good example
occurred in the late 1990s, when the U.S. government found itself with a budget
surplus, and much debate centered on what to do with it.
Many policymakers favored leaving the budget surplus alone, rather than
dissipating it with a spending increase or tax cut. They based their conclusion
on the analysis we have just seen: Using the surplus to retire some of the gov-
ernment debt would stimulate private investment and economic growth.
Other policymakers took a different view. Some thought the surplus should
be used to increase government spending on infrastructure and education be-
cause, they argued, the return to these public investments is greater than the
typical return to private investment. Some thought taxes should be cut, arguing
that lower tax rates would distort decisionmaking less and lead to a more effi-
cient allocation of resources; they also cautioned that without such a tax cut,
Thus, the most basic lesson about budget deficits follows directly from their ef-
fects on the supply and demand for loanable funds: 
When the government reduces
national saving by running a budget deficit, the interest rate rises, and investment falls.
Because investment is important for long-run economic growth, government bud-
get deficits reduce the economy’s growth rate.
Government budget surpluses work just the opposite as budget deficits. When
government collects more in tax revenue than it spends, its saves the difference by
retiring some of the outstanding government debt. This budget surplus, or public
saving, contributes to national saving. Thus, 
a budget surplus increases the supply of