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I'm having trouble with understanding what the results would be...

Let's suppose the situation where the newly formed government act to cut government spending and, by doing so eliminate the current federal government budget deficit.

Does this shift the demand curve or the supply curve in the loanable funds market?

I watched a Youtube video and it said demand would increase (crowding out) but my lecture notes contradict that by saying supply will decrease (crowding out) or does that result to the same thing?

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    $\begingroup$ No deficit spending means the government will NOT need to borrow funds to finance projects...what does this imply about the availability of funds? What does this imply about the demand for funds? Also consider carefully if reducing a budget deficit could cause crowd out. Do you think perhaps it might instead reduce crowd out? $\endgroup$
    – 123
    Apr 27 '15 at 12:18
  • $\begingroup$ Wouldn't the increase of demand be "crowding in", not out? And is demand decreasing "supply" really crowding out? $\endgroup$
    – FooBar
    Jun 9 '15 at 12:01
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If the opposite were true and the government proposes spending $1 trillion on infrastructure spending we will see a shift outward of the demand curve and rates will tick upward to a new equilibrium point. The crowding out occurs when we have movement along the demand curve (from the old interest rate --> new demand curve intersection up to the new intersection of the S and D curve).

enter image description here With a decrease in government spending your demand curve for the loan-able funds market will shift inward and push the interest rate lower. When a fall in the interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending.

It is somewhat agreed upon that contractionary fiscal policy leads to a surplus and the government can act as a creditor rather than a debtor. It will also leave more money for private investments for people such as small borrowers.

(There are some economists that believe that under the right circumstances that expansionary government policies may produce crowing in instead of crowding out. Keynesian economists may suggest that if the policy is strong enough to change the economic climate then businesses may find it profitable to add capacity -induced investment- which works to counteract and possibly out weigh the crowding out effect.)

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Supply will increase, as more money becomes available for the government to lend out to borrowers. This is the opposite of the crowding out effect, as mathtastic says, because investment increases.

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The "loanable funds market" does not exist - it is a misrepresentation of how banking works. See this document from the Bank of England.

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Before answering this question please take in mind the following

  1. Borrowing and lending is achieved by selling and buying bonds respectively. Lending is demonstrated by a demand curve while borrowing is demonstrated by supply curve
  2. Bond prices have negative relation with interest rates.

Graph showing Supply (S) and Demand (D) bond market curves

A government spending cut and a decrease in government borrowing as a result of favorable decrease in budget deficit will shift the supply curve of bond markets to the left leading to higher bond prices and lower interest rates.

Crowding out occurs when government borrowing is raising interest rates by issuing new bonds to finance its deficits and shifting the supply curve of bond market to the right. A decrease in government spending and borrowing will decrease interest rates. This will encourage corporation to borrow and participate in the bonds market.

enter image description here

For more information about the fundamentals of bonds market as well as factors shifing supply and demand for bonds please visit http://www.oswego.edu/~edunne/340ch6part2.htm

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  • $\begingroup$ A decrease in the government deficit would shift the supply curve to the right, not the left, and vice versa. Think about it intuitively. Your graphic does not show crowding out because quantity of loanable funds demanded and supplied is greater at this new equilibrium, which runs contrary to what crowding out is by definition. $\endgroup$
    – DornerA
    Dec 7 '15 at 13:11

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