When the government spends more than it earns, it has to borrow money, which has repercussions throughout the economy. In this lesson, learn how government spending can crowd out private investment in the market for loanable funds.
Budget Surplus & Budget Deficit
In this lesson, we're talking about how government overspending and borrowing negatively impacts private investment and leads to lower economic output. Let's take a look at the federal budget and see how deficit spending can affect the lives of everyday citizens in the market for loanable funds and why it leads to lower economic growth.
The federal government takes in money, which they call revenues. However, you might as well say 'taxes' because that's where the money comes from. The largest tax collected by the federal government is the income tax. When Bob pays income taxes, this money goes to fund the federal government.
The government then spends this money on a variety of things, which hopefully benefit the folks in the neighborhood. One example of this is transfer payments. A transfer payment is a when the government simply transfers money from one group to another. The largest transfer payments inside the federal budget include Social Security, Medicare, and Medicaid, which help provide for millions of people each year. Allison is a retired woman in Bob's neighborhood who's living on Social Security payments. Every month she receives her check, which she depends on to pay the bills for her groceries and her basic necessities. When you think about it, Allison and Bob are both safe because of a national defense that the government pays for.
Major transfer payments in the federal budget
It takes a lot of income tax revenue to pay for all these benefits. Two things happen with the government's budget each year, just like they do with your budget or my budget. Either we end up with a surplus of money or we end up with a shortfall. When the government spends less than it collects in net taxes, economists refer to this as a budget surplus. In the late 1990s, the federal government announced its first surplus in decades - over $69 billion. On the other hand, when the government spends more than it collects in taxes, economists refer to this as a budget deficit. For example, in fiscal year 2010, the federal government received about $2.2 trillion in revenue and spent about $3.5 trillion. The shortfall is considered a budget deficit, and when the government doesn't collect enough money to cover all expenditures, it has to borrow this difference.
The national debt is kind of like the balance on someone's credit card. It represents the cumulative amount of debt owed by the federal government. It is the sum total of all the budget deficits incurred by the government. For example, a budget deficit of $200 billion would add $200 billion to the national debt because Congress has to borrow money to make up the shortfall.
Government overspending has a powerful impact on the lives of citizens. To see what I mean, let's look at Bob. Bob is the numero uno lawn service guy who needs new mowers from time to time (he's just received the Business Owner of the Year Award, by the way).
When the government borrows money to make up these shortfalls, there's an unintended consequence that economists are concerned about, which we call crowding out. Crowding out is not when too many people show up to a concert and you have to stand outside. It's a term that starts in the market for loanable funds.
The market for loanable funds is where households borrow money to invest in homes and where firms borrow money to invest in capital equipment. You can think of it as the collection of financial institutions that offer loans, which you probably heard about through advertising many times. The last time Bob bought a new mower for his business, he borrowed the money. Now, he may not have been aware of this, but he went to the loanable funds market. When Bob wants to borrow money to invest in additional lawn mowers for his business, he goes to the loanable funds market to borrow money. This is where the federal government goes when it needs to borrow money as well.
We illustrate this market by showing the relationship between the quantity of loanable funds and the price of money, otherwise known as the interest rate.
The interest rate is really the price of money because investors borrow money to invest and then they make monthly loan payments. These ongoing loan payments are an ongoing cost to them that directly affects their profit margins. For example, when interest rates are low, their loan payments are low and their profits are higher. However, if interest rates are high, their loan payments are also high, and that means their profits are much lower. When interest rates get high enough, investors will stop investing because rates are so high and profit is so low that there's no incentive to invest anymore.
Graph of the relationship between the quantity of loanable funds and the interest rate
Interest Rates & Investors
What happens is that when the government borrows money to make up their budget shortfall, they go into the same market as households and firms. This increases the demand for loanable funds, which moves supply and demand to a new equilibrium at a higher interest rate. What does this mean? This means interest rates are higher for everyone in the market, not just for the government. These higher rates 'crowd out' private investors, some of whom will choose not to invest.
Just imagine that Bob really needs a new mower for his lawn business so he can expand. Expanding his business would be great not only for the neighborhood but also the economy as a whole.
Now, let's say that Bob drives to a financial institution and sits down to discuss borrowing money so he can invest, and when he does this he discovers an awful truth: that the government had a huge deficit last year and beat Bob to the market, increasing the demand for loans and causing interest rates on Bob's loan to be 15% instead of 7%. When Bob hears about this, he pulls out his calculator with an attitude of great concern. When he calculates the payments on a new loan and compares them to how much additional income he would make if he could mow more lawns, he realizes that it isn't worth it anymore because interest rates are too high.
Distraught, Bob walks out of the bank, drives home, and changes the message on his answering machine, so it alerts new prospects that he's not accepting new lawn service customers at this time. Crowding out is when government borrowing competes with private investment, driving up interest rates and reducing investment. Because of crowding out, the government's budget deficits raise the cost of borrowing for entrepreneurs, and that discourages private investment in the economy, leading to lower economic output. So, the key here is a reduction in investment like this within the economy means lower economic growth, so this is not a good thing.
To summarize, some of the largest components of the federal budget include transfer payments, such as Social Security, Medicare, and Medicaid programs.
When the government spends less than it collects in net taxes, economists refer to this as a budget surplus. In the late 1990s, the federal government announced its first surplus in decades - over $69 billion. On the other hand, when the government spends more than it collects in net taxes, economists refer to this as a budget deficit.
The national debt is kind of like the balance on someone's credit card. It represents the cumulative amount of debt owed by the federal government. It is the sum total of all the budget deficits incurred by the government.
Crowding out is when the government competes with private borrowers for loanable funds, causing an increase in interest rates and a decrease in investment. Because of crowding out, the government's budget deficits raise the cost of borrowing for entrepreneurs, and that discourages private investment in the economy, which leads to lower economic output.
By the end of this chapter you'll be able to:
- Know about Social Security, Medicare and Medicaid
- Explain the difference between a budget surplus and a budget deficit
- Understand how the national debt is calculated
- Define the concept of crowding out
- Explain why crowding out leads to a rise in budget deficit