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Macroeconomics guide, Unit 5, step 17 of 23Previous stepNext step

Step 17: Deficits, Debt and Crowding Out

By the EconTutorials team. 10-minute read with 6 practice questions.
SyllabusAP Macro 5.4–5.5 · Cambridge 10.3 · IB 3.6
In 30 seconds
  • A budget deficit is a flow: government spending exceeds revenue in one year. The national debt is a stock: the total of all past deficits minus past surpluses.
  • Debt is usually measured as a percentage of GDP, because what matters is the debt compared with the economy’s ability to pay.
  • Deficits are financed by selling government bonds. That borrowing raises the demand for loanable funds, raises the real interest rate and reduces private investment: crowding out.
  • Less investment means a smaller capital stock and slower long-run growth. How serious debt is depends on who holds it, what it paid for, and whether the interest rate is above or below the growth rate.
Video lesson coming soonA short animated lesson for this step will appear here.

Deficit, surplus and debt: a flow and a stock

Think about a student with a part-time job. If she spends $50 more than she earns this month, she has a deficit of $50 and puts it on her credit card. The card balance is her debt. Each deficit month adds to it; in a month she earns more than she spends, she has a surplus and can pay some off.

A government works the same way. The deficit happens over a period (a flow, like water from a tap); the debt is owed at a point in time (a stock, like water in the bath).

Key termBudget deficit: the amount by which government spending (including transfer payments) exceeds tax revenue in a given year. It is a flow.
Key termNational (government) debt: the total amount the government owes at a point in time, built up from all past deficits minus all past surpluses. It is a stock.
\[ \text{Debt}_{\text{end of year}} = \text{Debt}_{\text{start of year}} + \text{Deficit during the year} \]

A surplus counts as a negative deficit, so it reduces the debt.

Worked example

For example, a government spends $900 billion this year and collects $820 billion in taxes. Its debt at the start of the year was $1,200 billion. Next year it runs a surplus of $30 billion. Find this year’s deficit and the debt at the end of each year.

Step 1Deficit \( = 900 – 820 = 80 \) billion
Step 2Debt at end of this year \( = 1200 + 80 = 1280 \) billion
Step 3Debt at end of next year \( = 1280 – 30 = 1250 \) billion

Only the surplus year makes the debt fall.

Common mistake“The government has cut the deficit, so the debt is falling.” This is wrong. A smaller deficit still adds to the debt. The debt falls only when the government runs a surplus. Exam questions test this every year.

Measuring debt as a percentage of GDP

A $1 trillion debt would crush a small country but be modest for a huge one. So economists use the debt-to-GDP ratio, since GDP measures the income the government can tax.

\[ \text{Debt-to-GDP ratio} = \frac{\text{Government debt}}{\text{Nominal GDP}} \times 100 \]

Deficits are also given as a percentage of GDP. Using the numbers above, if nominal GDP is $1,600 billion, the deficit of $80 billion is \( \frac{80}{1600} \times 100 = 5\% \) of GDP, and the debt of $1,280 billion is \( \frac{1280}{1600} \times 100 = 80\% \) of GDP.

The debt ratio can even fall during a deficit, if GDP grows faster than the debt.

Worked example

For example, a country has debt of $800 billion and nominal GDP of $1,000 billion. Next year it runs a deficit of $20 billion and nominal GDP grows by 5%. What happens to the debt-to-GDP ratio?

Step 1Starting ratio: \( \frac{800}{1000} \times 100 = 80\% \)
Step 2New debt \( = 800 + 20 = 820 \); new GDP \( = 1000 \times 1.05 = 1050 \)
Step 3New ratio: \( \frac{820}{1050} \times 100 \approx 78.1\% \)

The debt went up by $20 billion, but the ratio fell from 80% to about 78.1%, because the economy grew faster (5%) than the debt (\( \frac{20}{800} \times 100 = 2.5\% \)).

How deficits are financed

A government covers a deficit mainly by selling government bonds: IOUs that pay interest each year and repay the amount borrowed on a set date.

Who buys the bonds?

  • Domestic savers, pension funds and banks: the country’s own saving.
  • Foreign investors: future interest payments flow abroad.
  • The central bank, which pays with newly created money. This is called monetising the deficit. On a large scale it causes inflation, even hyperinflation, as in Zimbabwe in 2007–2008.

Crowding out through the loanable funds market

When the government sells bonds to the public, it competes with firms for the same pool of saving. Its extra borrowing shifts the demand for loanable funds to the right and the real interest rate rises. At the higher rate, fewer investment projects are worth borrowing for, so private investment falls.

Key termCrowding out: the reduction in private investment caused by government borrowing raising the real interest rate.
DiagramDraw the loanable funds market: vertical axis “Real interest rate (r)”, horizontal axis “Quantity of loanable funds”. Draw an upward-sloping supply curve SLF (saving) and a downward-sloping demand curve DLF1. Mark equilibrium at r1 and Q1. The government runs a larger deficit, so shift demand right to DLF2. The new equilibrium is at a higher real interest rate r2. Reading across from r2 to DLF1, private borrowing is now less than Q1: that fall is the crowding out. (Some textbooks instead shift the supply curve left because the deficit reduces national saving; the real rate still rises and investment still falls.)
Worked example

For example, in an economy the supply of loanable funds is \( Q_S = 60 + 20r \) and private demand is \( Q_D = 300 – 20r \) ($ billions, r in percent). The government starts borrowing $40 billion at every interest rate. Find the change in the real interest rate and in private investment.

Step 1Before: \( 60 + 20r = 300 – 20r \Rightarrow 40r = 240 \Rightarrow r = 6\% \); \( Q = 60 + 120 = 180 \)
Step 2After: \( 60 + 20r = 340 – 20r \Rightarrow 40r = 280 \Rightarrow r = 7\% \); total \( Q = 60 + 140 = 200 \)
Step 3Private investment at 7%: \( 300 – 20(7) = 160 \). Crowding out \( = 180 – 160 = 20 \)

The real interest rate rises from 6% to 7%. The government’s $40 billion of borrowing is met by $20 billion of extra saving (200 − 180) and $20 billion of private investment that no longer happens.

Investment, growth and the burden of debt

Why do economists care about crowding out? Investment builds the capital stock: machines, factories and software. If deficits keep crowding out investment, the capital stock and productivity grow more slowly, and long-run aggregate supply (or the production possibilities curve) shifts out more slowly. Future living standards are lower than they would have been.

The size of the effect depends on the situation:

  • Near full employment, saving is limited and crowding out is strong.
  • In a deep recession, firms are not borrowing much anyway, saving sits idle and interest rates may be close to zero, so crowding out is small.
  • If the government borrows to invest in roads, broadband, education or research, it can raise the return on private capital and encourage firms to invest more. This is called crowding in.

Is government debt a burden? Arguments that it is:

  • Interest payments use tax revenue that could fund schools or hospitals.
  • Intergenerational burden: tomorrow’s taxpayers pay, and inherit a smaller capital stock.
  • Foreign-held debt means interest payments leave the country.
  • Risk: if lenders doubt repayment, they demand higher interest rates, making the debt harder to manage.

Arguments that the burden can be overstated:

  • Domestically held debt is partly “owed to ourselves”: taxpayers pay interest to bondholders in the same country.
  • If borrowing paid for productive investment, future generations inherit the assets too.
  • What matters is the ratio to GDP. Economics Made Simple writes the change in the debt ratio as \( \Delta(D/Y) \approx (r – g)(D/Y) – \text{primary balance} \), where \( r \) is the interest rate on the debt, \( g \) is the growth rate of nominal GDP and the primary balance is the budget balance excluding interest. If \( g \) is greater than \( r \), the ratio tends to fall on its own.
Worked example

For example, debt is 100% of GDP (\( D/Y = 1.00 \)), the interest rate on the debt is 4%, nominal GDP grows by 2% and the primary balance is zero. Approximately how does the debt ratio change in a year? What if growth were 6% instead?

Step 1\( \Delta(D/Y) \approx (0.04 – 0.02) \times 1.00 – 0 = 0.02 \): the ratio rises by about 2 percentage points
Step 2With \( g = 6\% \): \( (0.04 – 0.06) \times 1.00 – 0 = -0.02 \)
Step 3The ratio now falls by about 2 percentage points, from 100% to about 98%

The same debt grows or shrinks relative to GDP depending on whether \( r \) is above or below \( g \).

Recap: automatic stabilisers and discretionary policy

Automatic stabilisers are parts of the tax and benefit system that change the budget on their own. In a recession, tax revenue falls and unemployment benefit claims rise, so the deficit widens automatically and supports spending. In a boom the budget moves towards surplus.

Discretionary fiscal policy is a deliberate decision to change spending or tax rates, such as a stimulus package or a tax cut. It is slower and harder to reverse.

The cyclical deficit is the part caused by the economy being below full employment; it disappears in recovery. The structural deficit is the part that would remain even at full employment; it only shrinks if policy changes. A large structural deficit is the bigger worry for long-run debt and crowding out.

Exam tipFor AP Macroeconomics (5.4–5.5), use the loanable funds graph with “Real interest rate” on the vertical axis, shift demand right for a deficit, and explain the full chain: deficit → government borrowing → demand for loanable funds rises → real interest rate rises → private investment falls → slower capital accumulation → slower long-run growth. For Cambridge 9708 and IB, the evaluation marks come from “it depends”: the state of the economy (recession or full employment), whether borrowing finances investment (crowding in), who holds the debt, and whether \( r \) is above or below \( g \). Always say whether you mean the deficit (flow) or the debt (stock).

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A government spends $450 billion and collects $410 billion in tax. Its debt was $600 billion at the start of the year. Find the deficit and the debt at the end of the year. Show worked answer
Deficit \( = 450 – 410 = 40 \) billion.
Debt at end of year \( = 600 + 40 = 640 \) billion.
EasyQ2. State whether each is a stock or a flow: (a) the budget deficit, (b) the national debt, (c) the interest paid on the debt this year. Show worked answer
(a) Flow: measured per year.
(b) Stock: measured at a point in time.
(c) Flow: it is an amount paid over the year.
MediumQ3. Government debt is $900 billion and nominal GDP is $1,500 billion. This year’s deficit is $45 billion. Express the debt and the deficit as percentages of GDP. Show worked answer
Debt ratio \( = \frac{900}{1500} \times 100 = 60\% \).
Deficit \( = \frac{45}{1500} \times 100 = 3\% \) of GDP.
MediumQ4. Debt is $500 billion and nominal GDP is $1,000 billion. Next year the government runs a deficit of $30 billion and nominal GDP grows by 8%. Does the debt-to-GDP ratio rise or fall? Show worked answer
Starting ratio \( = \frac{500}{1000} \times 100 = 50\% \).
New debt \( = 500 + 30 = 530 \); new GDP \( = 1000 \times 1.08 = 1080 \).
New ratio \( = \frac{530}{1080} \times 100 \approx 49.1\% \).
The ratio falls, even though the debt rose, because GDP grew by 8% while debt grew by \( \frac{30}{500} \times 100 = 6\% \).
MediumQ5. Supply of loanable funds is \( Q_S = 40 + 10r \) and private demand is \( Q_D = 160 – 10r \) ($ billions, r in percent). The government borrows $20 billion at every rate. Find the new real interest rate and the amount of private investment crowded out. Show worked answer
Before: \( 40 + 10r = 160 – 10r \Rightarrow 20r = 120 \Rightarrow r = 6\% \); \( Q = 40 + 60 = 100 \).
After: \( 40 + 10r = 180 – 10r \Rightarrow 20r = 140 \Rightarrow r = 7\% \); total \( Q = 40 + 70 = 110 \).
Private investment at 7%: \( 160 – 10(7) = 90 \).
Crowding out \( = 100 – 90 = 10 \) billion. The real interest rate rises from 6% to 7%.
ExamQ6. The economy of Country Y is at full employment. The government increases its budget deficit, financed by selling bonds to the public. (a) Using a correctly labelled loanable funds graph, show the effect on the real interest rate. (b) Explain the effect on private investment. (c) Explain the effect on long-run economic growth. (d) Give one reason why the effect in (b) might be small. [6 marks] Show worked answer
(a) [2 marks] Graph with vertical axis “Real interest rate” and horizontal axis “Quantity of loanable funds”, upward-sloping supply and downward-sloping demand (1). Demand shifts right; the real interest rate rises from r1 to r2 (1).
(b) [2 marks] Private investment falls (1) because the higher real interest rate raises the cost of borrowing for firms, so fewer projects are profitable: crowding out (1).
(c) [1 mark] Long-run growth slows because lower investment means slower growth in the capital stock and productivity, so LRAS shifts right more slowly.
(d) [1 mark] Any one, explained: the deficit pays for public investment that raises the return on private capital (crowding in); OR foreign capital inflows increase the supply of loanable funds, limiting the rise in the real rate; OR if the economy were in recession with idle saving, the rate would rise very little.

Check yourself

1. A government reduces its deficit from 6% to 2% of GDP. The national debt:

Any deficit adds to the debt; only a surplus reduces it.

2. Crowding out happens because government borrowing:

Extra demand for loanable funds raises the real rate, and investment falls.

3. Which is an automatic stabiliser?

It changes the budget automatically with the cycle, with no new decision needed.

Your score: 0 out of 3

The short version

  • The deficit is a yearly flow; the debt is the accumulated stock. Only a surplus reduces the debt.
  • Debt is judged as a percentage of GDP; the ratio can fall during a deficit if GDP grows faster than the debt.
  • Deficits are financed by selling bonds. Government borrowing raises the demand for loanable funds and the real interest rate, crowding out private investment and slowing long-run growth.
  • Crowding out is strong at full employment and weak in a deep recession; public investment can crowd in.
  • Automatic stabilisers move the budget with the cycle (cyclical deficit); discretionary policy and structural deficits are deliberate choices that matter most for long-run debt.

Further reading on EconTutorials

Older in-depth articles on this topic from our blog:

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