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A-Level Economics · Loanable funds (crowding out) diagram question

Complete the crowding-out chain: government borrowing → interest rate rises → …?

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The diagram

The answer

Borrowing becomes more expensive for firms, so private investment falls, the capital stock grows more slowly and long-run productive potential is lower. The business that wanted to borrow £50k now pays 10% interest, not 5% — so the project no longer stacks up and does not happen. With a finite supply of savings, the government and the private sector compete for the same pool of loanable funds. Government borrowing raises demand for those funds → the equilibrium interest rate is pushed up → financing investment costs firms more → private I falls → the capital stock grows more slowly → long-run productive potential is lower than it would have been. The short-run AD gain comes at a long-run supply-side cost.

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This is one of 6 questions on the loanable funds (crowding out) diagram — every corner lettered, every wrong answer diagnosed.

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