Crowding out effect. Help Please

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cfa_ candidate_ 2011

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Crowding out effects mention that goverment deficit reduces private investment because of the increase in real interest rate (CFAI textbook december 2011, pg no. 441, second paragraph).
And here i am thinking why??

if interest rate is high(doesn't matter nominal or real), we would like to invest our savings, as it would be more than the oppourtunity cost of our consumption..

and now here this crowding effect mentions that an inrecase in real interest rate decrease private investment, decrease quantity of loanable funds..

Can anybody give me a logical explanation please. I would be really great.

Thanx in advance.
 
A very simple and logical way of looking at this would be:
Govt. has a deficit, so it borrows money from banks, then there would be a lower quantity of loanable funds, and thus, interest rates would go up ( nominal or real), higher interest rates would discourage prospective investors to invest money as there borrowing costs would go up.
Hope this helps
 
Just to add to what iaf10 said:
The government must borrow from the loanable funds market to finance the deficit. Higher government borrowing lowers the supply of loanable funds available for the private sector. This decrease in supply results in higher interest rates, that cause investment to fall.
Basically, private investment gets ‘crowded out’ by high government borrowing.
 
Funny you ask this, I just asked Schweser the same thing. Cinderella is right; the gov’t is competing for the same pool of funds as the private sector, so when they run up deficits and need to borrow, they compete and drive up demand for loanable funds. This ends up driving up rates.
 
iaf10
” borrowing costs would go up”
+1 for this.
Thank you iaf10, Cinderella, and Var_99 for your valuable inputs.
 
Also, since not all government borrowing is from banks, even in the open markets, the extra government debt boosts treasury supply, which means the government has to lower prices on debt (by raising the interest rate) to attract more investors to allocate more funds to treasuries. This in turn shifts the entire credit curve upwards as treasuries are basically “crowding out” other forms of investment.
 
Black Swan wrote:
Also, since not all government borrowing is from banks, even in the open markets, the extra government debt boosts treasury supply, which means the government has to lower prices on debt (by raising the interest rate) to attract more investors to allocate more funds to treasuries. This in turn shifts the entire credit curve upwards as treasuries are basically “crowding out” other forms of investment.
Wouldn’t able to understand more without the concept of treasury securities. Thank you black swan. I am a crystal clear now. :d
 
I completely agree with Cinderella here.
When economists speak of the crowding out effect they are not speaking of financial investments alone but rather the interaction between financial markets and real investment. In the economists eye, financial markets simply deliver capital to entrepreneurs who use it to make real investments (buy computers, set up new factory, etc.). In this sense, the higher interests arising from govt spending (as described by Cinderella) make it more expensive for entreprenuers to borrow money from financial markets (pay back higher interest) and therefore real investment falls.
 
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