Fiscal sustainability refers to a situation where the government operates a balanced or surplus budget. This implies a low level or no government borrowing to finance its expenditures. When a government operates a budget deficit, the deficit is financed through borrowing. A government may operate a budget deficit in the short run but in the long run, it is necessary to balance the government’s budget. Failure to strike a balance in the government budget leads to crowding out effect in the loanable funds market.
Since the government borrows funds from the loanable funds from the public through issue of government bonds and other securities, households and commercial institutions are left with less funds to supply to the loanable funds market (Mankiw 565). This leads to an inward shift in the supply curve for loanable funds as shown in the diagram below. The supply of funds in the loanable funds market is equal to savings since lenders supply funds to the market from their savings while the demand is equal to investments since borrowers borrow funds from the market to invest.
Interest rate, r S2
S1
R2
R1
D (Investment)
Q2 Q1 Quantity of loanable funds
In the above diagram, the crowding effect due to government borrowing to finance its budget deficit leads to a decrease in the supply of funds in the market for loanable funds (Mankiw 567). This leads to an increase in real interest rate from R1 to R2 as shown above. The cost of borrowing in the market will therefore increase and the equilibrium quantity of loanable funds (investment) will fall from Q1 to Q2 which represent investment by private businesses and individuals. A budget deficit will therefore lead to a reduction in private business since it causes a reduction in the supply of funds in the loanable funds market and hence an increase in the cost of borrowing.
Works Cited
Mankiw, Nicholas Gregory. Principles of economics. 3. ed. Mason, Ohio: Thomson/South-Western, 2004. Print.
