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When government increases spending without increasing revenue, it must borrow, increasing demand for loanable funds and raising interest rates. Higher interest rates reduce private investment and possibly consumption, offsetting part of the stimulus. Complete crowding out occurs if the interest rate rise reduces private spending by exactly the amount of government spending, leaving total output unchanged. Partial crowding out is more common, with the degree depending on monetary policy response and the economy's openness.
From fiscal policy, you know that government spending can boost aggregate demand directly through the multiplier mechanism. From loanable funds, you know that borrowing competes in a market where the interest rate equilibrates saving and investment. Crowding out connects these two frameworks: it describes the mechanism by which expansionary fiscal policy carries within it a partial offset — higher spending sows the seeds of higher interest rates that dampen private activity.
Here is the chain of logic. When government increases spending without raising taxes, it runs a deficit and must finance it by borrowing — issuing bonds. This increased demand for loanable funds shifts the demand curve for funds rightward. Holding the supply of national saving constant, more demand for funds drives up the equilibrium interest rate — you can read this directly off the loanable-funds diagram. This is not a metaphor: the Treasury auctions bonds in real markets, and a surge in bond supply drives yields higher to attract buyers.
The higher interest rate is the mechanism of crowding out. Private firms finance capital investment by borrowing; households finance housing and durable goods on credit. When borrowing costs rise, marginal investment projects that were profitable at the lower rate are no longer worth undertaking — the hurdle rate for capital budgeting has risen. Firms cut back investment, housing slows, and some consumption financed by credit falls as well. Government has "crowded out" private spending: its borrowing absorbed part of the available saving pool, leaving less for private use and driving up the price for what remains.
Complete crowding out is the classical extreme: every dollar of government spending displaces exactly one dollar of private spending, leaving total output unchanged. This requires private investment demand to be perfectly interest-elastic (a flat IS curve) or saving supply to be perfectly inelastic. It is the baseline of the classical model and implies fiscal policy is entirely ineffective. Partial crowding out — the empirically more realistic case — occurs when private spending falls by less than the government increase, so output rises but by less than a naive multiplier calculation would suggest. The actual degree of crowding out depends on: how interest-sensitive private investment is, whether monetary policy accommodates the fiscal expansion (the central bank can prevent rate rises by expanding money supply), and whether the economy is open to foreign capital.
Two important qualifications shift the analysis. First, in an open economy, foreign investors can lend to the government, expanding the supply of loanable funds and limiting the upward pressure on domestic interest rates. But foreign capital inflows require a stronger exchange rate to be attracted, which makes exports more expensive and imports cheaper — a current account deficit that crowds out net exports instead of domestic investment. Fiscal stimulus trades domestic crowding out for external crowding out. Second, if the central bank monetizes the deficit by purchasing government bonds, it prevents the rise in interest rates altogether — at the cost of a larger money supply and potential inflation. The effectiveness of fiscal policy cannot be analyzed without specifying the monetary policy response.