Final answer:
Substantial government borrowing increases the demand for loanable funds, leading to higher interest rates and the potential crowding out of private investment. This relationship is demonstrated as the demand curve for financial capital shifts rightward. However, during recessions, such crowding out may be temporarily suspended due to central bank interventions that reduce interest rates.
Step-by-step explanation:
When a government engages in substantial borrowing, it increases the demand for loanable funds in financial markets. This scenario is illustrated in budget deficits and interest rates scenarios, where increased government borrowing shifts the demand curve for financial capital from D0 to D1. As a result, the equilibrium interest rate rises (e.g., from 5% to 6%), and the equilibrium quantity of loanable funds as a percentage of GDP might increase (e.g., from 20% to 21%). This shift can potentially crowd out private investment as the cost of borrowing increases.
The 'crowding out' effect refers to the situation where private investment diminishes because government borrowing drives up interest rates, making it more expensive for the private sector to borrow funds for investment. This effect was temporarily suspended during the Great Recession, when interest rates were drastically lowered to stimulate the economy. As the economy recovers and interest rates naturally rise, there could be renewed pressure on interest rates due to government borrowing, which could resume the crowding out of private investment.