Question
The 'Crowding Out' effect of fiscal policy refers to:
Solution
- Crowding Out is a potential negative consequence of expansionary fiscal policy (increased government spending or tax cuts) when it is financed by borrowing from the domestic loanable funds market .
- The government increases its demand for funds to finance its deficit.
- This increased demand competes with private borrowers (firms wanting to invest) for a limited supply of savings.
- This competition drives up the real interest rate .
- Higher interest rates make borrowing more expensive for private firms, leading them to postpone or cancel investment projects .
Thus, the increase in public sector activity "crowds out" private sector investment, potentially reducing the overall effectiveness of the fiscal stimulus.
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