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      Question

      The 'Crowding Out' effect of fiscal policy refers to:

      A Government spending increasing private investment. Correct Answer Incorrect Answer
      B Government borrowing leading to higher interest rates, reducing private investment. Correct Answer Incorrect Answer
      C Exports reducing domestic consumption. Correct Answer Incorrect Answer
      D Imports replacing domestic production. Correct Answer Incorrect Answer
      E Public sector enterprises outcompeting private firms. Correct Answer Incorrect Answer

      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 .
        1. The government increases its demand for funds to finance its deficit.
        2. This increased demand competes with private borrowers (firms wanting to invest) for a limited supply of savings.
        3. This competition drives up the  real interest rate .
        4. 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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