Crowding out occurs when investment declines because a budget
a. deficit makes interest rates rise.
b. deficit makes interest rates fall.
c. surplus makes interest rates rise.
d. surplus makes interest rates fall.
The Correct Answer and Explanation is:
Correct Answer: a. deficit makes interest rates rise.
Explanation
Crowding out is a concept in macroeconomics that refers to a situation where increased government spending leads to a reduction in private sector investment. This usually occurs when the government runs a budget deficit and borrows money to finance its spending by issuing government bonds.
As the government increases its demand for loanable funds, the total demand in the credit market rises. According to the loanable funds theory, when demand increases (with supply of funds relatively constant), the interest rates in the economy tend to rise. Higher interest rates make borrowing more expensive for private businesses and households.
This is problematic because businesses often finance investment projects—such as purchasing new equipment or expanding operations—by borrowing money. If the interest rates rise significantly, some of these investments become less profitable or unaffordable, causing businesses to cut back on investment. This decline in private investment is the essence of the crowding-out effect.
For example, suppose the government increases spending on infrastructure by borrowing $500 billion. If this borrowing causes interest rates to rise from 3% to 6%, many private firms that were planning to invest based on a 3% borrowing cost may now find the higher rate too expensive, leading them to delay or cancel those plans.
It’s important to note that crowding out is more likely to occur in full-employment economies, where most resources are already being used efficiently. In contrast, during a recession or when there is slack in the economy, increased government spending may not crowd out private investment significantly. Instead, it might stimulate demand and output, potentially encouraging private investment—a situation known as crowding in.
In summary, crowding out happens when a budget deficit increases interest rates, thereby reducing private investment—which makes option (a) the correct answer.
