Crowding out occurs when
A. firms borrow more to expand operations which results in an increase in interest rates.
B. governments must borrow funds which causes interest rates to rise and thus private investment is crowded out.
C. interest rates increase as firms spend a larger amount of resources on research and development.
D. interest rates increase because the Federal Reserve reduces that economy’s money supply.
The correct answer and explanation is:
The correct answer is B: governments must borrow funds which causes interest rates to rise and thus private investment is crowded out.
Explanation:
Crowding out refers to the economic phenomenon where increased government borrowing leads to higher interest rates, which in turn reduces private investment. When the government borrows large amounts of money, typically through issuing bonds to finance budget deficits or fund public projects, it increases the demand for available funds in the financial markets. This higher demand for funds pushes up interest rates.
Interest rates are the price of borrowing money, and when they rise, it becomes more expensive for private businesses to borrow funds for their own investments. This makes it more difficult for firms to finance projects such as expanding operations, purchasing new equipment, or investing in research and development. As a result, the private sector reduces its level of investment, which is the essence of crowding out.
Crowding out is often discussed in the context of expansionary fiscal policy. When the government increases its spending or cuts taxes to stimulate economic growth, it often finances this by borrowing money. If the government’s borrowing needs are large enough, they can absorb a significant portion of the capital available in the economy, leaving less for private investors. In extreme cases, this can lead to a slowdown in private investment, which can reduce the overall effectiveness of the government’s policy measures.
This concept is particularly relevant when the economy is operating near full capacity, and the supply of savings is limited. In such cases, the government’s borrowing may indeed “crowd out” private investment, making it harder to achieve the intended stimulatory effect. However, in economies with excess capacity or low interest rates, crowding out may be less pronounced or even negligible.