Question

Crowding out refers to a situation in which _______.

a		an increase in the Fed Funds rate leads to lower financial frictions, thus stimulating aggregate demand and with it the economy.
b		an increase in government spending leads to additional consumption, thereby amplifying the total aggregate demand effect.
c		an increase in government spending leads to higher inflation and therefore higher interest rates, which in turn reduces consumption and investment expenditures.
d		increased competition across firms leads to more crowded market conditions, which lowers inflation.

Answer 1

Answer - The correct option is C ie., an increase in government spending leads to higher inflation and therefore higher interest rates, which in turn reduces consumption and investment expenditures.

When there is full employment in the economy and the government increases their spending capacity due to expansionary fiscal policy. Thus, due to this it will take loan from banks and this will lead to less availability of funds in the economy and thus the interest rates would go up as to resist people from borrowing money. This situation will lead to inflation and thus people will spend less as they cannot borrow money. Further, it will lead to less investment by the private sector. Thus, government spending led to crowding out of private sector spending.