Question

Crowding out occurs when debt-financed government spending increases

A) inflation.

B) exchange rates.

C) expectations.

D) mindfulness.

E) interest rates.

Answer 1

Option E is correct - Interest rates

Crowding out occurs when due to excessive borrowing by the government there is a decrease in the private investment. This happens when there is excessive government spending or there is a decrease in the tax revenues that leads to borrowings by the government. This debt is then financed in a way that decreases private investments. We know that investment and rate of interest have a negative relationship, as the investments decreases, rate of interest increases and vice versa.

Thus, here the decrease in private investments will lead to an increase in the rate of interest.