Which one of the following best describes the 'Crowding Out Effect' in the context of fiscal policy?
Last updated Jun 9, 2026
Correct Answer:
Option B —
A situation where Government borrowing leads to higher interest rates, which reduces private investment
How the Crowding Out Effect Works:
Increased Government Borrowing: When a government spends more than it earns in revenue (fiscal deficit), it borrows heavily from the financial market.
Rising Interest Rates: The massive demand for funds by the government reduces the total pool of loanable funds available in the banking system. According to the laws of demand and supply, this scarcity drives up the cost of borrowing (interest rates).
Reduction in Private Investment: Because interest rates are now higher, it becomes expensive for private businesses to take loans for expansion, factories, or new projects. Thus, government borrowing "crowds out" (pushes aside) private investment.
Answer verified by Quintessence Classes faculty — Karan Nagar, Srinagar.
