Crowding Out Effect (Fiscal Policy Evaluation)

Question 1

Crowding Out Effect

Answer 1

When the government increases spending (fiscal expansion), it often needs to borrow money from the loanable funds market.

Question 2

1

Answer 2

This increases demand for loanable funds (shifts demand curve for loans from D1 to D2).

Question 3

2

Answer 3

The interest rate rises from i1 to i2 because of higher demand for funds.

Question 4

3

Answer 4

Higher interest rates make borrowing more expensive for the private sector.

Question 5

4

Answer 5

As a result, private investment decreases since firms face higher borrowing costs.

Question 6

5

Answer 6

This fall in private investment partially or fully “crowds out” the initial increase in government spending.

Question 7

6

Answer 7

The overall effect: reduced private investment may slow down aggregate demand and economic growth despite increased government spending.