Which one of the following best describes the 'Crowding Out Effect' in the context of fiscal policy?
A situation where private investment increases due to increased Government spending
A situation where Government borrowing leads to higher interest rates, which reduces private investment
A situation where an increase in taxes leads to increased private sector investment
A situation where Government spending has no impact on aggregate demand
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Correct Answer: B — A situation where Government borrowing leads to higher interest rates, which reduces private investment
Explanation:
The crowding out effect refers to public borrowing absorbing available funds in financial markets. That pressure can push interest rates upward. Higher borrowing costs then discourage private investment, which is exactly what option (b) says.