Which is true about crowding out? If it occurs, it would ____ policy.

Question

BlackTom AI · Accepted Answer

An increase in government spending or borrowing that raises interest rates and reduces private investment describes crowding out, so it weakens expansionary fiscal policy.

1) Relevant concepts:
- Expansionary fiscal policy: increased government spending or tax cuts intended to raise aggregate demand (AD).
- Loanable funds/IS-LM mechanism: higher government borrowing increases demand for loanable funds (or shifts IS right), which tends to raise the real interest rate.
- Crowding out: the rise in interest rates reduces private investment (and sometimes consumption), offsetting some of the fiscal stimulus.

2) Step-by-step reasoning:
- Government increases spending by ΔG to stimulate demand.
- To finance ΔG (in a closed economy without money-financed deficits), the government issues bonds and borrows from the pool of loanable funds.
- Higher borrowing shifts demand for loanable funds rightward; with a given supply, the equilibrium interest rate rises.
- The higher interest rate makes some planned private investment projects unprofitable, so investment falls by ΔI.
- The net effect on aggregate demand is ΔAD = ΔG − ΔI. Because ΔI > 0 (investment falls), the initial expansionary effect is reduced.

3) Simple numerical illustration:
- Initial investment = 100, government spending increases by 20 (ΔG = 20).
- Interest rates rise, causing investment to drop by 10 (ΔI = 10).
- Net AD change = 20 − 10 = 10. The fiscal stimulus still works but is weakened by the 10 lost in private investment.

4) Why the correct answer is correct:
- Crowding out specifically describes the weakening of expansionary fiscal policy through higher interest rates and reduced private spending. Thus “weaken expansionary fiscal” directly matches the mechanism.

5) Why the other options are incorrect:
- “Weaken contractionary monetary”: contractionary monetary policy (raising rates) already reduces AD; crowding out is not described as weakening that.
- “Weaken contractionary fiscal”: contractionary fiscal (spending cuts/tax hikes) is not what crowding out refers to; crowding out reduces the effectiveness of expansionary fiscal measures.
- “Weaken expansionary monetary”: expansionary monetary policy (lowering rates) counteracts crowding out rather than being weakened by it.

6) Conclusion:
Crowding out reduces the effectiveness of fiscal expansion by raising interest rates and cutting private investment, so the correct choice is “weaken expansionary fiscal,” matching the provided answer.

Which is true about crowding out? If it occurs, it would ____ policy.单项选择题

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