Question

The crowding-out effect works through interest rates to: 
A. Increase the effectiveness of expansionary fiscal policy
B. Decrease the effectiveness of expansionary fiscal policy
C. Decrease the effectiveness of contractionary fiscal policy
D. Increase the effectiveness of contractionary fiscal policy

Answer 1

The crowding-out effect decreases the effectiveness of expansionary fiscal policy by causing higher interest rates, which leads to reduced business investment and household spending.

Step-by-step explanation:

The crowding-out effect is a phenomenon where government borrowing leads to higher interest rates, which in turn discourages businesses and households from borrowing and spending. This can decrease the effectiveness of expansionary fiscal policy, which relies on tax cuts or spending increases to boost aggregate demand. Instead of stimulating the economy, the fiscal policy's impact may be weakened due to these higher interest rates reducing business investment and household consumption.

When the economy is near its potential GDP and the government runs large budget deficits, this increased demand can lead to inflationary pressures. In response, the central bank might implement a contractionary monetary policy to combat inflation, further increasing interest rates. The synergistic effect of government borrowing and central bank policy can then significantly crowd out private investment.

Answer 2

Answer: Option (B) is correct.

Step-by-step explanation:

Suppose there is an increase in the government spending which means that it is a expansionary fiscal policy, this will also results in an increase in the government borrowings. Now, this increase in the government borrowings will increase demand for the loanable funds, as a result interest rate increases. This rise in the interest rate will lead to a reduction in investment spending.

Hence, the government spending crowding out the investment spending. Therefore, crowding out reduces the effect of expansionary fiscal policy.