Question

Holding all else constant while government is borrowing to cover budget deficits, the crowding out concept suggests interest rates ________ borrowing and spending by business and households.

Answer 1

The crowding out effect suggests that when the government borrows to finance budget deficits, it can lead to higher interest rates, which may in turn reduce borrowing and spending by businesses and households.

Step-by-step explanation:

The concept of crowding out refers to a situation where the government borrows to cover budget deficits, increasing the demand for financial capital, which in turn raises interest rates. Higher interest rates may discourage borrowing and spending by businesses and households because the cost of investment increases. This can lead to a decrease in private investment, as firms find it more expensive to finance their investments. During times such as recessions, when the central bank lowers interest rates to stimulate the economy, the crowding out effect can be dampened. However, as the economy recovers and interest rates begin to rise, the impact of government borrowing on interest rates—and thus its potential to crowd out private investment—can become more pronounced.

A survey of economic studies has suggested that an increase of 1% in the budget deficit can lead to a rise in interest rates of between 0.5 and 1.0%. Consequently, an increase in government borrowing tends to push up interest rates, which can lead to reduced investment by the private sector.

Answer 2

If the government has a budget deficit, crowding out might occur. Crowding out leads to all of the following; a higher real interest rate, a smaller capital stock in the future and a decreased quantity of investment. Borrowing from the rest of the world Government budget surpluses, private saving.