Crowding out
A)does not occur in the liquidity trap
B)is caused by a rise in interest rates resulting from expansionary fiscal policies
C)cannot happen if the LM-curve is horizontal
D)cannot happen if the IS-curve is vertical
E)all of the above

Question

Quizplus · Accepted Answer

Crowding out is a situation where increased government spending leads to a reduction in private sector spending. This phenomenon does not occur in a liquidity trap (A), as interest rates are already so low that they cannot decrease further to stimulate investment. It is indeed caused by a rise in interest rates resulting from expansionary fiscal policies (B), as government borrowing can lead to higher interest rates, which in turn can reduce investment spending by the private sector. If the LM-curve is horizontal (C), it indicates that the money supply is perfectly elastic, and thus any increase in demand for money due to government spending can be met without increasing interest rates, preventing crowding out. Similarly, if the IS-curve is vertical (D), it suggests that investment is perfectly inelastic with respect to interest rates, meaning changes in interest rates do not affect investment, and thus crowding out does not occur.

Crowding Out