Which statement best explains the crowding-out effect?
A) An increase in government expenditures decreases the interest rate and so increases investment spending.
B) An increase in government expenditures increases the interest rate and so reduces investment spending.
C) A decrease in government expenditures increases the interest rate and so increases investment spending.
D) A decrease in government expenditures decreases the interest rate and so reduces investment spending.

Question

Quizplus · Accepted Answer

The crowding-out effect occurs when an increase in government spending increases the demand for loanable funds, which in turn increases the interest rate. As a result, investment spending by firms decreases, because borrowing funds is now more expensive. Therefore, option B is the correct statement because it suggests that an increase in government spending leads to higher interest rates, which crowds out private investment spending.

Which Statement Best Explains the Crowding-Out Effect