An increase in government spending will completely crowd out investment if
A) money supply is increased at the same time.
B) money demand is not sensitive to the interest rate.
C) the economy is operating at capacity.
D) the economy is operating well below capacity.

Question

Quizplus · Accepted Answer

If the economy is operating at full capacity, an increase in government spending will lead to an increase in interest rates due to a rise in demand for loans. This increase in interest rates will lead to a decrease in investment, as borrowing becomes more expensive. Therefore, an increase in government spending will completely crowd out investment in this scenario. However, if the economy is operating well below capacity, an increase in government spending can stimulate investment and overall economic activity without crowding it out completely. Choices A and B are not relevant to the question.

An Increase in Government Spending Will Completely Crowd Out Investment