Crowding out occurs when investment declines because a budget deficit makes inte

Question

Crowding out occurs when

investment declines because a budget deficit makes interest rates fall.

investment increases because a budget surplus makes interest rates rise.

investment declines because a budget deficit makes interest rates rise.

investment increases because a budget surplus makes interest rates fall.

investment declines because a budget deficit makes interest rates fall.

investment increases because a budget surplus makes interest rates rise.

investment declines because a budget deficit makes interest rates rise.

investment increases because a budget surplus makes interest rates fall.

Explanation / Answer

(c) Investment declines because a budget deficit makes interest rate rise.

Budget deficit means that government is spending more (in the form of G and tranfer payments) than it it receiving in tax revenues. When in the IS-LM framework, government runs a budget deficit through its expansionary fiscal policy, it causes aggregate spending to rise, which shifts the IS curve upwards and causes interest rate to rise. This rise in interest rate dampens the interest sensitive investment, thereby lowering it. Crowding out is basically the dampening effect of expansionary policy of government on the equilibrium income. So, crowding out occurs whenever investment falls due to higher interest rates which are the result of higher government spending (or bugdet deficit).

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