Economics Fiscal Policy Questions
The crowding out effect in fiscal policy refers to the phenomenon where increased government spending, financed through borrowing, leads to a decrease in private sector investment. This occurs because when the government borrows money from the financial markets to fund its spending, it increases the demand for loanable funds, which in turn drives up interest rates. Higher interest rates make it more expensive for businesses and individuals to borrow money for investment purposes, leading to a decrease in private investment. As a result, the increase in government spending crowds out private sector investment, reducing overall economic growth and potential.