UPSC Previous Year Question | Prelims GS | 2026

Which one of the following best describes the 'Crowding Out Effect' in the context of fiscal policy?

  1. A situation where private investment increases due to increased Government spending
  2. A situation where Government borrowing leads to higher interest rates, which reduces private investment
  3. A situation where an increase in taxes leads to increased private sector investment
  4. A situation where Government spending has no impact on aggregate demand

Answer

Correct Answer

A situation where Government borrowing leads to higher interest rates, which reduces private investment

Explanation

The crowding-out effect occurs when increased government borrowing raises demand for loanable funds and can put upward pressure on interest rates. Higher borrowing costs may then discourage or reduce private-sector investment. Hence option B correctly describes the effect.

Topics: crowding out, economy, fiscal policy, investment