Q6. 聽In January, the interest rate ... [FREE SOLUTION]

Chapter 13: Q6. (page 283)

In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion, driving the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true?
There is no crowding-out effect because the government鈥檚 increase in borrowing exceeds firms鈥� decrease in borrowing.
There is a crowding-out effect of $20 billion.
There is no crowding-out effect because both the government and firms are still borrowing a lot.
There is a crowding-out effect of $25 billion.

Short Answer

Expert verified

Option (b): There is a crowding-out effect of $20 billion.

Step by step solution

Meaning of crowding-out effect

The crowding-out effect is the elimination of some amount of total private investment from the economy.When government expenditure exceeds its revenue collection, the extra spending is funded by borrowing. This borrowing increases the demand for loans, resulting in an increase in the cost of borrowing or financing the investment.

Thus, a higher interest rate reduces private investment. This decline in private investment due to the expansionary fiscal policy is called the crowding-out effect

Explanation for the answer

As the fed government doubled its borrowing from $25 billion to $50 billion, the hike in interest rate from 5% to 7% reduced the private sector borrowing. The investment from private firms declined from $50 billion to $30 billion. The difference of $20 billion in investment arises because of the expansionary fiscal policy.

The expansionary fiscal policy created a negative impact on private investment. Therefore, there occurred a crowding-out effect of $20 billion (= 50-30).