What is crowding out in macroeconomics?

• A. When higher government spending financed by borrowing drives up interest rates and reduces private investment.
• B. When tax cuts stimulate private investment due to lower costs.
• C. When government spending crowds out exports.
• D. When the central bank buys government bonds to keep interest rates low.

Answer: (A)

When the government funds higher spending by borrowing, it competes with households and firms for the available saving. That extra demand for funds tends to push up interest rates, making borrowing more expensive for private entities. As a result, private investment falls because projects that would have been profitable at lower rates become unprofitable at higher rates. This is crowding out—the public sector's borrowing reduces the private sector’s investment by raising the cost of borrowing.

The size of this effect depends on policy and the economy. If monetary policy keeps interest rates low or if there is ample unused capacity, crowding out is smaller or may be negligible. If the economy is near full employment, the higher interest rates have a larger bite on private investment.

Other options describe different mechanisms. Tax cuts can boost private investment (not crowding out). Government spending affecting exports would involve a different dynamic, not the standard crowding-out channel. When the central bank buys government bonds to keep rates low, that policy action can offset or prevent crowding out rather than defining it.