Learning Path
Question & Answer1
Understand Question2
Review Options3
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Explore TopicChoose the Best Answer
A
It leads to higher interest rates, which may discourage private investment.
B
It lowers interest rates, encouraging more private investment.
C
It has no effect on interest rates, thus maintaining private investment levels.
D
It causes private investors to increase their risk appetite regardless of interest rates.
Understanding the Answer
Let's break down why this is correct
Answer
When a government borrows more money, it adds to the demand for loanable funds in the market. This extra demand pushes up the price of borrowing, which is the interest rate. As rates rise, it becomes more expensive for private companies to borrow money for projects, so they may cut back or postpone new investments. For example, if the government takes out an additional $100 billion, the interest rate might climb from 3 % to 4 %, making a small firm’s loan more costly and causing it to delay building a new factory. Thus, higher government borrowing can crowd out private investment by raising interest rates.
Detailed Explanation
When the government borrows more, it asks for more loanable funds from the market. Other options are incorrect because The idea that borrowing lowers rates comes from thinking supply of money increases; Some believe borrowing has no effect because they confuse supply and demand.
Key Concepts
Crowding Out Effect
Risk and Return in Loanable Funds
Interest Rate Determination
Topic
Loanable Funds Market Analysis
Difficulty
hard level question
Cognitive Level
understand
Practice Similar Questions
Test your understanding with related questions
1
Question 1How might an increase in the central bank's discount rate affect private sector investment in an environment of rising government debt?
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Practice
2
Question 2How might an increase in foreign capital inflows impact domestic interest rates and the level of private investment in a country experiencing high government borrowing?
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Practice
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