CFA Practice Question

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CFA Practice Question

The crowding-out model implies that a ______
A. budget deficit is likely to stimulate aggregate demand and trigger a multiplier effect that will lead to inflation.
B. budget deficit will increase the real interest rate and thereby retard private spending.
C. budget surplus will retard aggregate demand and throw the economy into a downward spiral.
Explanation: The crowding-out theory implies that government borrowing drives up real interest rates and thus "crowds out" private investment. Private investment falls under higher interest rates because the cost of investment (the real interest rate) rises if the government borrows heavily. Under the usual law of supply and demand, the government causes the interest rate to rise under deficit spending because there is a limited supply of loanable funds. The government competes with the private sector for these resources and thus drives up the price (i.e., the interest rate).

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