CFA Practice Question

CFA Practice Question

The crowding-out effect implies that an expansionary fiscal policy will have following result(s):

I. Higher real interest rate
II. Higher nominal interest rate
III. Higher dollar value in foreign exchange market
IV. Increased net exports
A. II and IV
B. II and III
C. I and III
Explanation: The real interest rate will be higher, since government borrowing will increase the demand for loanable funds. The nominal interest rate will be determined by both the real rate AND the inflation rate, and it's uncertain whether it will be higher. The higher real interest rate will attract financial capital from abroad and lead to appreciation of the dollar, which in turn will reduce net exports.

User Contributed Comments 6

User Comment
kevin This could happen, though, if the inflation rate is decrease. The point is to remember that nominal rate is determined by BOTH real rate and inflation rate.
jwp2 Real rates increase, government deficit spending increases, nominal rates decrease. Do you have an example of when this has ever happened?
Will1868 Isn't this example similar to our current situation? The government has been spending and borrowing (and foriegn countries have been our biggest financers) but the dollar value is plummeting and our exports have increased ???
keithinny crowding out effect is when excess government borrowing pushes up and rates. This means that fewer private projects are viable at the higher rate. Higher rates should in theory lead to higher dollar value. Answer is confusing though because it staes that only real rates will be higher. Hard to see real rates being higher without nominal rates moving higher too.
justin real interest rate is determined by supply and demand, while the norminal rate is the real one + inflation premium. we are talking about the real rate here. II is not ecessarily true as the inflation rate could be lower due to other reasons. The point here is to remember that government borrowings crowd out private borrowings by increasing the real interest rate.
harrybay We have to think of it as an economy where nominal rate (e.g. rate set by the central bank) stays constant.

Here's the intuition: Government borrows and spend---> Crowding out effect---> Foreigners lend to government---> Increases demand for local currency---> Appreciation of local currency---> Lower inflation---> Higher real rates.

Alternatively, Government borrows and spend---> Increase in aggregate demand---> Increase in Income---> Increase in money demand---> Increase in real rates.

So nominal rates don't need to increase for real rates to increase.
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