UPSC Prelims 2026 · Question 59 of 96

UPSC Prelims 2026 question on Crowding Out Effect

Which one of the following best describes the 'Crowding Out Effect' in the context of fiscal policy?

  1. A situation where private investment increases due to increased Government spending
  2. A situation where Government borrowing leads to higher interest rates, which reduces private investment
  3. A situation where an increase in taxes leads to increased private sector investment
  4. A situation where Government spending has no impact on aggregate demand
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Answer: B. A situation where Government borrowing leads to higher interest rates, which reduces private investment

The 'Crowding Out Effect' describes a phenomenon where increased government involvement in a sector of the market substantially affects the remainder of the market, specifically by reducing private sector spending or investment. Hence option (b) is the correct answer.

When the government increases its borrowing to finance its spending (expansionary fiscal policy), it increases the demand for 'loanable funds'. This surge in demand pushes up equilibrium interest rates. As borrowing becomes more expensive, private firms find it less profitable to take out loans for expansion or new projects, leading to a decrease in overall private investment.

Options (a) and (c) describe the opposite outcome, namely an increase in private investment, and option (d) denies any impact of government spending on aggregate demand. Neither corresponds to the crowding out effect.

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