CFA Level I · CFA Level I Exam · Fiscal Policy
A central bank is raising its policy rate to curb inflation while the government runs a large deficit financed by issuing bonds. The most likely effect of this policy mix on interest rates and the private sector is:
The mix most likely leads to higher interest rates and crowding out of private investment. A rising policy rate raises borrowing costs, and large government bond issuance competes for funds, pushing yields up further, so private firms cut back investment.
- ALower rates and stronger private investment
- BLittle change in rates and private investment
- CHigher rates and crowding out of private investmentCorrect
Explanation
Tight monetary policy raises short-term rates, and heavy government bond issuance adds to demand for loanable funds, pushing yields up. Higher borrowing costs reduce private investment, which is the crowding-out effect. Lower rates would require easier policy or smaller deficits.
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