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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

A government finances a large budget deficit by borrowing heavily from the domestic bond market, pushing up interest rates and reducing private investment by firms. This effect is best described as:

This is crowding out: government borrowing absorbs savings and pushes interest rates up, which makes borrowing dearer for firms and reduces private investment. It is different from the accelerator, which links investment to output changes, or from cost-push inflation, which concerns rising costs.

  1. AThe accelerator effect
  2. BCrowding outCorrect
  3. CThe paradox of thrift
  4. DCost-push inflation
  5. Hysteresis

Explanation

Crowding out occurs when government borrowing raises interest rates and displaces private sector investment. The accelerator links investment to changes in output, the paradox of thrift concerns saving, cost-push concerns supply costs, and hysteresis concerns persistent unemployment.

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