CFA Level I · CFA Level I Exam · Fiscal Policy
A government increases its deficit by borrowing heavily in the bond market, and the central bank holds the money supply constant. Private firms then reduce capital spending because borrowing costs rise. This effect is best described as:
This is best described as crowding out. Government borrowing with a constant money supply raises interest rates, which discourages private investment and offsets part of the fiscal stimulus. Ricardian equivalence and the multiplier describe different mechanisms.
- Athe Ricardian equivalence effect
- Bcrowding outCorrect
- Cthe multiplier effect
Explanation
Heavy government borrowing with a fixed money supply pushes interest rates up, reducing private investment. That is crowding out. Ricardian equivalence concerns households saving more in anticipation of future taxes, and the multiplier concerns the amplified income response to spending.
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