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

Which of the following best describes how large government borrowing can reduce private investment by firms, a phenomenon called crowding out?

Crowding out occurs when government borrowing increases demand for loanable funds and pushes interest rates up. Firms then face higher financing costs and undertake fewer investment projects, offsetting part of the fiscal stimulus.

  1. AGovernment borrowing lowers the money supply directly, so firms cannot pay wages
  2. BHigher government demand for loanable funds can push up interest rates, raising firms' cost of finance and deterring investmentCorrect
  3. CGovernment spending always raises taxes on firms by the same amount
  4. DGovernment borrowing causes exports to rise, reducing domestic sales
  5. Government borrowing lowers inflation expectations, so firms stop investing

Explanation

When the government competes for funds, interest rates may rise, increasing firms' cost of capital and reducing the number of viable projects. The other options describe mechanisms that are not part of crowding out.

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