Crowding Out Effect in fiscal policy — UPSC Prelims PYQ 2026

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

1. Increased private investment due to higher Government spending
2. Government borrowing leads to higher interest rates reducing private investment
3. Taxation leads to increased private investment
4. Government borrowing has no impact on aggregate demand

Explanation

Option (b) is correct

• The Crowding Out Effect happens when the government borrows heavily to finance its spending. Since both the government and private businesses borrow money from the same financial market, greater government borrowing increases competition for available funds. As demand for loans rises, interest rates usually increase. Higher interest rates make borrowing more expensive for companies, so businesses may postpone or reduce investments such as expansion, new projects, or purchasing machinery. So, More government borrowing → higher interest rates → lower private investment

Answer: (b) A situation where Government borrowing leads to higher interest rates, which reduces private investment; Difficulty Level: Easy