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UPSC Prelims 2026 GS Paper 1, question 94

Topic: Economy

Q94

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

  1. (a) A situation where private investment increases due to increased Government spending
  2. (b) A situation where Government borrowing leads to higher interest rates, which reduces private investmentCorrect answer
  3. (c) A situation where an increase in taxes leads to increased private sector investment
  4. (d) A situation where Government spending has no impact on aggregate demand

Solution.

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

  1. In macroeconomic fiscal policy, the 'Crowding Out Effect' occurs when heavy government borrowing to finance a fiscal deficit absorbs loanable funds in the financial market and drives up real interest rates.
  2. Higher interest rates increase the cost of capital for private firms, reducing private sector investment spending.