Which one of the following best describes the ‘Crowding Out Effect’ in the context of fiscal policy?
Answer & explanation
Answer: (b) A situation where Government borrowing leads to higher interest rates, which reduces private investment
Crowding out happens when heavy government borrowing absorbs the available savings and raises the cost of funds, leaving less credit and lower investment for the private sector. Option (b) states exactly this.
- ✓ (b) Government borrowing competes with private borrowers for savings and credit; the RBI’s Urjit Patel Committee report notes government market borrowing crowding out funds to the private sector.
- ✗ (a) This is the opposite, called crowding in, where government spending raises private investment.
- ✗ (c) Higher taxes reduce, not raise, private disposable income and do not describe crowding out.
- ✗ (d) Crowding out is about the effect on private investment; government spending does affect aggregate demand.
Remember · Crowding out: government borrowing pushes up interest rates or absorbs credit, so private investment falls. Opposite: crowding in.
Sources
- RBI: Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Jan 2014), credit to government ↗ “whenever the net market borrowing of the government has increased, the ratio of incremental investment by banks in government securities has gone up, leading to lower share of non-food credit in bank finance, i.e., pointing to crowding out of the private sector … As government market borrowing crowds out funds to the private sector, in turn placing pressure on liquidity, the central bank is often forced to accommodate the resultant liquidity shortages”
Question and answer: UPSC's provisional GS Paper I (2026, Series A) — paper ↗ · answer key ↗. Explanation: Minimalist IAS, checked 30 Sept 2026 (how we verify). Permalink ·