IAS 2026 — Economics Economy

2026mcqmedium

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

Official previous-year question

Verified 2 Aug 2026.

Options

AA situation where private investment increases due to increased Government spending
BA situation where Government borrowing leads to higher interest rates, which reduces private investment
CA situation where an increase in taxes leads to increased private sector investment
DA situation where Government spending has no impact on aggregate demand

Did you get this right?

Solution

Correct Option

The correct option is B. A situation where Government borrowing leads to higher interest rates, which reduces private investment.

[as per provisional answerkey]

Explanation

The 'Crowding Out Effect' is an economic phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.

Mechanism: When a government adopts an expansionary fiscal policy and increases its spending, it often finances this through borrowing from the market. This increased demand for loanable funds by the government leads to a rise in interest rates.
Impact on Private Sector: Higher interest rates increase the cost of borrowing for the private sector. Consequently, private firms find it less profitable to invest in new projects, leading to a reduction in private capital expenditure.
Resource Allocation: In this scenario, the government "crowds out" private investment by absorbing the available financial resources and driving up the price of capital.

Key Takeaway:

The Crowding Out Effect occurs when high government borrowing increases interest rates, thereby discouraging and reducing private sector investment.

Your note

IAS Economy in other years

Economy 2025 Economy 2024 Economy 2023 Economy 2022 Economy 2021 Economy 2020 Economy 2019 Economy 2018 Economy 2017 Economy 2016 Economy 2015 Economy 2014

More IAS Economy questions

A bond whose proceeds are used only to finance or refinance a combination of both environmental and social projects is called :

2026easy

Which of the following statements about Crowdfunding is/are correct? 1. Crowdfunding is solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project. 2. Small and Medium Enterprises (SMEs) are able to raise funds at lower cost of capital without undergoing rigorous procedures. Select the answer using the code given below:

2026medium

Which one of the following correctly represents the three key sub-indices of the Financial Inclusion Index (FI-Index) of the Reserve Bank of India (RBI)?

2026easy

Which one of the following best describes the key objective of India's 'Open Network for Digital Commerce' (ONDC) initiative?

2026easy

With reference to different Committees in India, consider the following details: Sl. No. | Committee | Objective | Organization under which it was formed 1. | R.N. Malhotra Committee | Comprehensive reforms of Insurance sector in India | Insurance Regulatory and Development Authority of India 2. | L.C. Gupta Committee | Preparing a roadmap for the introduction of derivatives trading in India | Securities and Exchange Board of India 3. | Urjit R. Patel Committee | Preparing a roadmap for reforming bank lending to the Housing sector | Reserve Bank of India 4. | Y.H. Malegam Committee | Preparing a roadmap for reforms in Microfinance sector in India | Reserve Bank of India In which of the above rows are all the details correctly matched?

2026hard

View all Economy questions

Keep practicing Economy

Work through every IAS Economy PYQ, year by year.

Browse all Economics topics

Correct Option

The correct option is B. A situation where Government borrowing leads to higher interest rates, which reduces private investment.

[as per provisional answerkey]

Explanation

Mechanism: When a government adopts an expansionary fiscal policy and increases its spending, it often finances this through borrowing from the market. This increased demand for loanable funds by the government leads to a rise in interest rates.
Impact on Private Sector: Higher interest rates increase the cost of borrowing for the private sector. Consequently, private firms find it less profitable to invest in new projects, leading to a reduction in private capital expenditure.
Resource Allocation: In this scenario, the government "crowds out" private investment by absorbing the available financial resources and driving up the price of capital.

Key Takeaway:

The Crowding Out Effect occurs when high government borrowing increases interest rates, thereby discouraging and reducing private sector investment.