Which one of the following best describes the 'Crowding Out Effect' in the context of fiscal policy ?
- (a) A situation where private investment increases due to increased Government spending
- (b) A situation where Government borrowing leads to higher interest rates, which reduces private investment ✓ UPSC's answer
- (c) A situation where an increase in taxes leads to increased private sector investment
- (d) A situation where Government spending has no impact on aggregate demand
Why the answer is (b)
• When a government runs a deficit it borrows from the same pool of savings that firms draw on; the extra demand for loanable funds pushes interest rates up.
• Higher interest rates make private borrowing costlier, so some private investment that would otherwise have occurred is 'crowded out' — this is option (b).
• Crowding out is the classic argument for fiscal discipline embodied in India's FRBM framework.
Why the other options are wrong
- (a) A situation where private investment increases due to increased Government spending
- This describes crowding in, the opposite effect.
- (c) A situation where an increase in taxes leads to increased private sector investment
- Higher taxes do not raise private investment; this is not crowding out.
- (d) A situation where Government spending has no impact on aggregate demand
- This describes fiscal policy having no demand effect, not crowding out.
Asked in the GS Paper I of the UPSC Civil Services Preliminary Examination 2026, held on 24 May 2026. Question and answer key: Union Public Service Commission. Explanation: UPSC Answer Check.