In which situation is crowding-out more likely to occur?

• A. During a recession with idle resources
• B. When private savings are abundant
• C. When the central bank targets a low inflation rate
• D. When the economy is at or near full capacity

Answer: (D)

Crowding out happens when increased government borrowing pushes up interest rates, making private investment more expensive or less attractive. This is most likely when the economy is at or near full capacity because resources are scarce and investment opportunities compete for a finite pool of funds; the government’s borrowing raises the cost of funds and private firms scale back on investment as a result. In a recession with idle resources, or when private savings are abundant, or when monetary policy keeps rates down, the pressure for crowding out is much weaker because funds and capacity aren’t as tightly constrained. So the situation where the economy is operating at or near full capacity creates the strongest likelihood of crowding out.