What could central bank do to counteract crowding-out effects?

• A. Raise taxes on households
• B. Increase reserve requirements
• C. Sell government bonds to drain reserves
• D. Lower policy rate and expand money supply

Answer: (D)

When the government borrows heavily, it competes with private borrowers for loanable funds. This can push up interest rates and crowd out private investment. The way to counter this is for the central bank to loosen monetary policy, increasing liquidity and lowering borrowing costs. Lowering the policy rate and expanding the money supply achieves this, making funds cheaper and more available for private investment even while government borrowing is high.

Raising taxes on households reduces disposable income and overall demand rather than directly addressing the funding cost for private investment. Increasing reserve requirements tightens liquidity, which would raise, not lower, interest rates. Selling government bonds to drain reserves reduces money supply and elevates rates, worsening crowding out. So the expansionary move of lowering the policy rate and increasing the money supply best offset crowding-out effects.