UPSC Prelims 2026 Question:

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

 

Answer: 2 

Explanation:  

The crowding out effect refers to the decrease in private sector investment due to increased government  borrowing and spending, which can raise interest rates and reduce available capital.

• The theory of crowding out contrasts with crowding in, where government spending during economic  downturns can stimulate private sector activity. 
• According to the crowding in theory, government borrowing during periods of low economic activity  can increase demand, generate employment, and stimulate private spending and investment. This helps  revive economic growth. In contrast, “crowding out” occurs when excessive government borrowing raises  interest rates and reduces the availability of funds for the private sector. Higher borrowing costs and taxes  may reduce private investment, spending, and overall economic activity, making crowding out generally  harmful for growth. 

Therefore, option (2) is the correct answer