How can crowding-out affect long-run potential GDP growth?

How can crowding-out affect long-run potential GDP growth?

• A. Has no long-run effect
• B. Always increases growth
• C. Can reduce potential growth by limiting private investment
• D. Only affecting inflation

Answer: (C)

Crowding out happens when, as the government borrows more to finance deficits, interest rates rise and private investment becomes more expensive or less attractive. Long-run potential GDP grows mainly through the accumulation of capital, which comes from private investment (along with labor and technology). If private investment is reduced, the economy builds less capital, lowering the growth of potential output over time. That’s why the best description is that crowding out can reduce potential growth by limiting private investment. The other statements don’t fit: crowding out isn’t guaranteed to have no long-run effect, it doesn’t always increase growth, and its impact isn’t solely about inflation.

Crowding out happens when, as the government borrows more to finance deficits, interest rates rise and private investment becomes more expensive or less attractive. Long-run potential GDP grows mainly through the accumulation of capital, which comes from private investment (along with labor and technology). If private investment is reduced, the economy builds less capital, lowering the growth of potential output over time. That’s why the best description is that crowding out can reduce potential growth by limiting private investment. The other statements don’t fit: crowding out isn’t guaranteed to have no long-run effect, it doesn’t always increase growth, and its impact isn’t solely about inflation.