Crowding out is most likely to occur with which of the following changes?

• A. A reduction in negative externalities through the imposition of a Pigovian tax
• B. A decrease in government regulation that encourages more private sector activity
• C. An increase in subsidies for goods with positive externalities
• D. An increase in government spending that leads to higher interest rates and reduced private investment

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concept of crowding out. Crowding out occurs when increased government spending leads to higher interest rates, which then reduces private investment spending.
2. Step 2: Analyze each option in terms of its effect on government spending and private investment. For example, a Pigovian tax reduces negative externalities but does not necessarily increase government spending or interest rates.
3. Step 3: Recognize that a decrease in government regulation encouraging private sector activity typically promotes private investment rather than crowding it out.
4. Step 4: Consider that increasing subsidies for goods with positive externalities involves government spending but usually aims to complement private investment, not reduce it.
5. Step 5: Identify that an increase in government spending can raise demand for loanable funds, pushing up interest rates and thereby reducing private investment, which is the classic scenario for crowding out.