Figure Crowding Out Interest rate SLF1 SLF2 12 DLF2 DLF1 01

Figure: Crowding Out Interest rate SLF1 SLF2 12 DLF2 DLF1 01 02 Q Quantity of loanable funds Reference: Ref 26-16 Figure: Crowding Out) We can demonstrate the impact of government borrowing in the loanable funds market by the movement from DLF1 to DLF2 DLF2 to DLF1 SLF1 to SLF2 SLF2 to SLF1

Solution

Crowding out situation arises when government borrow in the loanable fund market, for government expenditure. Then the demand curve of loanable fund shift rightward, as a result the interest rate increase, so it is expensive for private investors, so they borrow less for investment, as a result the demand for loanable fund decrease. Hence it is known as the crowding out because demand for loanable fund decrease.

In the above diagram, the impact of government borrowing in the loanable fund market has been shown by the movement from DLF1 to DLF2.

Hence option first is the correct answer.