AP Macroeconomics Question 256: Answer and Explanation

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Question: 256

11. An increase in the federal deficit may affect the demand for loan funds and therefore the real interest rate and investment spending. Which of the following gives the correct direction of these effects?

Demand for loanable funds      Real interest rate      Investment spending

  • A. Increases           Increases      Increases
  • B. Decreases           Decreases      Decreases
  • C. Decreases           Decreases      Increases
  • D. Increases           Increases      Decreases
  • E. Increases           Decreases      Increases

Correct Answer: D


(D) The government must borrow to finance the federal deficit and this raises the demand for loanable funds. The result will be an increase in the real interest rate and decrease in investment spending. This chain of events is known as crowding out.