AP Macroeconomics Question 256: Answer and Explanation
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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.