Crowding out means decrease in Investment due to increase in interest rate brought by an expansionary fiscal policy; that is, increase in Government expenditure.

Whether crowding out takes place or not will depend on the slope of LM curve.

(a) If LM curve is positively sloped → Partial crowding will take place (Fig. 11.8)

(b) If LM curve is horizontal → No crowding out takes place (Fig. 11.9)

(c) If LM curve is vertical → Full crowding out takes place (Fig. 11.10)

Crowding Out When LM Curve is positively Sloped:

Changes in the fiscal policy affect the IS Curve IS equation shows that the IS curve is affected by both the Government expenditure and taxes.

When the Government expenditure increases, that is fiscal expansions takes place, crowding out takes place.

Reason:

Expansionary fiscal policy leads to an increase in the interest rate which decreases the investment.

When the Government expenditure increases, at a given interest rate, AD will increase and the IS curve will shift to the right because

IS equation: Y = C + I + G

↑ G → ↑ Y → ↑ AD

... At given interest rate, IS shift to right to IS1

However, the extent of shift in IS will depend on the extent of the multiplier (αG) Greater the value of multiplier (αG), greater will be the horizontal shift of the IS curve. At a given interest rate, equilibrium income will increase by αG∆G. (a) Initially the economy is in equilibrium at point E (IS0 = LM)

Income → Y0

i→i0 (Fig. 11.8)

(b) With fiscal expansion e.g. If the Government spending increases with real money supply (M/P) constant:

IS curve will shift parallel to the right from IS0 to IS1 by an amount = αG∆G

Income will increase to Y2 at the given i → i0

Income will increases by αG ∆G because an increase in the Government spending increases the AD which in turn increases the output.

At the given i → i0

The equilibrium in the product market is at E2 at income level → Y2.

But at E2, the money market is not in equilibrium. As money supply is constant, therefore at E2 there is excess demand for money.

This is because when income increases, the transaction demands for money (L1) increases.

Result:

(i) Demand for real balances will be greater than supply of real balances, that is, Md > Ms. To meet the increased demand for money, people will sell bonds.

(ii) As a result

Supply of bonds will increase.

When supply of bonds > demand for bonds:

Price of bonds will decrease interest rate will increase (because bond prices and interest rate are inversely related). But when interest increases both money market and the product market is affected.

In the money market when interest rate increases, L2 will decrease because L2 = f(i)

... Md will decrease.

In the product market:

When interest rate increases the Investment decreases. Due to decrease in investment, AD will decrease and thus income level will decrease.

Thus, both product and money market move from point E to E1.

General equilibrium is established at point E1 where IS1 = LM

Interest rate is i1 (i1 > i0) and,

Income level is Y1 (Y1 < Y2).

Thus, when i ↑ → ↓ I → ↓Y

This, is known as crowding out, that is, an increase in the Government spending crowds out Investment spending. However, the extent of crowding out will depend on the slope of IS and the LM curve.

(a) Flatter the LM curve:

Income increase will be more and the interest rate increase will be less.

(b) Flatter the IS curve:

Income increase will be less and interest rate increase will be more. Thus, the extent of crowding out will depend on the extent of increase in the interest rate. The greater the interest rate increases when the Government spending increases, the greater will be the crowding out.

Crowding Out when LM is Horizontal— (Liquidity Trap Region) Keynes Approach:

I. No crowding out takes place because the LM curve is horizontal.

Reason of horizontal LM curve:

In the liquidity trap region, any change in the monetary policy cannot affect the interest rate. The interest rate has fallen to such a low level, that is, the price of bonds are so high that people prefer to hold money in cash, that is, in liquid form. They believe that buying other assets e.g. bonds will lead to a capital loss. Therefore, LM curve becomes horizontal parallel to the x-axis. (Fig. 11.9)

In this region the monetary policy is totally ineffective but the fiscal policy is fully effective and therefore, when the Government spending increases, it has full multiplier effect on the equilibrium level of income but no effect on the interest rate. Since interest rate does not change, investment will not decrease and, thus, it will have no adverse effect on the income level. Due to an expansionary fiscal policy, IS curve shifts to the right from IS0 to IS, Income level increases from Y0 to Y1

∆Y = Y0Y1

As interest rate is unaffected, increase in income (∆Y) = αGG.

Crowding Out When LM is Vertical—Classical Approach: Though an increase in the Government spending will shift the IS curve to the right yet it will have no effect on the level of income; only the interest rate will increase. This is because when LM curve is vertical, the demand for money does not respond to changes in the interest rate. Initially the economy is in equilibrium at point E (Fig. 11.10).

Income level → Y0

i → i0

Investment → I0

Due to fiscal expansion IS curve will shift to the right to IS1.

The economy is in equilibrium at E1 but at a higher interest rate i1 and same income level Y0.

Due to an increase in the interest rate, cost of borrowing increases, therefore, Investment decrease from I0 to I1 which is equal to government spending.

Thus, an increase in the interest rate will crowd out private spending by an amount equal to the increase in the Government spending, that is, decrease in income = increase in the Government spending and there is full crowding out.