CROWDING-OUT EFFECT

1. CROWDING-OUT EFFECT Definition Graphical Illustration Partial Crowding out Full Crowding out Factors that Affect the Crowding-out Summary

2. Definition • The increase in government expenditure will lead to the fall of private expenditure, thus resulting in a smaller multiplier effect on the equilibrium level of income. • Underlying assumption: Y  I G r

3. Multiplier Effect

4. r IS2 IS1 A B 0 Y Shifting of IS Curve Distance AB = Y Y1 Y2

5. Crowding-out Effect • Increase in G •  IS curve shifts to the right by the horizontal distance (Gmultiplier) •  if LM curve is upward sloping, then the rise in interest rate will lead to the fall of I •  the fall of I will lead to the decrease in Y •  eventual  in Y is less than (Gmultiplier)

6. r LM No Crowding-out C r1 G  Y1 to Y2 A B Crowding-out I  Y2 to Y3 IS2 IS1 Y 0 Y1 Y2 Y3 Diagram

7. Slope of LM and Crowding-out

8. r LM1 A B H K Y 0 Y1 Y2 Steeper LM & Crowding-out (1) E IS2 IS1 Y3

9. r LM2 LM1 A B K H Y 0 Y1 Y2 Steeper LM & Crowding-out (2) F IS2 IS1 Y3

10. r LM1 LM2 G A LM3 B K Y 0 Y1 Y2 Steeper LM & Crowding-out (3) IS2 IS1 =Y3

11. Slope of LM and Crowding-out LESS ELASTIC MORE ELASTIC MORE ELASTIC LESS ELASTIC

12. Slope of IS and Crowding-out

13. r LM1 IS1 IS2 B r1 0 Y Y1 Y2 Y3 Diagram C Crowding-out effect A Y2to Y3

14. r LM1 IS2 IS1 B r1 0 Y Y1 Y2 Y3 Diagram Crowding-out effect C A Y2to Y3

15. r r LM1 LM1 IS2 IS1 IS2 C IS1 C A A B B r1 r1 0 Y 0 Y Y2 Y2 Y1 Y1 Y3 Y3 Comparison

16. Slope of IS and Crowding-out More Elastic Less Elastic Smaller Larger

17. r IS1 IS1” LM1 IS2 IS2” A r1 Y 0 Y1 Diagram C B larger MPS smaller MPS

18. Summary • The crowding-out effect depends on • the slopes of IS & LM curves • The steeper the LM curve, the larger the crowding-out effect • The flatter the LM curve, the smaller the crowding-out effect • The existence of crowding-out effect will affect the effectiveness of fiscal policy