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

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: G r I Y 

Multiplier Effect

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

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)

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

Slope of LM and Crowding-out

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

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

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

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

Slope of IS and Crowding-out

Diagram r Y LM1 IS2 IS1 C Crowding-out effect Y3 A Y1 r1 Y2 B Y2 to Y3

Diagram r Y LM1 IS2 IS1 Crowding-out effect C A Y3 Y1 r1 Y2 B Y2 to Y3

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

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

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

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