Crowding Out and Fiscal Policy

HS202
What is Crowding out
 The term crowding out refers to the
reduction in private expenditure (or
invest) caused by an increase in
government expenditure through deficit
budget via a tax cut or increased money
supply or bond issue.

 There are three different ways that a

national government can fund its
spending, and the way it chooses affects
the macroeconomic effects of that
spending.
Cont.
 Pretty much everyone agrees that if a
government funds additional spending
with taxes, the macroeconomic effects are
small.
 The tax increase cancels out any multiplier
effect of the spending, so its overall effect
is negligible.
 Also, everyone pretty much agrees that if a
government funds additional spending by
printing money, the effect on total
spending will be large.
 No one's spending is cancelled out in this
case, and both monetary and fiscal policy
are working together.
What is IS Curve?
 The IS curve depicts the set of all levels of interest
rates and output (GDP) at which total investment
(I) equals total saving (S).
 At lower interest rates, investment is higher, which translates
into more total output (GDP), so the IS curve slopes
downward and to the right.
IS curve
 (I) for investment (S) for savings When the central bank allows the banking
system to create more money, banks increase their lending.
 This additional supply of funds reduces interest rates.
 Lower interest rates increase investment, which has a multiplier effect on
total spending. A contraction of money will have opposite results.
What is LM Curve ?
 The LM curve shows the combinations of interest
rates and levels of real income for which the money
market is in equilibrium.
 It shows where money demand equals money supply.
LM Curve
 (L for liquidity preference (M) for money supply). If, for example, the government
reduces taxes, thereby raising its deficit, it must borrow more.
 This added borrowing increases the demand for loanable funds and the price of these
funds, which is the interest rate, should rise. The higher interest rate makes holding idle
funds more expensive, and should result in an increased velocity of money.
IS –LM Equilibrium
IS-LM stands for
“investment-saving” (IS)
and “liquidity preference-
money supply” (LM). IS-LM
can be used to describe
how changes in market
preferences alter the
equilibrium levels of
gross domestic product
(GDP) and market
interest rates.
Effective Fiscal policy
 For fiscal policy to be effective as a tool of
macroeconomic policy, it must not crowded
out other spending.