Question

Explain crowding-out effect. Show these effects separately in AD-AS model and loanable funds / money market.

Answer 1

* Under Classical assumption AS curve is vertical at full employment.It means that the firm will supply full employment level of output whatever be the price level.In that case position of AD determines price level.If there is fiscal expansion in the form of increase in Government Expenditure then AD shift rightwards.It causes excess demand for goods at same price level (E1 to E2).

* As a result firms try to produce more of output by employing more of workers. However with full employment in labour market it results in into increase in wages.As firms compete among themselves to employ more labour due to this cost of production increases which causes increase in price level.With increase in price level economy moves along AD and output returns to full employment level. Therefore, Entire fiscal expansion is crowded out.

*In terms of IS-LM framework, as shown in dig. fiscal expansion shifts IS curve rightwards. As a result output exceeds full employment level. Consequently price level rises due to higher labour cost. Increase in price level reduces real money supply and LM curve shift leftwards so that output returns back to full employment level and entire fiscal expansion has been crowded out due to increase in interest rate which causes reduction in private investment