Question

5. Can the government and the central bank work together to prevent crowding out effect? Use an IS-LM diagram to explain the steps. What should be done by the government and the central bank? Explain your answer.

Answer 1

Yes, crowding out effect can be prevented by simultaneous mix of expansionary fiscal policy and expansionary monetary policy.

Higher government purchase increases budget deficit ceteris paribus, so government borrowing increases for deficit financing purposes. Increase in government borrowing raises interest rate, reducing investment and lowering output. This is the crowding-out effect. This can be prevented as discussed below.

Increase in government borrowing increases output, so IS curve shifts to right, raising both interest rate and output. To prevent crowding out, interest rate has to be kept at original level. Central bank then uses expansionary monetary policy to raise money supply, shifting LM curve rightward, lowering interest rate and restoring original interest rate, further increasing output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. As government spending rises, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1. To keep interest rate unchanged, when money supply is increased, LM0 shifts right to LM1, intersecting IS1 at point C with same interest rate r0 but further higher output Y2.