Question

Part 5

Assume an economy is in recession and the government is considering using fiscal stimulus measures to boost spending, production and employment.

a) Using the IS-LM curve diagram, illustrate the crowding out problem that could occur as a result of increased government spending. Make sure to clearly indicate the new equilibrium position including showing how both the interest rate and level of Y change.

b)  Explain how 'crowding out' can harm productivity growth.

c)  Explain how the 'crowding out' problem associated with increased government spending can be avoided. In your answer identify any additional policy that is needed.

At the end of your answer to Part 5 state the combined word count for sub-parts b and c. Your answer to Part 5 sub-part b and c should not exceed 150 words.

(3 marks for sub-part a, 1.5 marks each for sub-parts b and c plus 0.25 marks for satisfying the word count requirements - Part 5 worth 6.25 marks)

Answer 1

The IS-LM schedules are used to see how the changes in government spending and money supply affect the equilibrium values of aggregate income and interest rate.

a) Each point on the IS curve indicates the equilibrium point in the goods market for a given interest rate r.

At a constant rate of interest r, with an increase in Govt spending (G) the IS curve shifts to the right

As the LM curve is constant, and IS curve shifts to right, a new equilibrium level of interest rate and income are obtained where IS1 and LM0 intersect. interest rate increases from r0 to r1 and income increases from Y0 to Y1.

Due to this expansionary fiscal policy (increase in G) the interest rate increases. This increase in r leads to a reduction in Investment (I) as I is inversely proportional to r. This is known as the crowding-out effect. People tend to save more at a higher interest rate and as loans become more expensive, consumption also reduces.

b) In the given case the country/ economy is n recession due to which the goverment increased spending. But due to the crowding-out effect, the stimulus provided will not increase Y from Y0 to Y1. Instead, as I and even C falls, the effect in change in Y will reduce (Y = C + I + G) and income will not increase as much as it should have in absence of crowding-out. This turns out to be counterproductive in cases of recession where the main aim if the govt is to increase income (Y). A high cowding-out may even lead to lesser levels of income in the economy.

c) Crowding-out can be avoided by monetary policy measures will will consequently shift the interest rate to avoid this problem. The monetray policy should also be expansionary wherein the money supply is increased and it leads to lower levels of interest rate (r). Money supply and interest rate are inversely proportional. Thus an increase in money supply will reduce r, and I will increase at lower levels of r. Thus this measure will help correct the crowding-out effect and increase Income in the recession phases of the economy. If both IS and LM curves shift to the right due to expansionary fiscal and monetary policies, the shift can be controlled in such a way that the equilibrium interest rate doesn't change.