Question

explain the difference between zero, incomplete, and complete crowding out. if crowding out is complete, does it call into question the effectiveness of a rise in government purchases in order to remove an economy from a recessionary gap? explain and diagrammatically represent your answer.

Answer 1

Zero crowding out- When any government policy does not change the private investment, it does not change the initial increase in total investment is called zero crowding out. In that case, government policy is fully effective.

Incomplete crowding out- When government policy increase the interest rate, In response of this private investment reduce and so it dampens the initial investment in some extent so government policy is not fully effective is called incomplete crowding out.

Complete crowding out- When government policy increase the interest rate, in the response of this private investment reduce and it totally neutralize the initial investment so the government policy is totally ineffective is called complete crowding out.

Any rise of government expenditure shift IS curve to the right. If there is no crowding out then GDP would be increased to a full extent. But as there is full crowding out that means to increase interest rate in the response to increasing government expenditure leads to a reduction of private investment which is equal to the initial increase in investment. It is possible when LM curve is vertical. Government's expansionary policy becomes totally ineffective in this case so increase government purchase cannot remove recessionary gap if there is full crowding out.

When IS curve shifts from IS1 to IS2 then Y would be increased Y to Y' but as interest rate increases from r1 to r2 private investment decreases from Y' to Y so there is no increment of GDP. Full ineffective of government policy.