Question

. Explain why, according to the classical model, an increase in government purchases will “crowd out” investment. Suppose that increased consumer confidence leads to an increase in autonomous consumption. Would that also crowd out investment, according to the classical model? Why or why not?

Answer 1

Consider the given problem here according to the “Classical theory” the goods market equilibrium condition is given below.

=> Y = C + I(r) + G, => I(r) = Y – C – G = (Y – T – C) + (T – G).

Consider the above condition we can see that the “left hand side” shows the “Investment” which depends on the “r=real rate of interest” and “RHS” is the “National saving”, where “Y=output” is fixed because the inputs are fixed.

So, if “G”, increases, => national saving decreases, since “Y” and “C” are remain same as before, =>decrease in “National Saving. So as the “National saving decreases, => “r” will increase to maintain the equality between “National Saving” and “Investment”, => “I” will also fall and the above equality will be maintained. So, this reduction of “Investment” is called the “crowd out” of investment.

Now, assume that increase in the “consumer confidence” leads to an increase in autonomous consumption, => crowd out of investment with the same reason as “G”. As the “consumer confidence” increases, => decrease in “National Saving. So as the “National saving decreases, => “r” will increase to maintain the equality between “National Saving” and “Investment”, => “I” will also fall and the above equality will be maintained. So, this reduction of “Investment” is called the “crowd out” of investment.

So, we will get the similar result here.