Question

Can the government and the central bank work together to prevent crowding out effect? Use an IS-LM diagram (with upward sloping LM function) to explain the steps. What should be done by the government and the central bank?

Answer 1

Solution ::

When government increases its spending (leaving tax unchanged), budget deficit increase, so government borrows more to finance the deficit. Higher government borrowing increases interest rate, dampening investment and lowering output. This is called crowding-out effect.

Higher government borrowing increases output, shifting IS curve rightward, increasing both interest rate and output. To keep interest rate unchanged (to prevent crowding out), interest rate has to be reduced. Central bank, therefore, engages in expansionary monetary policy to increase money supply, which shifts LM curve rightward, decreasing interest rate and bringing it back to the original level and 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.

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