Clearly explain what “crowding out” refers to and its overall effects. Graphically illustrate the level of...

Clearly explain what “crowding out” refers to and its overall effects. Graphically illustrate the level of crowding out in an IS-LM model. Explain in detail how the interest elasticity of investment affects the level of crowding out. Be sure to explain why this is the case. Note: This question requires lengthy dialogue and a corresponding graph. Be sure to answer all parts of the question.

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Expert Solution

Crowding out effect refers to the fall in private investment due to rise in government spending. When government spending rises, it is financed through borrowing. Excessive borrowing by government from market causes rise in the demand for money in market. Rise in demand for money causes rise in the interest rate. Rise in interest rate raises cost of borrowing. Thus, private investment falls or so the aggregate demand as well.

But the effectiveness of crowding out depends on the interest elasticity of investment. or sensitiveness of investment to interest rate. If elasticity of investment is larger, crowding effect would be predominant. If investment is less sensitive to interest rate, there will be less effects of rise in interest rate.

Following is diagram:

In above diagram, multiplier effect of government expenditure is equal to E and K. But it pushes up interest rate which reduces the private investment equal to the C and K. The Gap between C and K is called crowding out effect,

Rahul Sunny answered 1 year ago

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