CROWDING-OUT EFFECT

•Definition

•Graphical Illustration

•Partial Crowding out

•Full Crowding out

•Factors that Affect the Crowding-out

•Summary

Definition

• The increase in government expenditure will lead to the fall of private expenditure, thus resulting in a smaller multiplier effect on the equilibrium level of income.

• Underlying assumption:

G r I Y

Multiplier Effect

Cause Process YG =$1 AE1=$1 Y1=$1

(b = 0.8) C1=bY1=AE2Y2=$0.8

C2=bY2=AE3Y3=$0.64

C3=bY3=AE4Y4=$0.512

)

b1

1(GΔYΔ

Shifting of IS Curve

0

r

Y

IS1IS2

A B

Y1 Y2

Distance AB = Y

Crowding-out Effect

• Increase in G IS curve shifts to the right by the horizontal

distance (Gmultiplier) if LM curve is upward sloping, then the rise

in interest rate will lead to the fall of I the fall of I will lead to the decrease in Y eventual in Y is less than (Gmultiplier)

Diagram

0

r

YIS1

IS2

Y1 Y2

A B

LM

Cr1

Y3

G Y1 to Y2

No Crowding-out

I Y2 to Y3

Crowding-out

Slope of LM and Crowding-out

Slope of LM Largercrowding-out effect

Smallercrowding-out effect

Interest-elasticity ofdemand for MIncome-elasticity ofdemand for M

Steeper LM & Crowding-out (1)

0

r

YIS1

IS2

LM1

A B

Y1 Y2

E

Y3

K H

Steeper LM & Crowding-out (2)

0

r

YIS1

IS2

LM2

A B

Y1 Y2

F

Y3

K H

LM1

Steeper LM & Crowding-out (3)

0

r

YIS1

IS2

LM1

A B

Y1 Y2

G

K

LM2

LM3

=Y3

Slope of LM and Crowding-out

Slope of LM Largercrowding-out effect

Smallercrowding-out effect

Interest-elasticity ofdemand for MIncome-elasticity ofdemand for M

LESS ELASTIC

MORE ELASTIC

MORE ELASTIC

LESS ELASTIC

Slope of IS and Crowding-out

Slope of IS

Largercrowding-out effect

Smallercrowding-out effect

Interest-elasticity ofdemand for IMPS

Diagram

0

r

Y

IS1

LM1

Y1

r1

IS2

A

Y2

B

C

Y3

Crowding-out effect

Y2 to Y3

Diagram

0

r

Y

IS1

LM1

Y1

r1A

Y2

B

C

IS2

Y3

Crowding-out effect

Y2 to Y3

Comparison

0

r

Y

IS1

LM1

Y1

r1

IS2

A

Y2

B

C

Y30

r

Y

IS1

LM1

Y1

r1A

Y2

B

C

IS2

Y3

Slope of IS and Crowding-out

Slope of IS

Larger crowding-out effect

Smaller crowding-out effect

Interest-elasticity of demand for I

MPS

More Elastic Less Elastic

Smaller Larger

Diagram

0

r

Y

IS1 LM1

Ar1

Y1

IS1”

IS2

B

IS2”

C

larger MPSsmaller MPS

Summary

• The crowding-out effect depends on– the slopes of IS & LM curves

• The steeper the LM curve, the larger the crowding-out effect

• The flatter the LM curve, the smaller the crowding-out effect

• The existence of crowding-out effect will affect the effectiveness of fiscal policy