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The Crowding Out Effect

• In the IS-LM model the crowding out effect occurs when an exogenous increase in spending in the goods sector results in higher interest rates (because of higher money demand in the financial sector) and a subsequent reduction in private spending (investment).

• ΔG↑ fl ΔY↑ fl ΔMd↑ fl Δr↑ fl ΔI↓• The size of the crowding out effect (COE) can be found as the

difference between the simple expenditure multiplier and the equilibrium expenditure multiplier.


• Equilibrium in the goods sector is represented by the IS curve.• The equation for the IS curve is:

• The simple expenditure multiplier is:

• Equilibrium in the financial sector is represented by the LM curve.


• General Equilibrium implies simultaneous equilibrium in both the goods and financial sectors and is represented by the intersection of the IS and LM curves.

• This yields an equilibrium income (Y*) and equilibrium interest rate (r*).

• The equilibrium expenditure multiplier is:


• The size of the crowding out effect (COE) can be found as the difference between the simple expenditure multiplier and the equilibrium expenditure multiplier.

• Simplifying:

• How do the parameters Cy, Ir, Ly, and Lr affect the COE?

The Crowding Out Effect• Ly is the income elasticity of money demand. As Ly gets bigger the COE

also gets bigger.

• We can see this graphically by noting that Ly is the horizontal distance the Md curve shifts when income changes.

r

MM0

Md(Y0)

r0

Ms

Md(Y1) – Big Ly

r1

Md(Y1) – Small Ly

r2

M1 M2


• As Ly gets bigger the COE also gets bigger.• For any given change in income, say from Y0 to Y1, the bigger is Ly the

more the money demand curve shifts. The more the Md shifts, the bigger will be the change in interest rate r.

r

MM0

Md(Y0)

r0

Ms

Md(Y1) – Big Ly

r1

Md(Y1) – Small Ly

r2

M1 M2


• Ir is the interest elasticity of investment demand. As Ir gets bigger the COE also gets bigger.

• We don’t need the graph to figure this one out. The chain of causality for the COE is ΔG↑ fl ΔY↑ fl ΔMd↑ fl Δr↑ fl ΔI↓

• But it should be noted that the slope of the IS curve is

• As Ir gets bigger the IS curve gets flatter and the COE gets bigger!• If Ir is small, then for any given change in r the resulting change in I will be small.

But if Ir is large, then for any given change in r the change in I will be large as well.


• Cy is the marginal propensity to consume. As Cy gets bigger the COE gets bigger.

• Again Cy affects the slope of the IS curve. Bigger Cy means a flatter IS curve and a bigger crowding out effect.

• The intuition is as follows. A bigger Cy means that for any given spending change the impact on income will be greater, i.e. the IS curve shifts by more when Cy is larger. This will lead to a bigger increase in Md (larger increase in Y leads to larger increase in Md). This will cause interest rate to rise more the larger is Cy.


Y

r

Y0

r0

LM(M0)

IS(A0, T0) – Small Cy or Small Ir

IS(A0, T0) – Big Cy or Big Ir


Y

r

Y0

r0

LM(M0)



IS(A1, T0) – Small Cy or Ir

r2

Y2


Y

r

Y0

r0

LM(M0)



IS(A1, T0) – Big Cy or Ir

r1

Y1


Y

r

Y0

r0

LM(M0)



IS(A1, T0) – Small Cy or Ir

IS(A1, T0) – Big Cy or Ir

r1

r2

Y2Y1


• Lr is the interest elasticity of money demand. As Lrgets bigger the COE gets smaller.

• The slope of the LM curve is

• As Lr gets bigger the LM curve gets flatter and the COE gets smaller.


• The slope of the money demand curve is 1/Lr. As Lrgets bigger the Md slope gets flatter (smaller).

Ms

r

MM0

Md(Y0) – Small Lr

r0

Md(Y0) – Big Lr


• An increase in income caused by the spending shock will shift the Md curve to the right.

Ms

r

MM0

Md(Y0) – Small Lr

r0

Md(Y0) – Big Lr

The Crowding Out Effect• The larger is Lr the more agents want to reduce their money holdings as the interest

rate rises. This has the effect of mitigating the rise in r caused by the increase in Md. The smaller increase in r results in a smaller COE.

• Below both the big Lr money demand and the small Lr money demand shift by the same dollar amount. But because big Lr agents care about the interest rate more, they conserve their money holdings more and the interest rate does not rise by as much.

Ms

r

MM0

Md(Y0) – Small Lr

r0

Md(Y0) – Big Lr

r1

r2

Md(Y1) – Big Lr

Md(Y1) – Small Lr


• How do extreme values of the parameters Cy, Ir, Ly, and Lr affect the COE?

• As Cy → 1 the COE → .

• As Lr → 0 the COE → .

• As Ir→ 0 the COE → 0.

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