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Using the IS/LM system as the appropriate analytical framework illustrate how an increase in government spending might crowd out private spending. Carefully identify the factors which determine the degree of crowding out.

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Introduction

Using the IS/LM system as the appropriate analytical framework illustrate how an increase in government spending might crowd out private spending. Carefully identify the factors which determine the degree of crowding out. Introduction The IS/LM framework, developed by John Hicks represents all equilibrium levels of income and the rate of interest. It may be used to examine the effects of monetary and fiscal policy; however, this essay will focus on the effects of fiscal policy. It will explain, with the aid of illustrations, the effects of an increase in government spending, on crowding out. In addition, it will identify the factors which determine the degree of crowding out that may occur in an economy. Crowding out effects Fiscal policy, which involves the use of government expenditure and taxes to manipulate levels of aggregate demand, is said to have crowding-out effects. (Economics, 1997) In this case, we will focus only on crowding out resulting from increases in government spending therefore we will assume that taxes are held constant. As government spending (G) is an element of aggregate demand (AD), an increase in G will increase AD, causing the IS schedule to shift out (IS to IS?). This is presented in Figure 1 below: This shift from IS to IS? ...read more.

Middle

will bring about an income. Due to the highly responsive nature of money demand to changes in income, the rise in income will lead to an even larger rise in the demand for transactions and precautionary money. This would require that the speculative demand for money is lowered, which would result from a rise in the interest rate. Since money demand is interest inelastic, in other words, sincety money demand is not very sensitive to changes in the rate of interest, a large increase in the interest rate is required to restore equilibrium. This leads to a large reduction in investment demand (Y? - Y*). Therefore there is a large degree of crowding out. Figure 4, illustrated on the following page, represents the case where the LM schedule is interest elastic. An interest elastic LM schedule exists either when money demand is very responsive to changes in the rate of interest or when it is not very responsive to changes in income. In this case, as government spending and income increases, the transactions and precautionary demand for money increase. Due to the fixed supply of money, the interest rate rises. However, since money demand is interest elastic, only a small increase in the interest rate, shown by the distance (R - R?) ...read more.

Conclusion

(Froyen, 2002) 3. Employment level of Output in the Economy The third condition which is important to consider is the existence of full employment of ouput. In all the above situations, we are assuming that prices are fixed (that the aggregate supply curve is perfectly elastic). This is only valid if the economy is operating below full employment. In a situation of full employment or near full employment, an increase in government spending would as always, lead to an increase in the transactions and precautionary demand for money. However, when this spills over into the money market, the government tries to reach equilibrium by decreasing the money supply. (Economics, 2003) This shifts the LM schedule to the left (LM to LM?) shown in Figure 10 below. This means that the new equilibrium at (R?, Y) will be at a much higher interest rate (R?). Full employment of output is achieved (Y). This results in a great degree of crowding out, which is shown by the distance (Y to Y*). Conclusion To conclude, an increase in government expenditure leads to higher interest rates, which in turn leads to the crowding out of private sector spending. The degree of financial crowding out, however may be determined by two factors; the slope of the LM schedule, the slope of the IS schedule. Finally, the degree of resource crowding out may be determined by the employment level at which an economy is operating. ...read more.

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