According to the standard closed-economy IS-LM model, in which the IS curve is d

Question

According to the standard closed-economy IS-LM model, in which the IS curve is downward sloping and the LM curve is upward sloping in Y-r space, an increase in government expenditures shifts the IS curve to the right, increasing income by an amount defined by the government-expenditures multiplier.  Nevertheless, in this case, the increase in equilibrium income (defined by the intersection of IS and LM curves) is less than the increase in income defined by the government-expenditures multiplier.  Why is this the case? Please defend your reasoning.

Typed answers only please

Explanation / Answer

The reason is crowding-out effect of government expenditure.

When government spending increases, budget deficit increases (or budget surplus decreases), assuming taxes do not change. This causes the government resort to borrowing as deficit financing purpose, which increases market interest rate. As interest rate increases, investment demand decreases, and aggregate demand decreases, and as a result, final aggregate demand is lower than that predicted by spending multiplier model. This is called the crowding-out effect of private investment.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.