Question

Use the IS-LM model to show the new GDP and real interest rate after Fiscal Policy is implemented by the government (to reach natural real GDP).Is there any "crowding out:"? describe crowding out by using the IS-LM model.

Answer 1

The crowding out is a phenomenon where the increased interest rates crowd outs the private investment in the economy. When there is an expansionary fiscal policy the government increase the spending and this will increase the aggregate demand in the economy. So the increased aggregate demand curve results in higher real GDP and interest rate. The interest rate is the cost of borrowing the money so at a higher interest rate no one would be willing borrow the funds, so the increased interest rate negatively affect the private investment and there is a crowding out of investment and this is shown by the below. When the government increases the spending and the IS curve shifts to the right resulting in a higher interest rate and the real GDP.