Question

Use the money market and the aggregate demand (AD) curve to illustrate how an increase in government purchases can be offset by reduction in investment.

Answer 1

This is essentially the crowding out of private investment by fiscal expansion. I will illustrate this using the IS Lm model framework.

in the diagram above, the is curve represent the good market equilibrium whereas the lm curve represents the money market equilibrium. An fiscal expansion is an increase in government spending or the reduction in taxes which results in a rightward shift of the IS curve. this rightward shift of the IS curve causes interest rates to increase which discourages investment crowding it out. A full crowding out of private investment takes places when the LM curve is vertical. This means that that the economy is operating at full employment as seen in the classical case