Question

1. Show the crowding out effect for the following cases:
a) Inelastic LM curve
b) Elastic IS curve
2. Assume that there is a negative monetary shock causes the decreasing in money supply.
a) Please use IS-LM analysis and explain the effect.
b) Based on case 2(a), please use IS-LM analysis to show how fiscal policy can recover the economy back to initial level of income.

Answer 1

1.

a) If LM curve is inelastic, but positively sloped, then partial crowding will take place.

b) If IS curve is elastic, then partial crowding will take place. When the Government expenditure increases, that is fiscal expansions takes place, crowding out takes place.

2.

a) If a negative monetary shock causes the decrease in money supply, then LM curve will shift leftwards, so the interest rate will increase and the income level will decrease.

b) Fiscal policy can shift IS curve rightwards and recover the economy back to initial level of income.