Answer to Question #190944 in Macroeconomics for Larna Michaels

Question

The Government of Botswana is expected to increase expenditure 

by P20 billion for the financial year 2022/23. Using the IS – LM 

analysis, explain with the AID of a diagram how this would cause 

“crowing out”. How could monetary authorities address this problem 

Of crowding out?

Answer 1

Crowding out:

The increase in government spending increases the demand for loan-able funds

thus increasing the interest rate. An increase in the interest rate increases the cost of investment and leads to a decrease in the private sector investment. As a result, the government spending crowds out private sector investment spending, this is called crowding out.

Explanation:

According to the above figure, the x-axis measures the level of income, and the y-axis measures the interest rate. Initially, the equilibrium is at point E where the IS and LM curves intersect each other. The initial level of interest rate is r and the income is Q.

After the increase in government spending by P20 billion the IS curve shifts to the right from IS to IS1. If the interest rate remains the same then the income will increase to Q2. But due to the increase in the interest rate from r to r1 the private investment decreases and the income only increases from Q to Q1. So the new equilibrium stops at E1 and the government spending crowds out the income of Q1Q2.

The monetary authorities can address this problem by shifting the LM curve to the right. To shift the LM curve to the right, the monetary authorities will increase the money supply by the open market purchase of government bonds. Due to an increase in money supply, the interest rate will decrease and it will come back to r. As a result, there will be no crowding out of income and income will increase to Q2.

Graphical presentation after the action of monetary policy:

According to the above figure, after open market purchase of government bonds the LM curve will shift to the right from LM to LM1. As a result, the new equilibrium will be at E2 and income will increase to Q2. There will be no crowding out.