Answer to Question #224886 in Macroeconomics for Anum naz

Question

What is crowding out, and when would you expect it to occur? In the face of substantial
crowding out, which will be more successful—fiscal or monetary policy?

Answer 1

IS curve showing an inverse relationship between interest and output. It is showing the goods market in equilibrium. While the LM curve showing direct relation interest and output. LM curve showing money and asset market in equilibrium.

If expansionary fiscal policy causes an increase in interest rate, which causes a decrease in private spending or investment is known as crowding out. In other words, crowding out is a process in which an increase in government expenditure crowds out private investment from the market due to an increase in interest rate. It is a case of increase in interest rate and output both or increase in interest rate only due to an expansionary fiscal policy.

In the case of substantial crowding out monetary policy is more effective. If a vertical LM curve is given then there is an expansionary fiscal policy used then the best way to overcome crowding out is to use expansionary monetary policy. In other words, using expansionary monetary policy which is equivalent to expansionary fiscal policy effect causes a fall in the interest rate and comes to 0 crowding out and output also increases. For showing this diagram-1 drawn below:

If in case there is crowding out present in an economy then best way to come out of it is using expansionary monetary policy which accommodate effect of expansionary fiscal policy.