The Crowding Out Effect

Transcription

1 In the IS-LM model the cowding out effect occus when an exogenous incease in spending in the goods secto esults in highe inteest ates (because of highe money demand in the financial secto) and a subsequent eduction in pivate spending (investment). ΔG fl ΔY fl ΔM d fl Δ fl ΔI The size of the cowding out effect (COE) can be found as the diffeence between the simple expenditue multiplie and the equilibium expenditue multiplie.

2 Equilibium in the goods secto is epesented by the IS cuve. The equation fo the IS cuve is: The simple expenditue multiplie is: Equilibium in the financial secto is epesented by the LM cuve.

3 Geneal Equilibium implies simultaneous equilibium in both the goods and financial sectos and is epesented by the intesection of the IS and LM cuves. This yields an equilibium income (Y * ) and equilibium inteest ate ( * ). The equilibium expenditue multiplie is:

4 The size of the cowding out effect (COE) can be found as the diffeence between the simple expenditue multiplie and the equilibium expenditue multiplie. Simplifying: How do the paametes C y, I, L y, and L affect the COE?

5 L y is the income elasticity of money demand. As L y gets bigge the COE also gets bigge. We can see this gaphically by noting that L y is the hoizontal distance the M d cuve shifts when income changes. M s 2 1 M d (Y 1 ) Big L y M 0 M 1 M 2 M d (Y 1 ) Small L y M d (Y 0 ) M

6 As L y gets bigge the COE also gets bigge. Fo any given change in income, say fom Y 0 to Y 1, the bigge is L y the moe the money demand cuve shifts. The moe the M d shifts, the bigge will be the change in inteest ate. M s 2 1 M d (Y 1 ) Big L y M d (Y 1 ) Small L y M d (Y 0 ) M 0 M 1 M 2 M

7 I is the inteest elasticity of investment demand. As I gets bigge the COE also gets bigge. We don t need the gaph to figue this one out. The chain of causality fo the COE is ΔG fl ΔY fl ΔM d fl Δ fl ΔI But it should be noted that the slope of the IS cuve is As I gets bigge the IS cuve gets flatte and the COE gets bigge! If I is small, then fo any given change in the esulting change in I will be small. But if I is lage, then fo any given change in the change in I will be lage as well.

8 C y is the maginal popensity to consume. As C y gets bigge the COE gets bigge. Again C y affects the slope of the IS cuve. Bigge C y means a flatte IS cuve and a bigge cowding out effect. The intuition is as follows. A bigge C y means that fo any given spending change the impact on income will be geate, i.e. the IS cuve shifts by moe when C y is lage. This will lead to a bigge incease in M d (lage incease in Y leads to lage incease in M d ). This will cause inteest ate to ise moe the lage is C y.

9 LM(M 0 ) IS(A 0 ) Big C y o Big I IS(A 0 ) Small C y o Small I Y 0 Y

10 LM(M 0 ) 2 IS(A 1 ) Small C y o I IS(A 0 ) Big C y o Big I IS(A 0 ) Small C y o Small I Y 0 Y 2 Y

11 LM(M 0 ) 1 IS(A 1 ) Big C y o I IS(A 0 ) Big C y o Big I IS(A 0 ) Small C y o Small I Y 0 Y 1 Y

12 LM(M 0 ) 2 1 IS(A 1 ) Big C y o I IS(A 1 ) Small C y o I IS(A 0 ) Big C y o Big I IS(A 0 ) Small C y o Small I Y 0 Y 1 Y 2 Y

13 L is the inteest elasticity of money demand. As L gets bigge the COE gets smalle. The slope of the LM cuve is As L gets bigge the LM cuve gets flatte and the COE gets smalle.

14 The slope of the money demand cuve is 1/L. As L gets bigge the M d slope gets flatte (smalle). M s M d (Y 0 ) Big L M d (Y 0 ) Small L M 0 M

15 An incease in income caused by the spending shock will shift the M d cuve to the ight. M s M d (Y 0 ) Big L M d (Y 0 ) Small L M 0 M

16 The lage is L the moe agents want to educe thei money holdings as the inteest ate ises. This has the effect of mitigating the ise in caused by the incease in M d. The smalle incease in esults in a smalle COE. Below both the big L money demand and the small L money demand shift by the same dolla amount. But because big L agents cae about the inteest ate moe, they conseve thei money holdings moe and the inteest ate does not ise by as much. M s 2 M d (Y 1 ) Small L 1 M d (Y 1 ) Big L M d (Y 0 ) Big L M d (Y 0 ) Small L M 0 M

17 How do exteme values of the paametes C y, I, L y, and L affect the COE? As C y 1 the COE. As L 0 the COE. As I 0 the COE 0.