W3P3 - Crowding Out

Question 1

What is the impact of an increase in government spending on the Keynesian Cross Model?

Answer 1

When government spending increases in the Keynesian Cross model, the AE schedule shifts up. Via the multiplier effect we will see an increase in consumption and hence in income. Interest rates are exogenous in the Keynesian Cross model and hence an increase in government spending will leave the interest rate unaffected.

Question 2

What is the impact of an increase in government spending on the ISLM model?

Answer 2

In the ISLM model the increase in government spending and hence the
increase in income will lead to a higher money demand in the money market and hence to an increase in the interest rate given the fixed
money supply. The increase in the interest rate will reduce private investment.

Question 3

Which model sees the bigger increase in output, and why?

Answer 3

When government spending increases the impact on output is bigger in the Keynesian Cross model as there is no crowding out of private investment. In the Keynesian Cross model, the interest rate is exogenous
i.e. it does not depend on income and hence the level of government spending. On the other hand, in the ISLM model the interest rate is
endogenous i.e. it depends on income. When income increases in the ISLM model, this will lead to higher money demand. When the money
supply is fixed, the increase in money demand will lead to higher interest rates.