Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

b) Fiscal Expansion: 
An increase in government spending (or cut in taxes) will 
shift the IS curve or MDS to right. The given diagram for monetary 
policy can be used to explain the effect of fiscal expansion. 
As the Classical AS curve vertical, the shift in MDS due to 
fiscal expansion has no effect on output and employment. It only 
helps to increase the prices. 
At the initial equilibrium price of P. Fiscal expansion leads to 
exceed demand. This bid up prices. A higher price reduces the 
0
*
Y
E
Output
Pr iceLevel
1
P
P
'
MDS
MDS
1
E
AS

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aggregate demand. With given nominal stock of money, higher 
prices reduce real money balance increase the rate of interest and 
reduce the private expenditure on investment and consumption. 
Thus the aggregate demand falls to potential level of output at E
1
. 
It is observed that higher government spending finally reduce 
private sector investment through reduced real money balance and 
high interest. There is complete crowding out of private investment 
in Classical model. 
There are five differences in concept of crowding out in 
Keynesian and Classical model. 
In Keynesian model, prices and wages are not flexible. 
Fiscal expansion leads to increase in output and income. This will 
lead to an increase in demand for money and this raises rate of 
interest. 
In Classical model, interest rate rises due to reduced supply 
of real money balance caused by increase in price level. 
Crowding out take place in both the case due to increased 
interest rate. But reasons for increase in interest rate are different. 
Under Keynesian model, output is demand determined and 
hence the Keynesian economists believed that by changing factors 
on demand side output and employment can be changed. But the 
Classical economists believed that output is supply determined and 
these economists are known as supply side economists.