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

 
FIGURE 8.10: FISCAL EXPANSION AND LM CURVE 
As a result of increased government expenditure, the IS
1
curve shift to IS
2
. The increase in income will increase the demand 
for money. Since the supply of money remains constant, there will 
be an increase in interest rate. As a result, private sector 
investment declines (I is inversely related to interest rate). This 
causes depressing effect on income and output. 
Therefore, the potential expansion of income, according to 
Keynesian multiplier does not take place. The income increases 
from Y
1 
to Y
2
, which is less than Y . Income and interest rate move 
along with LM curve from E
1
to E
2
. 
Fiscal expansion thus leads to increase in equilibrium level 
of income and rate of interest rate. 
1
E
2
E
1
i
2
i
LM
E
InterestRate
1
Y
2
Y
0
Income / Output
Y
1
IS
2
IS

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8.3.3 Fiscal Policy and Crowding Out Effect: 
 
The displacement of investment due to increase in 
government expenditure is known as Crowding Out Effect. Fiscal 
policy expansion leads to expansion of income and output which 
will raise the demand for money. As the money supply remains 
constant, this will raise the rate of interest. 
As the interest rate rises, private investment will decline. 
Thus finally increased government spending displaces private 
investment. The extend of Crowding Out depends on the following 
factors: 
a) Investment response to change in rate of interest (given as 
‗b‘ in the equation I I bi ); Crowding Effect will be higher if 
the value of ‗b‘ is higher. 
b) 
Income elasticity of demand for money (given as ‗k‘ in 
equation