Difficulty: Intermediate | Prerequisites: Part 1 of these Ch. 12 notes (goods-money market links), Chapter 11 (Fed tools), Chapter 9 (multiplier)
Part 1 established that the goods market and the money market are connected through income and the interest rate. This section puts that connection to work: what happens when the government changes taxes or spending (fiscal policy), or the Fed changes the money supply (monetary policy)? The key new idea is the crowding-out effect, which explains why fiscal policy is less powerful than the simple multiplier suggests. Understanding crowding out and the policy mix is typically worth several exam questions.
Fiscal policy (taxes and government spending) works through the goods market first but feeds back through the money market because higher output raises the interest rate, which crowds out private investment. Monetary policy works through the money market first by changing the interest rate, which then changes investment and output. The size of crowding out depends on how sensitive investment is to the interest rate, and the Fed can reduce it by accommodating a fiscal expansion with more money.
Fiscal policy
Government decisions about taxes and spending aimed at influencing aggregate output. It affects the goods market directly (through G and T) and the money market indirectly (through income and money demand).
In simple terms, it is the government's budget lever for steering the economy.
Monetary policy
Fed decisions about the money supply aimed at influencing aggregate output. It affects the money market directly (through M^s) and the goods market indirectly (through the interest rate and planned investment).
Think of it as the Fed's lever: change the money supply, move the interest rate, move investment, move output.
Expansionary fiscal policy
An increase in government spending or a decrease in net taxes, intended to raise aggregate output and reduce unemployment.
Contractionary fiscal policy
A decrease in government spending or an increase in net taxes, intended to reduce aggregate output and slow inflation.
Expansionary monetary policy
An increase in the money supply (e.g. the Fed buys bonds, lowers the discount rate, or reduces the reserve ratio), intended to lower the interest rate, boost investment, and raise output.
Contractionary monetary policy
A decrease in the money supply (e.g. the Fed sells bonds, raises the discount rate, or increases the reserve ratio), intended to raise the interest rate, reduce investment, and lower output.
Crowding-out effect
The reduction in private planned investment that occurs when government spending increases output, raises money demand, pushes up the interest rate, and thereby discourages investment. It partially (or fully) offsets the fiscal stimulus.
In simple terms, the government's extra spending "crowds out" some private spending by driving up the cost of borrowing.
Policy mix
The particular combination of fiscal and monetary policy in use at any given time. Different mixes produce different effects on the interest rate, investment, and the composition of output.
Expansionary fiscal policy chain:
Government raises G (or cuts T) → aggregate expenditure (AE) rises → output (Y) rises.
Higher Y raises money demand (M^d).
With a fixed money supply, the interest rate (r) rises.
Higher r reduces planned investment (I).
Lower I partially offsets the original rise in AE and Y.
Summary sequence: AE↑ → Y↑ → M^d↑ → r↑ → I↓ → AE↓ (partial offset).
Contractionary fiscal policy chain:
Government cuts G (or raises T) → AE falls → Y falls.
Lower Y reduces M^d.
Interest rate falls.
Lower r raises planned investment.
Higher I partially offsets the original fall in Y.
Summary sequence: AE↓ → Y↓ → M^d↓ → r↓ → I↑ → AE↑ (partial offset).
Expansionary monetary policy chain:
Fed increases M^s → surplus of money → r falls.
Lower r raises planned investment (I).
Higher I raises AE → Y rises.
Summary: r↓ → I↑ → AE↑ → Y↑.
Contractionary monetary policy chain:
Fed decreases M^s → shortage of money → r rises.
Higher r lowers I.
Lower I reduces AE → Y falls.
Summary: r↑ → I↓ → AE↓ → Y↓.
The crowding-out effect is the feedback channel that weakens fiscal policy. Its size depends on how sensitive planned investment is to the interest rate.
Steep (nearly vertical) investment schedule: Investment barely responds to rate changes. Crowding out is small. Fiscal policy is relatively effective.
Flat (nearly horizontal) investment schedule: Investment is very sensitive to rate changes. Crowding out is large. Fiscal policy is relatively ineffective.
Perfectly vertical investment schedule: No crowding out at all. The full multiplier effect is realised. Fiscal policy works at full strength, but monetary policy is completely ineffective (changing r does not change I).
Perfectly horizontal investment schedule: Complete crowding out. Government spending rises, but the induced fall in investment exactly offsets it. Output does not change. Monetary policy, however, is very effective.
Starting values: C = $400 bn, I = $200 bn, G = $100 bn, so Y = $700 bn. MPC = 0.8, so the simple multiplier = 5.
Additional assumptions:
Every 1% rise in r reduces planned investment by $5 bn.
Every $10 bn rise in G raises the interest rate by 1%.
If G rises by $20 bn:
Without crowding out: ΔY = 5 × $20 bn = $100 bn.
But the $20 bn rise in G pushes r up by 2%, which cuts investment by $10 bn.
Net stimulus to spending = $20 bn − $10 bn = $10 bn.
Actual ΔY = 5 × $10 bn = $50 bn (not $100 bn).
If G rises by $30 bn:
r rises by 3%, investment falls by $15 bn.
Net stimulus = $30 bn − $15 bn = $15 bn.
ΔY = 5 × $15 bn = $75 bn. New equilibrium = $700 bn + $75 bn = $775 bn.
If the Fed increases the money supply at the same time the government runs an expansionary fiscal policy, the extra money absorbs some of the increased money demand, so the interest rate does not rise as much. Less rise in r means less fall in investment, which means less crowding out.
Fed accommodates fully (r does not rise at all): zero crowding out.
Fed accommodates partially (r rises a little): crowding out is reduced but still positive.
Fed does nothing: standard crowding-out effect.
Fed tightens at the same time: crowding out is amplified, and the fiscal expansion is undermined.
Monetary policy works by changing r, which changes I. If investment does not respond to the interest rate (vertical schedule), monetary policy is ineffective. The more sensitive investment is to the interest rate (flatter schedule), the more effective monetary policy becomes.
Different combinations of fiscal and monetary policy produce different outcomes:
Fiscal | Monetary | Output | Interest rate |
|---|---|---|---|
Expansionary | Expansionary | Rises | Could go either way |
Expansionary | Contractionary | Could go either way | Rises |
Contractionary | Expansionary | Could go either way | Falls |
Contractionary | Contractionary | Falls | Could go either way |
The composition of output also shifts:
Contractionary fiscal + expansionary monetary → favours investment over government spending (lower r, higher I).
Expansionary fiscal + contractionary monetary → favours government spending over investment (higher r, lower I).
Crowding-out calculation pattern:
Find the interest-rate increase caused by the rise in G (use the given rule).
Find the resulting fall in planned investment (use the investment-sensitivity rule).
Net spending change = ΔG − fall in I.
ΔY = multiplier × net spending change.
Multiplier with crowding out is effectively smaller than the simple multiplier 1/(1 − MPC). You do not need a new formula; just net out the investment offset before applying the multiplier.
During the 2009 US fiscal stimulus, some economists warned that higher government borrowing would push up interest rates and crowd out private investment. The crowding out turned out to be modest because the Fed simultaneously held rates near zero (monetary accommodation). This is a textbook example of the Fed reducing the crowding-out effect by expanding the money supply alongside expansionary fiscal policy.
"Crowding out means government spending is always wasted." Crowding out is a partial offset, not a full cancellation (unless the investment schedule is perfectly horizontal, which is an extreme case). Fiscal policy still raises output in most scenarios.
"The crowding-out effect is about the government literally taking resources from firms." In this model it works through the interest rate. The mechanism is financial (higher rates discourage borrowing for investment), not physical.
"Expansionary monetary and expansionary fiscal policy together always lower the interest rate." They both raise output, but they push the interest rate in opposite directions. The net effect on r is ambiguous.
"If the investment curve is vertical, both fiscal and monetary policy are useless." Fiscal policy is fully effective when the curve is vertical (no crowding out). Monetary policy is the one that becomes ineffective.
⚠️ Be able to trace the full causal chain for each of the four policy types (expansionary/contractionary × fiscal/monetary), including the feedback.
⚠️ Crowding-out calculations using a table or given rules are a staple exam question. Practise the Table 12.2 style problems until the steps are automatic.
⚠️ Know the relationship between the slope of the investment schedule and the size of the crowding-out effect. Steeper = less crowding out. Flatter = more crowding out.
⚠️ Policy-mix questions ask you to predict the direction of output and the interest rate. Memorise the table above, or reason it out from the chains.
⚠️ The Fed "accommodating" a fiscal expansion is a common scenario question. It means the Fed increases M^s to prevent or limit the rise in r.
True or false: Fiscal policy affects the money market through its impact on income and money demand. True.
True or false: The crowding-out effect means increases in government purchases cause reductions in private saving. False. It causes reductions in private planned investment (through higher interest rates).
True or false: The more sensitive planned investment is to the interest rate, the less effective fiscal policy is. True.
True or false: If the Fed wants to reduce inflation, it should lower the discount rate. False. To reduce inflation the Fed should raise the discount rate (or sell bonds), which is contractionary.
Fill in the blank: A decrease in the money supply aimed at decreasing aggregate output is called ________ monetary policy. Contractionary.
Q: What is the sequence of events following an expansionary monetary policy?
A: r↓ → I↑ → AE↑ → Y↑.
Q: Using Table 12.2 (multiplier = 5, $5 bn investment drop per 1% rate rise, 1% rate rise per $10 bn in G), if the government increases spending by $20 bn, what is the change in equilibrium output after accounting for crowding out?
A: G up $20 bn → r up 2% → I down $10 bn. Net spending boost = $20 bn − $10 bn = $10 bn. ΔY = 5 × $10 bn = $50 bn increase.
Q: Under what condition is there zero crowding-out effect?
A: When planned investment does not respond to the interest rate at all (the investment schedule is perfectly vertical).
Q: Which policy mix favours investment spending over government spending?
A: Contractionary fiscal policy combined with expansionary monetary policy. This lowers r, boosting investment, while reducing G.
Q: If the federal government cuts net taxes to stimulate the economy while the Fed sells bonds in the open market, what happens to the effectiveness of the fiscal expansion?
A: It is reduced. The Fed's bond sales shrink the money supply, raise the interest rate further, and increase the crowding-out effect.
Q: A policy mix of expansionary fiscal and expansionary monetary policy causes output to ________ and the interest rate to ________.
A: Output increases. The interest rate could increase, decrease, or remain unchanged (it is ambiguous because fiscal pushes r up and monetary pushes r down).
The crowding-out effect explains why the simple multiplier from earlier chapters overstates the impact of fiscal policy once you account for the money market. The policy-mix analysis here is the foundation for debates about government debt and Fed independence. The IS-LM appendix (Part 3 of these notes) formalises all of this into a two-curve diagram.
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