Question
In an economy characterized by an IS-LM framework, if
the demand for money is perfectly interest-inelastic (a vertical LM curve), the "Crowding Out Effect" of an expansionary fiscal policy will be:Solution
When the LM curve is vertical (Classical case), an increase in government spending shifts the IS curve to the right, putting upward pressure on interest rates. Because money demand does not change with the interest rate, the interest rate rises sharply until private investment declines by the exact amount of the government spending increase. Output remains unchanged, resulting in complete crowding out.
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