The Size of the Multiplier in the IS/LM Model

Let us consider the size of the fiscal multiplier by using this IS/LM model. Government spending G appears in IS Eq. (2.10) as a shift parameter, but does not appear in LM Eq. (2.9). In Fig. 2.2, an increase in government spending moves the IS curve upward from IS to IS'. It does not affect the LM curve. The new equilibrium point is E1.

The movement from E0 to E1 may be decomposed into a move from E0 to E2 and a move from E2 to E1. The movement from E0 to E2 corresponds to the multiplier effect at a given rate of interest, which is the multiplier effect in the 45-degree line model of Sect. 1.

The movement from E2 to Ej means that an increase in the interest rate depresses investment and hence income. This offsetting effect is called the crowding-out effect in the sense that an increase in public spending crowds out private investment. Through the increase in G, C increases but I decreases. The size of the crowding-out effect becomes larger if the elasticity of investment with respect to the interest rate is larger, and the elasticity of money demand with respect to the interest rate is smaller.

Note that the elasticity of investment with respect to the interest rate means the extent to which investment changes in response to an increase in the interest rate. The elasticity of money demand with respect to the interest rate has a similar meaning. If the elasticity of money demand with respect to the interest rate is small, an increase in G raises the rate of interest to a significant extent. Moreover, if the elasticity of investment with respect to the interest rate is large, an increase in the rate of interest reduces private investment significantly. Because of the crowding-out effect, the size of the fiscal multiplier in the IS/LM model is smaller than in the 45-degree line model.

 
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