Chapter 11, Problem 1VQP

To determine

Explain the difference between zero crowding out, incomplete crowding out, and complete crowding out effect.

Explanation of Solution

Zero crowding out: In zero crowding out effect, the government increases spending, but the private sector spending remains constant.

Incomplete crowding out: In incomplete crowding out, the government increases spending, then there is less than the proportionate decrease in price sector spending.

Complete crowding out: In complete crowding out effect, if the government increases spending, then there is an equal decrease in private sector spending.

Figure -1 shows the recessionary gap as follows:

In Figure -1, the recessionary gap occurs at point 1. Here, a fall in private expenditure offsets the initial increase in aggregate demand because of increase in government spending. Thus, the aggregate demand remains constant and there is no change in real GDP and unemployment rate. Therefore, the complete crowding out and expansionary fiscal policy does not have any effect on the economy.