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This diagram illustrates how expansionary fiscal policy can be offset by the crowding out effect, reducing the full impact of the Keynesian multiplier.
AD1: Initial aggregate demand before fiscal stimulus.
AD2: Increased AD due to government spending and the Keynesian multiplier.
AD3: Final aggregate demand after accounting for crowding out.
Keynesian Multiplier: The potential increase in output due to increased government spending.
Crowding Out: Reduction in private sector activity due to increased government borrowing and higher interest rates.
Expansionary fiscal policy, such as increased government spending, initially shifts aggregate demand from AD1 to AD2.
Due to the Keynesian multiplier, the increase in government spending can lead to a proportionally larger increase in aggregate demand.
However, the crowding out effect occurs when increased government borrowing raises interest rates, reducing private investment and consumption.
This leads to a partial leftward shift in AD from AD2 to AD3, diminishing the full potential impact of the multiplier.
The diagram captures this dynamic by showing both the theoretical multiplier effect and the offsetting impact of crowding out.
Explore other diagrams from the same unit to deepen your understanding
A diagram illustrating the fluctuations in real GDP over time, including periods of boom, recession, peak, and trough, relative to the long-term trend of economic growth.
This diagram shows the intersection of the aggregate demand (AD) and short-run aggregate supply (AS) curves to determine the equilibrium price level and real GDP.
A diagram showing the Classical model of aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS), used to explain long-run macroeconomic equilibrium.
A Keynesian aggregate demand and long-run aggregate supply (AD–LRAS) diagram showing how real GDP and the price level interact across different phases of the economy, including spare capacity and full employment.
A diagram showing an output (deflationary) gap, where the economy is producing below its full employment level of output (Ye).
A macroeconomic PPC diagram illustrating the trade-off between producing consumer goods and capital goods, highlighting opportunity cost and future growth implications.
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