Question

Consider a closed economy IS-LM model with downward sloping IS curve. If there is an increase in government spending, then which one of the following statements is CORRECT?

• A. If LM curve is horizontal, then the equilibrium level of income remains unchanged.
• B. If LM curve is horizontal, then the equilibrium interest rate increases.
• C. If LM curve is vertical, then the equilibrium level of income remains unchanged.
• D. If LM curve is vertical, then the equilibrium interest rate decreases.

Hint:

In the IS-LM model: \[ \text{Horizontal LM} \Rightarrow \text{Fiscal policy highly effective} \] \[ \text{Vertical LM} \Rightarrow \text{Complete crowding out of fiscal policy} \]

Answer 1

The Correct Option is C

Step 1: Set the IS LM scene.
We have a closed economy with a downward sloping IS curve and an upward sloping LM curve. Government spending now goes up.

Step 2: Shift the right curve.
More government spending raises planned demand at every interest rate, so the IS curve shifts to the right. The LM curve does not move.

Step 3: Read the new crossing.
Sliding up along the fixed LM curve, the new point sits higher and to the right. So both output and the interest rate go up.

Step 4: Explain the rate rise.
Higher output raises money demand, and with money supply fixed the interest rate must climb to clear the money market. That higher rate trims some investment, the usual crowding out.

Step 5: Conclude.
\[ \boxed{\text{Both income and interest rate rise}} \]