In the short-run IS-LM model (under the assumption the central bank sets the policy rate), what happens to the equilibrium interest rate and output when there is an increase in government spending?

Question

BlackTom AI · Accepted Answer

Context: In the short-run IS-LM model with the central bank targeting the policy rate, an increase in government spending shifts the IS curve to the right, increasing aggregate demand. Since the central bank is fixing the policy rate, the LM curve does not shift in response to the policy rate itself, but the higher demand raises the interest rate along the existing LM curve and increases output.

Option a. 'Interest rate is unchanged, output increases.' This would imply that monetary policy fully accommodates fiscal expansion without tightening interest rates, which contradicts the scenario where the policy rate is fixed by the central bank. In the IS-LM framework with a fixed policy rate, expansionary fiscal policy tends to push up the equilibrium output and the equilibrium interest rate along the LM curve, not keep the rate unchanged.

Option b. 'Interest rate decreases, output decreases.' This combination is inconsistent with an expansionary fiscal shift in a fixed-policy-rate regime. A rightward shift of the IS curve, given a fixed policy rate, would not generate a decrease in output, and certainly not accompanied by a falling interest rate, which would require monetary easing rather than the central bank’s rate setting.

Option c. 'Interest rate increases, output increases.' This matches the standard short-run IS-LM intuition under a fixed policy rate: government spending expansion raises aggregate demand, pushing the equilibrium point up the IS curve. With the policy rate fixed, the LM curve implies higher income and higher interest rates at the new equilibrium as money demand rises with income, leading to higher output and higher interest rate.

Option d. 'Interest rate increases, output is unchanged.' This would indicate tighter monetary transmission or an unchanged output despite a higher rate, which contradicts the IS-LM mechanism where an autonomous fiscal expansion shifts the equilibrium to higher output. If the rate rises due to the shift, output should also rise, not stay unchanged.

In summary, the only option that aligns with the IS-LM analysis under a central bank that fixes the policy rate is that expansionary government spending raises both the equilibrium output and the interest rate, which points to option c as the consistent description of the outcome.

In the short-run IS-LM model (under the assumption the central bank sets the policy rate), what happens to the equilibrium interest rate and output when there is an increase in government spending?Single choice

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