Question

Use the IS-LM model to explain under what conditions an increase in government spending is likely to have a) a greater impact on national output b) a smaller impact on national output.

Answer 1

a) An increase in government expenditure leads to greater impact on national output only when the value of multiplier is high. The increase in output is based on the value of multiplier. If multiplier is 3, output increases by thrice.

slope of Is = - 1 / kv1

where k = multiplier effect, v1 = investment response to interest rate.

Higher the level of multiplier, lower will be the slope. It will result in a flat IS curve. Hence, output increases by k* change in government expenditure.

b) An increase in government expenditure leads to a small impact on national output because of crowding out effect. Increase in government expenditure leads to increase in output by multiplier effect. This leads to an increase in money demand which further raises the interest rate to bring back the money market to equilibrium. This rise in interest rate dampens private investment and output. However, output increases but not at a multiplier effect but at a smaller level. This is because an increase in government investment leads to fall in private investment . This is crowding out effect.