Question

State whether the following statement is true or false and explain:

According to the IS/LM model, an equal increase in government spending and taxes by $1bn cannot raise GDP by more than $1bn.

Answer 1

The correct option would be

• True

For the aggregate expenditure be or , the equilibrium in the goods market would be where or or or .

For an increase in G and T by $1bn=$10^9, we have the new equilibrium as .

The change in GDP would be as

or

or

or

or

or . This is the increase in GDP in the goods market.

However unless the LM curve is horizontal line (interest rate doestn't change with Y), the net equilibrium GDP increase in the ISLM model would be less than the increase in GDP under goods market, and if LM is horizontal then the net increase in equilibrium GDP under ISLM would be equal to the $1bn change in the goods market. Hence, the GDP can not be raised by more than $1bn.

The ISLM model have the equilibrium output and equilibrium interest rate determined by the intersection of IS curve (the combinations of i and Y for equilibrium in goods market) and the LM curve (the combinations of i and Y for equilibrium in money market). Usually, the IS curve have negative slope while the LM curve have positive slope. Now, for an increase in equilibrium output in the goods market, the IS curve shifts to right by the same amount (for each interest rate, the GDP or Y is more than before by that amount). But the shift in IS curve also increases interest rate since LM curve have usually positive slope, and the net increase in GDP is less than the increase in GDP in goods market (the rest of the increase in GDP is reduced due to crowding-out effect). This is explained by the fact that increase in interest rate also decreases the investment spending, which decreases the total increase in GDP in the goods market.

If the LM curve is vertical, then all the increase in GDP in the goods market is absorbed in the crowding out effect. If the LM curve is horizontal, then there is no crowding out effect and the total increase in GDP is equal to the increase in GDP in goods market. In this case, the increase in GDP in the goods market is $1bn, and irrespective of the shape of LM curve, the statement that total increase in GDP is less than $1bn is true. If LM is vertical, then total increase in GDP is zero, if LM has positive slope, then total increase in GDP is less than $1bn due to crowding out effect, and if LM us horizontal, then total increase in GDP is equal to $1bn. As can be seen, in no case, the total increase in GDP is more than $1bn.