500 words essay on the question - "Using the extended ISLM model, explain how higher government...

500 words essay on the question - "Using the extended ISLM model, explain how higher government spending will impact private investment when the LM curve is vertical, compared to when it is horizontal. What are the implications of fiscal policy in these two extreme cases? "

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Expert Solution

LM curve shows the relationship between change in income and its effect on interest rate.

Vertical LM curve shows that income remain constant.so Increase in government spending will shift IS curve to right but The income will remain unchanged ,only interest rate will increase ,which lead to decrease in private Investment. Because income is constant,so we can conclude that in case of vertical LM Increase in government spending lead to complete crowding out of private Investment.

In case of horizontal LM ,it shows Income no longer effect interest. Interest rate remain Constant irrespective of income level.

So Increase in government spending will shift IS to right and income Increases. But because interest rate remain fixed ,so it doesn't effect private Investment. So by this we can conclude that In case of horizontal LM there is no crowding out of government spending Increase.

Rahul Sunny answered 5 months ago

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