Question

3. Using the IS-LM graphs, show that a decrease in government spending will cause output and interest rates to fall.

4. Using the IS-LM graphs, show what will happen to output and the interest rates if there is a balanced budget increase in spending—that is higher spending financed by higher taxes.

5. Using IS-LM graphs, predict what will happen to output and the interest rate if the central bank reduces the money supply.

Answer 1

In each graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

(3) A fall in government spending will decrease aggregate demand and output, shifting IS curve leftward, lowering both interest rate and output. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

(4) Since government spending multiplier is higher than tax multiplier, an equal increase in government spending and tax will effectively increase aggregate demand and output, shifting IS curve rightward, increasing both interest rate and output. In following graph, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1.

(5) Decrease in supply money will shift money supply curve leftward, increasing interest rate and decreasing quantity of money. As a result, LM curve will shift leftward, increasing interest rate and decreasing output. In following graph, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate r1 and lower output Y1.