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?

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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.

SESS0008_24-25 MCQ test (30 minutes)

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?

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SESS0008_24-25 MCQ test (30 minutes)

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?

View Explanation

Log in for full answers

Similar Questions

If, in addition, 𝑅 𝑡 = 𝑟 ¯ , short run output [ Select ] .

The IS curve shifts when any of the following economic variables change except:

When the LM curve is drawn, the quantity that is held fixed is:

If the short-run IS-LM equilibrium occurs at a level of income below the natural level of output, then in the long run the price level will __, shifting the ____ curve to the right and returning output to the natural level.

In the IS-LM model, a decrease in government purchases leads to a(n) ______ in planned expenditures, a(n) ______ in total income, a(n) ______ in money demand, and a(n) ______ in the equilibrium interest rate.

According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.

An increase in the money supply shifts the __ curve to the right, and the aggregate demand curve ____.

Other things equal, a given change in money supply has a larger effect on demand the:

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

If the short-run IS-LM equilibrium occurs at a level of income below the natural level of output, then in the long run the price level will , shifting the __ curve to the right and returning output to the natural level.

In the IS-LM model, a decrease in government purchases leads to a(n) in planned expenditures, a(n) in total income, a(n) in money demand, and a(n) in the equilibrium interest rate.

An increase in the money supply shifts the curve to the right, and the aggregate demand curve __.