Question

1. An increase in government spending drives up or increases the

private sector investment ." Explain this phenomenon using IS-LM model and evaluate its impact on AD-AS if any

Answer 1

IS-LM Model - IS(Investment saving ) LM (Liquidity preference Money supply ) this model describes the how market (financial and goods ) interact to the rate of interest and GDP.

Here Given that there is increase in govt.spending which means there is lower interest rate and higher govt. spending or investment it will translate in to more output(GDP), so the IS curve slope downward and to the right . As Investment /Govt spending increases ,output will increase for any given interest rate.This increase in govt spending shift out the IS curve.

The LM curve describes the set of all levels of income and interest rate at which money supply equal to demand . This curve tells us an increase in output increases the money demand which will leads to increase in interest rate to maintain money market equlibrium . As Govt spending increases this means there is more money in market which will lead to decrease in interest rate , and also increase in govt.spending leaves more money in hand of people which leads to aggregate demand all these utlimately leads to increase in GDP.