Question

Consider a closed economy IS-LM model with downward sloping IS curve. If there is an increase in government spending, then which one of the following statements is CORRECT?

• A. If LM curve is horizontal, then the equilibrium level of income remains unchanged.
• B. If LM curve is horizontal, then the equilibrium interest rate increases.
• C. If LM curve is vertical, then the equilibrium level of income remains unchanged.
• D. If LM curve is vertical, then the equilibrium interest rate decreases.

Hint:

In the IS-LM model: \[ \text{Horizontal LM} \Rightarrow \text{Fiscal policy highly effective} \] \[ \text{Vertical LM} \Rightarrow \text{Complete crowding out of fiscal policy} \]

Answer 1

The Correct Option is C

Step 1: Recall the IS-LM framework.
In the IS-LM model:
\[ IS \rightarrow \text{Goods market equilibrium} \] \[ LM \rightarrow \text{Money market equilibrium} \]
An increase in government spending shifts the IS curve to the right.

Step 2: Case of horizontal LM curve.
A horizontal LM curve represents the liquidity trap situation.
In this case, interest rate remains constant while output increases significantly.
Thus:
Income increases and
Interest rate does not increase
Therefore, options (A) and (B) are incorrect.

Step 3: Case of vertical LM curve.
A vertical LM curve implies money demand is insensitive to interest rate.
When government spending increases, the IS curve shifts rightward, but output cannot increase because the money market constrains income.
Hence:
Equilibrium income remains unchanged while
Interest rate rises
Thus, option (C) is correct and option (D) is incorrect.

Step 4: Final conclusion.
Therefore, the correct statement is
\[ \boxed{\text{If LM curve is vertical, then the equilibrium level of income remains unchanged}} \]
Hence, the correct option is (C).