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Explain why within the IS-LM curve model an increase in government spending causes the interest rate...

Explain why within the IS-LM curve model an increase in government spending causes the interest rate to rise. What factors determine the magnitude of the increase in the interest rate for a given increase in government spending?

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Answer #1

In the IS- LM model, an increase in the government spending increases the aggregate expenditure as it is a part of it. The increase in aggregate expenditure shifts the IS curve towards the right, causing an increase in the equilibrium output and interest rate.

The extent of this increase is determined by the slope of the LM curve. If the LM curve is too flat, the rise in the rate of interest due to the shift in the IS curve will be less compared to a situation where the LM curve is steeper.

These are shown in the figure below:

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