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An increase in government spending leads to lower investment in the IS-LM model. True or false...

An increase in government spending leads to lower investment in the IS-LM model.

True or false and why? (I assume an upward sloping LM curve)

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Answer #1

Ans.) True

In brief, When government spending rises, it leads to a rise in the interest rate. We know that investment is negatively related with interest rates, so as interest rates rises, private investment falls down. This known as "Crowding Out" of private investment.

In graph, the initial equilibrium is E. Due to an increase in government spending the IS curve shifts to IS' and the new equilibrium is reached at E' . But at this equilibrium, interest rates have increased so private investment goes down. This leads to a downward shift of the IS curve to IS'' . The magnitude of the downward shift of IS curve depends on the fall in private investment.

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