Question

Evaluate the following statements as either TRUE, FALSE, or UNCERTAIN, and EXPLAIN carefully. answer should be approximately one page long. Please use diagrams or algebra when answering the questions, when appropriate

1) According to the IS-LM model, the government has the power to increase GDP but, unless it can get cooperation from the central bank, this will always cause an increase in interest rates

Answer 1

Solution-

This statement is true.

When government increases its spending, aggregate demand in the economy rises. Whenever there is a rise in aggregate demand, IS curve shifts rightwards indicating a rise in GDP and interest rate. This is so because whenever aggregate demand rises price and output level of the economy rises. With increase in output level, income earned by the people also rises. As a result their transaction demand and thus overall demand for money rises. Thus people would start selling their bonds in order to get money. Supply of bonds rises and as a result price of bonds fall. As price of bonds fall, the yield from the bonds or the interest rate rise.

Thus unless the government gets a cooperation from the central bank, increase in GDP always leads to rise in interest rates.

Diagrams are given below.