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Assume the government increases spending by $100. Explain: (1) through the multiplier process, why income Y...

Assume the government increases spending by $100. Explain: (1) through the multiplier process, why income Y will increase; and (2) why the money market (LM Curve) cause investment to fall and thus the increase in GDP to be less than hoped for. Use math and graphs.

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Answer #1

As government increases spending by $100, income increases by $100 in first round of spending. This increases consumption demand, and higher consumption in second round increases income further (though by less than $100). As income increases in second round, again consumption demand rises and income rises more. This process continues until the last round of consumption demand has ended.

As a result, total income rises by more than $100.

However, as income rises, demand for money rises, and higher money demand shifts demand for money curve to right, increasing interest rate and quantity of money. Higher interest rate leads to lower investment demand, which offsets (even if partially) the increase in income.

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