Questions: The IS-LM Model

Question 1

The government increases spending without changing taxes. In the IS-LM framework, what is the immediate effect on equilibrium output and the interest rate?

• A. Output falls, interest rate falls
• B. Output rises, interest rate falls
• C. Output rises, interest rate rises
• D. Output is unchanged, interest rate rises

Answer: (C)

Higher government spending shifts IS rightward (more output demanded at every interest rate). With LM unchanged, the new intersection has higher output and a higher interest rate. The higher rate partially crowds out private investment — output rises by less than the full fiscal multiplier would suggest.

Question 2

In a liquidity trap, expansionary monetary policy (shifting LM right) is just as effective at raising output as expansionary fiscal policy.

• T. True
• F. False

Answer: False

In a liquidity trap, the LM curve is flat because interest rates are at the zero lower bound — people are indifferent between holding money and bonds, so the money market does not tighten as output rises. Shifting a flat LM curve right has no effect on the equilibrium interest rate or output. Fiscal policy (shifting IS), by contrast, moves along the flat LM curve and raises output fully, without being offset by higher rates.

Question 3

What is 'crowding out' in the IS-LM model, and why does it mean fiscal stimulus is less potent than a simple multiplier analysis suggests?

Model answer: Crowding out occurs when fiscal expansion (IS shifts right) raises equilibrium interest rates, which then reduces private investment. In the IS-LM model, the equilibrium moves up along the LM curve: output rises, but the higher interest rate suppresses investment, partially offsetting the stimulus. The net increase in output is smaller than the full multiplier effect because LM 'pushes back' through the interest rate.

A simple Keynesian multiplier ignores the money market. IS-LM adds it back: as output rises, money demand rises, pushing up interest rates. Higher rates discourage investment, dampening the output expansion. The degree of crowding out depends on the slope of LM (how sensitive interest rates are to output) and the slope of IS (how sensitive investment is to interest rates).