Answer to Question #102323 in Macroeconomics for Prashanth

Question

Bases on the IS-LM model, analyse the impact of a positive shock to government expenditure, focusing on the response of GDP, consumption, private savings, investment, government budget balance, public debt;

Answer 1

The basis of the IS-LM model is an analysis of the money market and an analysis of the goods market, which together determine the equilibrium levels of interest rates and output in the economy, given prices. The model finds combinations of interest rates and output (GDP) such that the money market is in equilibrium. This creates the LM curve. The model also finds combinations of interest rates and output such that the goods market is in equilibrium. This creates the IS curve. The equilibrium is the interest rate and output combination that is on both the IS and the LM curves.Government spending leads to a significant increase in consumption, while investment either falls or does not respond significantly.As the interest rate increases, the quantity of money demanded decreases because the interest rate represents an opportunity cost of holding money. When interest rates are higher, in other words, money is less effective as a store of value.