An increase in the autonomous government expenditure will result in :

Question

Accepted Answer

The correct option is 2: Higher level of income and higher rate of interest

This question is best analyzed using the Investment-Saving/Liquidity preference-Money supply (IS-LM) model, which depicts the simultaneous equilibrium in the goods market (IS curve) and the money market (LM curve). An increase in autonomous government expenditure is a form of expansionary fiscal policy. In the goods market, this increase acts as a boost to aggregate demand, shifting the IS curve to the right. This shift creates excess demand for goods, which leads to an increase in economic output or national income (Y). As income rises, the demand for money for transactions also increases in the money market. Given a fixed money supply (the LM curve is unchanged), this increased money demand drives up the equilibrium rate of interest (r). Therefore, the new equilibrium point, found at the intersection of the shifted IS curve and the original LM curve, shows both a higher level of income and a higher rate of interest. This effect is often referred to as partial 'crowding out,' where the rising interest rate slightly mitigates the full expansionary effect on income.

The incorrect option is 1: Higher level of income and lower rate of interest
While an increase in government expenditure does lead to a higher level of income, the resulting rise in the demand for money causes interest rates to increase, not decrease, assuming the money supply remains constant. A lower rate of interest would typically be the result of expansionary monetary policy, which shifts the LM curve, not fiscal policy.

The incorrect option is 3: Lower level of income and lower rate of interest
Lower income is generally associated with contractionary fiscal policy (like reduced government spending) or negative economic shocks, which is the opposite of an increase in autonomous government expenditure.

The incorrect option is 4: Lower level of income and higher rate of interest
This outcome is characteristic of stagflation or a negative supply shock, or sometimes the result of severe contractionary monetary policy; it contradicts the expected stimulative effect of increased autonomous government spending on national income.