In the IS-LM framework, an increase in autonomous government expenditure:

Question

Accepted Answer

The correct option is 3:
Will result in an increase in both income and interest rates.

The IS-LM model combines the Investment-Savings (IS) curve, which represents equilibrium in the goods market, and the Liquidity Preference-Money Supply (LM) curve, which represents equilibrium in the money market. An increase in autonomous government expenditure (fiscal expansion) raises aggregate demand at any given interest rate. This increase in demand shifts the IS curve outward and to the right. As the IS curve shifts right, the economy moves to a new intersection point with the fixed LM curve. This movement results in a simultaneous increase in equilibrium income (Y) due to the fiscal multiplier effect and an increase in the equilibrium interest rate (r) because the higher income level increases the demand for money, which pushes up the interest rate in the money market. This is the classic result of expansionary fiscal policy in the IS-LM framework.

The incorrect option is 1: Will result in a decrease in both income and interest rates.
This result is associated with contractionary fiscal policy (a decrease in government spending) or contractionary monetary policy (a decrease in money supply), which would shift the IS or LM curves inward, respectively.

The incorrect option is 2: Will result in a decrease in income and increase in interest rates.
This scenario typically describes the effect of contractionary IS policy combined with expansionary LM policy, or a sharp reduction in investment demand, which is the opposite of expansionary government expenditure.

The incorrect option is 4: Will result in an increase in income and decrease in interest rates.
This outcome is characteristic of expansionary monetary policy (an increase in money supply), which shifts the LM curve to the right, increasing income and decreasing the interest rate. It is not the effect of increased government spending.