Explain in Detail What Effect a Decrease in Government Spending

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The Answer is A decrease in government spending causes a decrease in disposable income and consumption. The fall in consumption causes a decrease in demand and the equilibrium level of output in the goods market becomes lower. This is reflected in a leftward shift in the IS curve. If the central bank controls the money supply, goods market events such as lower government spending does not shift the LM curve (only a movement along it). However, if the central bank controls the interest rate, in response to the decrease in the interest rate as a result of the fiscal contraction, the central bank conducts open market sales of bonds to decrease the money stock to keep the interest rate constant. This has the effect of shifting the LM curve upwards until the same interest rate is attained.

Explain in Detail What Effect a Decrease in Government Spending

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Explain in Detail What Effect a Decrease in Government Spending

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Correct Answer:
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