In the IS-LM framework, what happens to the equilibrium interest rate and output when there is a fiscal expansion?

• A. IS shifts left; Real GDP decreases; Interest rate falls
• B. IS shifts right; GDP increases; Interest rate rises
• C. LM shifts right; Real GDP increases; Interest rate falls
• D. IS remains unchanged; Real GDP remains unchanged

Answer: (B)

Fiscal expansion, like higher government spending or tax cuts, raises demand for goods. In the IS-LM framework that pushes the IS curve to the right. With a fixed money supply, the higher level of income boosts money demand, so the money market clears at a higher interest rate. The combined effect is higher output and a higher equilibrium interest rate. That’s why the correct description is: IS shifts right; Real GDP increases; Interest rate rises. If the money supply were allowed to rise, the LM curve would shift right and could keep the interest rate from rising as much, but with a fixed money supply the interest rate goes up.