economics hard MCQ

In the IS-LM model, an expansionary fiscal policy (increased government spending) will lead to the highest increase in national income when:

  1. The LM curve is perfectly vertical
  2. The IS curve is perfectly vertical
  3. The LM curve is perfectly horizontal (Liquidity Trap)
  4. Both IS and LM curves are perfectly inelastic

Answer: The LM curve is perfectly horizontal (Liquidity Trap)

When the LM curve is horizontal (a liquidity trap), the demand for money is perfectly elastic, meaning the public is willing to hold any amount of cash at the current low interest rate. Consequently, when the government increases spending (shifting the IS curve right), it does not drive up interest rates at all. With no interest rate increase to crowd out private investment, the fiscal multiplier operates at its absolute maximum, yielding the highest possible boost to national income.

Topic Macroeconomics - Models
Exam Relevance UPSC Prelims, SSC CGL
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