The IS-LM framework can be used to assess the effect of exogenous factors on variables such as output and interest rates. A fall in autonomous investment may be caused by a loss in business or investor confidence. Based on the IS-LM model, lo or Co will decrease causing the IS curve to shift (IS0 to IS1). This will lead to a reduction in output (Y0 to Y1) and interest rate (r0 to r1). In either scenario, the consumption must decline i.e. C = C0 + c1 (1-t1) Y will reduce. At the same time, government spending will remain unaffected, while the budget deficit, B = G0-tY, will rise in both scenarios because of the decrease in tax revenues.
A decrease in consumption, C0, leads to an increase in investment, l = l0- δr, due to a decline in interest rate (r). Thus, it can be observed that the LM curve makes the effect of overspending less severe. A decrease in consumption, C0, means that consumers are saving more. In the IS-LM model, this implies a decrease in interest rate, which results encourage investment. Thus, in the short run, an increase in consumer spending increases both recession and investment (a flatter LM curve). When the investment (l0) decreases, investments tend to decrease despite the interest rate being low as a huge drop in interest rate to increase investment would not affect the output.
