Final answer:
An increase in government spending as per the IS-LM model will lead to a rise in both output and interest rates, in line with option (a). This reflects the fundamental economic principle where government borrowing increases demand for capital, subsequently raising interest rates.
Step-by-step explanation:
According to the IS-LM model, an increase in government spending will cause output to increase and interest rates to rise. This is represented by option (a). When government spending increases, it shifts the aggregate demand (AD) curve to the right, which raises both income and output levels. Simultaneously, increased government borrowing to finance the additional spending leads to a shift in the demand for financial capital, raising interest rates in financial markets.
As the government deficit increases, competition for financial capital leads to crowding out of private investment due to higher interest rates. Moreover, when the budget deficit grows, concerns about the sustainability of government debt may cause further increases in interest rates. These higher rates tend to discourage investment in physical capital, affecting economic growth negatively.