Analysing an IS Curve Shift with Fixed Interest Rate

In summary, the IS curve shifts left by 1.5 units due to a foreign demand shock, resulting in a new IS curve (IS2). The central bank refuses to change the interest rate from 10%, leading to a new level of output, money supply, and required increase in government spending to stabilize output at the desired level.
  • #1
413
41
0
This is an econ question, i am not sure if i should post it here.


Assume that initially the IS curve is given by IS1: Y = 12-1.5T-30i+2G, and that the price level P is 1, and the LM curve is given by LM1: M= Y(1-i). Initially, the home interest rate equals the foreign interest rate of 10% or 0.1. Taxes and government spending both equal 2

-I found the output is 10 (this is the desired output)

There is now a foreign demand shock, such that the IS curve shifts left by 1.5 units at all levels of the interest rate, and the new IS curve is given by IS2: Y = 10.5-1.5T-30i+2G.

Assume that the central bank refuses to change the interest rate from 10%. In this case, what is the new level of output? What is the money supply? And if the government decides to use fiscal policy instead to stabilize output (to desired output=10), then, according to the new IS curve, by how much must government spending be increased to achieve this goal?


I don't get the part where it says assume central bank refuses to change interest from 10%, but when your IS curve shifts, won't interest decrease?

Any help would be appreciated.
 
Physics news on Phys.org
  • #2
The central bank refusing to change the interest rate from 10% means that the interest rate remains at 10%, even after the IS curve shifts. In this case, the new level of output would be 8.5, the money supply would be 85, and the government spending must be increased by 2.5 units in order to stabilize output to the desired output of 10.
 
  • #3



I would like to point out that this question is more suitable for an economist or a financial expert. However, I can provide some insights based on my understanding of economic principles and analysis.

Firstly, let's analyze the initial scenario where the IS curve is given by IS1: Y = 12-1.5T-30i+2G. This represents the equilibrium condition in the goods market, where Y is the output, T is taxes, i is the interest rate, and G is government spending. The equilibrium output level is 10, which is the desired output mentioned in the question. This means that at the given interest rate of 10%, the economy is producing the desired output of 10.

Now, let's consider the foreign demand shock that causes the IS curve to shift left by 1.5 units at all levels of interest rate. This shift represents a decrease in foreign demand for goods and services, which leads to a decrease in output. The new IS curve, IS2: Y = 10.5-1.5T-30i+2G, shows that at the same interest rate of 10%, the equilibrium output level has decreased to 10.5. This means that the economy is now producing more than the desired output of 10.

Next, we need to consider the impact of the central bank's decision to not change the interest rate from 10%. This means that the interest rate remains at 10%, even though the IS curve has shifted left. As you mentioned, this may seem counterintuitive as the decrease in output would typically lead to a decrease in the interest rate. However, this scenario assumes that the central bank is using a fixed interest rate policy, where they are not adjusting the interest rate in response to changes in the economy.

Given this scenario, the new level of output would still be 10.5, as the interest rate has not changed. However, the money supply would need to increase to accommodate the higher output level. This is because the LM curve shows the relationship between the money supply (M) and the interest rate (i). As output increases, the demand for money also increases, which means that the money supply needs to increase to maintain the interest rate at 10%.

Finally, let's consider the use of fiscal policy to stabilize output at the desired level of 10. According to the new IS curve, the government would need to increase spending by
 

1. What is an IS curve shift?

An IS curve shift refers to a change in the relationship between the real interest rate and the level of real output in an economy. It is represented graphically by shifting the IS curve, which shows the equilibrium points where the goods market and money market intersect.

2. How does a fixed interest rate affect the IS curve shift?

A fixed interest rate means that the real interest rate remains constant regardless of changes in the level of real output. This results in a vertical IS curve, where changes in real output have no effect on the real interest rate. Therefore, a fixed interest rate does not cause a shift in the IS curve.

3. What factors can cause an IS curve shift?

An IS curve can shift due to changes in any of the factors that affect the goods market and money market equilibrium. These include changes in consumer spending, investment, government spending, net exports, and money supply. Changes in expectations, fiscal and monetary policies, and external shocks can also cause an IS curve shift.

4. How can we analyse an IS curve shift with a fixed interest rate?

To analyse an IS curve shift with a fixed interest rate, we can use a graph to plot the IS curve and the fixed interest rate line. By comparing the new and original equilibrium points, we can determine the direction and size of the shift. We can also use algebraic equations to calculate the new equilibrium output level.

5. What are the implications of an IS curve shift with a fixed interest rate?

An IS curve shift with a fixed interest rate has different implications depending on the direction of the shift. A rightward shift indicates an increase in real output, while a leftward shift indicates a decrease. This can have effects on inflation, employment, and economic growth. A fixed interest rate also limits the effectiveness of monetary policy in stabilizing the economy during a shift.

Similar threads

Replies
1
Views
504
Replies
26
Views
4K
Replies
53
Views
34K
Replies
10
Views
2K
  • STEM Career Guidance
Replies
4
Views
1K
Replies
1
Views
1K
  • Engineering and Comp Sci Homework Help
Replies
3
Views
3K
  • General Discussion
Replies
29
Views
9K
  • General Discussion
Replies
11
Views
3K
  • Mechanical Engineering
Replies
1
Views
3K
Back
Top