Question

3 Understanding the IS Curve 1. Consider the following changes to the Macroeconomy. Use the diagram AND the mathematical representation of the IS curve to explain how and why GDP is affected in the short run. (a) A housing bubble bursts so that housing prices fall by 20%. (b) A new trade agreement fosters exports. (c) The Federal Reserve undertakes policy actions that have the effect of increasing the interest rate. (d) The government offers a temporary investment tax credit: for each dollar of investment that firms undertake, they receive a credit that reduces the taxes they pay on corporate income. (e) To reduce the risk of a pandemic spreading, citizens start practicing social distancing and reduce their outdoor activities like eating at restaurants, going to movies etc. (f) The Congress and the President decide to increase government pur- chases today. 2. Consider the previous increase in government purchases today. (a) What is the impact on the IS curve assuming that there is a multiplier effect involved? Can you mention a reason why the multiplier can be high? (b) What is the impact on the IS curve assuming that the Ricardian equivalence holds? Explain why.

Answer 1

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