Describe how, if at all, each of the following developments affects the IS and/o
ID: 1169854 • Letter: D
Question
Describe how, if at all, each of the following developments affects the IS and/or MP curves.
1) The central bank changes its monetary policy rule so that it sets a lower level of the real interest rate at a given level of output than before.
2) Government purchases fall, and at the same time the central banc changes its policy rule to set a higher real interest rate at a given revel of output than before.
3)The central bank changes its policy rule to be more aggressive in responding to changes in output. Specifically, it decides that it will increase the real interest rate by more than before if output rises, and cut it by more than before if output falls.
Explanation / Answer
IS CURVE
An IS curve symbolises INVESTMENT AND SAVING (IS). The IS curve displays equilibrium in the goods and services market in context with various interest rates prevailing the market.
ANALYSIS OF CHANGES IN THE IS CURVE:
SCENARIO 1: LOWER INTEREST RATE BY THE CENTRAL BANK FOR IS CURVE CHANGES
Change in interest by the central bank to a lower level will INCREASE the availability of funds in the market. This will enhance the borrowing of funds and boost the business and trade. It will lead to greater savings and investment. Thus, the IS curve will shift due to changes in interest rates.
SCENARIO 2: HIGHER INTEREST RATE BY CENTRAL BANK FOR IS CURVE CHANGES
Higher interest rates by central bank willblock the liquidity in the market and thus reduce the amount of borrowing done for the purpose of business and trade.
SCENARIO 3: CHANGES IN POLICY TOWARDS OUTPUT
This change will not directly affect the IS curve. Since investment and savings do not directly get affected due to output.
MP CURVE
MP Curve denotes the relationship between the real interest rate and the inflation level. It denotes the proportion of the inflation rate that affects the returns on the investment.
MP curve will get affected only in case of the 3rd Scenario, where there is a link between the level of output and the interest rates.