Question

Consider the following changes to the Macroeconomy. Using the IS curve, explain how and why GDP is affected in the short run.

(a) The Federal Reserve undertakes policy actions that have the effect of increasing the real interest rate above the marginal product of capital.

(b) 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.

(c) A housing bubble bursts so that housing prices fall by 20% and new home sales drop sharply.

Answer 1

a) when real interest rate rises, cost of borrowing increases that leads to decrease in investment spending. Decrease in investment spending shifts the IS curve leftward to IS'. At new equilibrium e' real gdp is lower.

b) investment tax credit reduces the cost of investment which leads to increase in investment spending that shifts IS curve rightward to IS'. At new equilibrium real gdp is higher.

c) decrease in housing prices leads to decrease in wealth that further leads to decrease in consumer spending. This shifts IS leftward and at new equilibrium real gdp is lower.