Question

Consider the goods and services market in Keynesian Theory. Which of the following shocks will lead to the most flattening of the IS curve. Use the following parameters: [G,T,r,a,b,io,i1]=[100,100,10,100,0.5,10,0.5]

A. An increase in G by 10 units.

B. Increase in Sensitivity of Investment to Change in Interest Rates (i1) from 0.5 to 1

C. A decrease in T by 10 units

D. Decrease in Marginal Propensity to Consume from 0.5 to 0.25

Answer 1

The correct answer is (B)  Increase in Sensitivity of Investment to Change in Interest Rates (i1) from 0.5 to 1

IS equation is given by:

Y = (1/(1-b))(A - i₁i) => i = (1/i₁)(A - Y(1 - b))

where A = Autonomous expenditure which includes G , T , Autonomous consumption , etc , i = interest rate and b = Marginal Propensity t consume

Where i is in Y axis and Y is on x axis.

For option (A) and (C) :

Change in T , G means that there is change in Autonomous Expenditure A will result in shift in IS curve and will not change the slope. Note that di/dY = (1/i₁)(-(1 - b)) = (1/0.5)(- 0.5) = -1

In option (b) there is  Increase in Sensitivity of Investment to Change in Interest Rates (i1) from 0.5 to 1

Now di/dY = (1/i₁)(-(1 - b)) = (1/1)(- 0.5) = -0.5

In option (d) there is Decrease in Marginal Propensity to Consume from 0.5 to 0.25

Now di/dY = (1/i₁)(-(1 - b)) =  (1/0.5)(-(1 - 0.25)) = -1.5

Hence As slope is highest for option (B). Hence,

Hence, the correct answer is (B)  Increase in Sensitivity of Investment to Change in Interest Rates (i1) from 0.5 to 1