Question

3. Explain what effect each of the following events will have on the IS curve in a flexible exchange rate regime: (1) an increase in foreign output; (2) a reduction in the foreign interest rate; and (3) an increase in the domestic interest rate

Answer 1

The IS curve represents the combination of Y and i which is level of output and Income and the i is the interest rate. a flexible exchange rate system allows the exchange rate to be determined by supply and demand. The IS curve of an open economy is teeper than the closed economy as increased leads to rise in imports.

1- effect of increase in  in foreign output- The increase in foriegn output will increase foriegn income that will lead to increasd spending on deomestic goods and thus net exports will increase. NX( net exports is a component of aggregate demand). This will raise aggregate demand and increased exports will cause a rightward shift of the IS curve.

2- A reduction in the foriegn interest rates will cause appreciation of the domestic currrency as the higher interest rates in a country increase the value of its currency relative to country with  lower interest rates. so the NX will reduce as imports will be costlier for the foreign country so the IS will shift to left.

3- An increase in the domestic interes will reduce investment as there is negative relation beteen investment and interest rates so an increase in the domestic interest rates will cause movement along th IS curve. Increased interest artes will cause demand to fall and consumption to fall.