Question

By extending the IS model including the foreign interest rates we can analyze how events in the world economy affect the US economy. Suppose there is an increase in the foreign interest rate. Explain in no more than 5 lines if the IS curve shifts or not and in why.

Answer 1

IS curve will shift to the right.

If we include the foreign interest rates in our model, we would basically be analyzing the IS-LM-BP model where BP denotes Balance of Payments.

Suppose initially the domestic interest rates and the foreign interest rates are equal and we are assuming perfect capital mobility.

Now if there is an increase in foreign interest rate, capital outflow kicks in because investing in foreign country is more profitable now. As capital moves out, the currency starts to depreciate ( due to increased supply and lesser demand). As currency depreciates, exports become cheaper and imports become expensive. Due to this the net exports (i.e exports - imports ) increases. As net exports goes up, the IS curve shifts to the right.

This is just the mechanism behind IS curve. There are other concepts such as fixed or flexible exchange rates , etc which are not part of this question and thus not explained.