Question

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

1) increase in foreign output means demand for their products has increased. Home country's imports will increase. In order to pay home will demand more foreign currency leading to its appreciation and vis a vis depreciation of domestic currency. IS will shift rightwards. As depreciation will increase export competitiveness of domestic country

2) a reduction in foreign interest rate will shift capital towards domestic market as interest rates are still same here. So there will be inflow of capital leading to increased demand of domestic currency and it's appreciation. Due to appreciation export would be demanded less as they're now more dearer. Hence IS will shift backwards.

3) effect of an increase in domestic interest rate is same as reduction in foreign interest rate. There will be inflow of capital leading to increased demand of currency and it's appreciation. Due to this country will lose export competitiveness hence IS will shift backwards.