Question

4. Consider the following changes in the macroeconomy. Use the IS curve to show the expected

impact on GDP and explain how and why GDP would be affected in the short-run. In each case,

assume the economy begins at its balance growth path (i.e. no short-run growth). If you get stuck,

see worked exercise #2 on page 306-307 in the text (4th edition).

a. The Federal Reserve takes action to increase real interest rates above the marginal

product of capital.

b. The adoption of smartphone technology significantly decreases productivity and leads to

a decline in the marginal product of capital.

c. A new government program subsidizes firms who undertake new capital investments,

leading firms to purchase new equipment and machinery.

d. A housing bubble bursts with house prices plummeting and new home sales dropping sharply

Answer 1

In following graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial equilibrium interest rate r0 and initial equilibrium output (GDP) Y0.

(a) An increase in real interest rate will cause an upward movement along the IS curve to point B, leading to lower GDP. In following graph, the new position will be at point B with higher interest rate r1 and lower output Y1.

(b) Decrease in marginal product of capital will decrease investment, shifting IS curve leftward which will decrease both real interest rate and GDP. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower GDP Y1.

(c) Firms purchasing new machinery will increase investment demand, which shifts IS curve rightward, increasing real interest rate and GDP. In following graph, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher GDP Y1.

(d) Plummeting house prices will reduce consumer wealth, thus decreasing output, which shifts IS curve leftward, decreasing real interest rate and GDP. In following graph, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower GDP Y1.