Solutions to Chapter 13

Chapter 11: The IS CurveInstructor’s Manual

Chapter 11: The IS Curve

Problem 1

The ex ante real interest rate is the interest rate that agents expect to occur. The ex poste real interest rate is the interest rate that actually occurs. When firms and households make decisions they do so based on their own imperfect expectations of the future, so it is the ex ante real interest rate that determines the levels of saving and investment.

Problem 2

Unexpectedly high inflation reduces the ex poste real interest rate and also reduces the real value of existing debt. Both of these factors help borrowers and hurt lenders. As a result, borrowers “win” from unexpected inflation and lenders “lose”.

Problem 3

The IS curve is downward sloping because an increase in income increases savings. An increase in the supply of savings reduces real and nominal interest rates in the capital market.

Problem 4

As investment becomes more responsive, the investment demand curve in the capital market becomes more horizontal. An increase in income will still lead to an increase in savings, but this increase in savings will not reduce interest rates as much as it did before. Therefore, changes in income are associated with smaller changes in interest rates when investment become less elastic and, as a result, the IS curve becomes more horizontal.

Problem 5

As saving becomes less responsive, the saving supply curve in the capital market becomes steeper. Any shift in the investment demand curve will now lead to a bigger change in the nominal interest rate. The IS curve becomes more horizontal which reflects the fact that the nominal interest rate are more responsive to any changes in the capital market.

Problem 6

a.A deficit reducing tax increase will increase national savings and shift the IS curve downward, toward lower interest rates for a given level of income.

b.A deficit-financed increase in government spending will reduce national savings and shift the IS curve upward, toward higher interest rates for a given level of income.

c.Pessimism which reduces investment demand will shift the IS curve downward, towards lower interest rates for a given level of income.

Problem 7

See Figure 11.2 in the text. This 1% increase in expected inflation reduces ex post real interest rates for a given level of the nominal interest rate, which decreases saving supply and increases investment demand. The end result of these shifts is that a 1% increase in expected inflation increases nominal interest rates by 1%, leaving the ex ante real interest rate, investment, and income unchanged.

Problem 8

The IS curve shifts to the right. This happens because expectations of higher inflation shift the investment demand curve to the right. Since households do not change their expectations of future inflation, the saving curve does not move. This implies that for a given level of GDP level (which determines the position of the saving curve), a rightward shift of the investment results in a higher equilibrium nominal interest rate. In other words, the IS curve moves up for every GDP level, Y.

Problem 9

There are conflicting views as to the cause of the investment boom of the 1990s. According to the Real Business Cycle view, the increase in investment was the result of new technologies that dramatically increased productivity. As long as these productivity-enhancing developments continue to take place, this boom will be sustainable. However, according to the Keynesian view, much of this boom in investment was caused by unsustainable and optimistic animal spirits. As a result, this investment boom is temporary.

Problem 10

Equilibrium in the capital market requires that saving equals investment, or Y – C – G = I. Plugging in the values for these variables and simplifying, the IS curve for this economy is

Y = 650 – 100i.

Problem 11

Answers will vary.