Question

Go to http://www.eurmacro.unisg.ch/Tutor/islm.html. Set the policy instruments to G = 80, t = 0.20, c = 0.75, and b = 40. Now increase government spending, G, from 80 to 160. By how much does the IS curve shift horizontally to the right? Why is the amount of shift greater than the increase in G? Now increase the marginal propensity to consume, c, from 0.75 to 0.90. In which direction does the IS curve shift, and why? By how much does it shift? Now increase the tax rate, t, from 0.20 to 0.28. In which direction does the IS curve shift, and why? By how much does it shift?

Short answer

IS curve would to the right because of an increase in government spending. because of the working of the multiplier, the shift in IS curve would be greater than the increase.

IS curve would shift to the right because of an increase in mpc.

IS curve would move to the left because of an increase in tax rates.

Step-by-step solution

Step 1. Introduction

An IS curve shows the different combinations of interest rate and output at which the goods market is at equilibrium.

Step 2. Explanation

An increase in government spending would cause the aggregate demand to increase. This would further cause equilibrium output at each interest rate to increase. As a result, the IS would move rightwards. Because of the working of the multiplier, an increase in government spending would cause a greater shift in the IS curve.

An increase in mpc would cause the consumption curve to become steeper. As consumption increases, the aggregate demand would increase as well. This would cause the equilibrium output to increase at every level. As a result, the IS curve would move to the right.

An increase in taxes would cause the aggregate demand to fall as the purchasing power declines. This would further cause the equilibrium output level to decrease at each level of interest rate. As a result, the IS curve would move leftwards.