Question

Suppose you read that prospects for stronger future economic growth have led the dollar to strengthen and stock prices to increase.

a. What effect does the strengthened dollar have on the IS curve?

b. What effect does the increase in stock prices have on the IS curve?

c. What is the combined effect of these two events on the IS curve?

Short answer

Strengthened dollar will increase IS, shift the curve rightwards. Increase in stock prices will decrease IS, shift the curve leftwards. Combined effect of both depends upon their relative magnitude.

Step-by-step solution

Introduction 

IS ie investment saving curve shows combinations of interest rates & output levels at which goods market is at equilibrium.

It is effected by level of Aggregate demand; which is further effected by Consumption, investment, net government expenditure & net exports.

Explanation 

• Strengthening of dollar implies that it becomes expensive in forex markets, which leads to expensive exports & cheaper imports. So, net exports decrease & aggregate demand falls, IS curve also decreases & shifts leftwards.
• Increase in stock prices imply that autonomous planned investment expenditure expenditure increases, due to economy being in growth stage. It leads to increase in AD & IS curve also increases, shifts rightwards.
• Strengthening of dollar & increase in stock prices have opposite impacts of increasing & decreasing IS respectively. So, the net impact depends on their magnitude relative comparison.