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Instructor’s Manual
Chapter 11: The IS Curve
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.
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Instructor’s Manual
Chapter 11: The IS Curve
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.
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