Question

1. The major advantage of the IS-LM model compared to the simple model developed earlier is that is introduces the effect of interest rates on the economy. Explain the effect that interest rates have on spending by households and firms, and show how this can be illustrated graphically through the Ap demand schedule.
2. Illustrate through the Ap demand schedule the following: assume that the Fed raises interest rates by one-quarter percent and the level of Ap spending falls by a substantial amount. Would the Ap demand function be relatively steep or flat? Explain.
3. What would be the shape of the Ap demand function if a change in interest rates by the Fed resulted in no change in planned autonomous spending? Explain.
4. Let’s assume that the Fed will be raising interest rates this year in response to strong economic growth. If we were to find that firms continued to spend just about the same amount after as before the rise in rates, what could we conclude about the slope of the IS curve? Illustrate and explain.
5. Assume that the dollar has fallen about 15% over the past year. A falling dollar makes imports more expensive and exports more competitive. How might that affect the position of the IS curve? Explain and illustrate.
6. George W. Bush convinced Congress in his first term to cut taxes. Illustrate this fiscal policy move via the IS curve.

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When interest rates are higher, there is an increased cost of borrowing which reduces investment spending. And when interest rates are higher, there is increased return to saving which reduces consumption. Similarly when interest rates are lower, the costs of borrowing are lower which results in increased investment and since the return to saving is reduced, the consumption spending increases. This can be depicted in the product market where interest-sensitive spending is downward sloping and is inversely related to interest rates as shown in the following figure....

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