Use the equation for the IS curve to discuss what happens to the IS curve
in response to
the following shocks:
a. An increase in autonomous consumption [5]
IS Curve:
Autonomous consumption is a key component of total autonomous
spending and an increase in consumption directly increases autonomous
spending. The slope does not change as a g does not get affected. The y
intercept, A0 increases meaning the vertical intercept increases. In the x
intercept,a g A 0, A0 increases meaning the horizontal axis increases. The IS
curve experiences a parallel shift to the right as the slope does not
change yet both axes do. Households are now willing to consume more at
any given interest rate. This increases aggregate demand.
b. A reduction in the interest sensitivity of investment [7]
Reduction in interest sensitivity of investment means a reduction in
parameter a. The slope increases (becomes more negative). The IS curve
becomes steeper. Parameter A relies on C 0 and G0 so A remains constant.
Because investment is now less sensitive to interest rates, a small
decrease in the interest rate will generate very little extra investment, and
therefore very little extra output.
c. An increase in the marginal rate of taxation [8]
An increase in tax rate (t) reduces the size of the multiplier (a).
1
a= so if (t) increases, the denominator gets bigger so (a)
1−MPC (1−t)
decreases.
Since A = a x autonomous spending, A decreases
Since a = a x investment sensitivity, (a) decreases
The IS curve becomes steeper because higher taxes act as an automatic
stabaliser. If the interest rate falls investment rises; this creates income.
Now the tax rate is higher, households have less disposable income. Total
boost to output is smaller than what is would’ve been with low taxes.