HE207 Tutorial 8-9 Qn 3

Prepared by:
Zanda Siew
Deng Qiang
Given AE
0
= C + I(i
0
) + G
0
+ - +

+ signs below C and G
0
refer to positive relationship with AE
0

- sign below I(i
0
) refers to negative relationship of investment and
interest rate and subsequently, affecting AE
0



(a) Overview of the given AE equation

Upper diagram

i
o
increase to i
1
-> Investment decrease -> AE
0
decrease to AE
1
(result
in a corresponding down shift of the AE graph) - > equilibrium output
decreases from Y
0
to Y
1


Lower diagram

Graph shows a negatively sloped IS curve when a line is drawn to join
the two equilibrium points, (Y
0
, i
0
) and (Y
1
, i
1
)



(a) Suppose interest rate increase from i
0
to i
1
, show what happens to
curve AE
0
(upper diagram) and identify the equilibrium point in the
goods market (lower diagram). Lastly, is the slope of the IS curve
positive or negative?
(a) What will happen to the IS curve if investment is not sensitive to
interest rate?
Two cases:

1. IS curve getting steeper
Investment is getting highly insensitive to interest rate and hence,
a change in i, will have little effect on I and subsequently, little
effect on AE and equilibrium Y

2. Vertical IS curve
Changes in interest rate will have no effect on I and hence, no effect
on AE and equilibrium Y
(b) Suppose G
0
increases, what will happen to AE
0
in the upper
diagram?
Upper diagram
An increase in G
0
-> AE
0
shifts up to AE
2
- > Equilibrium output
increases from Y
0
to Y
2

Lower diagram
* At the prevailing interest rate, i
0
, the new goods market equilibrium
is at (Y
2
, i
0
)
(b) Suppose C=C
0
+ bY, what is the extent of the horizontal shift of the
IS curve in the lower diagram?
C
0
: Autonomous consumption
b: Marginal propensity to consume

Taking into account of the multiplier effect of 1/(1-b)
Change in Y = 1/(1-b) * Change in G
Change in Y will be greater than one time of change in G. Why?

- MPC is defined as: 0 < b < 1
- As such, 1/(1-b) > 1 (keeping in mind that denominator is a fraction that
lies between 0 and 1, and its inverse will be a number greater than 1)
- Hence, the extent of the horizontal shift of IS curve from Y
0
to Y
3
is greater
than Y
0
to Y
2