Econ 110B Ch17 Solutions - Economics 110B Solutions to...

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Economics 110B Solutions to Practice Questions for Chapter 17 1) In the original IS-LM model, changes in Y and the interest rate were implicitly assumed permanent. In this expanded IS-LM model, current and future expected values are distinguished from each other. This means that changes in current output and the current interest rate need not be considered permanent. Since consumers and firms respond differently to permanent changes in output and interest rates than they do to temporary changes in these variables, the slope of the IS curve is affected. The factors that determine the slope of the IS curve are the spending multiplier and the interest rate sensitivity of investment. The spending multiplier is now smaller because changes in current output do not have as large an effect on current consumption as we had previously assumed. That means that the marginal propensity to consume is smaller, the multiplier smaller, and the IS curve steeper. Also, investment will be less sensitive to changes in the current interest rate. A drop in the current interest rate (holding future expected interest rates constant) will not cause investment to increase as much as we had previously assumed, which means output would not increase as much as previously, so again the IS curve will be steeper.
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