Consider the following changes in the macroeconomy. For each shock, state which
ID: 1105866 • Letter: C
Question
Consider the following changes in the macroeconomy. For each shock, state which demand parameter will be shocked (ac, aI, aG, aEX, aIM), and state whether the IS curve will shift left or right. a. The government offers a temporary investment tax credit: for each dollar of investment that firms undertake, they receive a credit that reduces the taxes they pay on corporate income. b. A booming economy in Europe leads to an unexpected increase in demand for US goods from European consumers. c. US consumers develop an infatuation with all things made in New Zealand and sharply increase their imports from that country. d. A housing bubble bursts so that housing prices fall by 20% and new home sales drop sharply.
Explanation / Answer
(a)
The government offers a temporary investment tax credit: for each dollar of investment that firms undertake, they receive a credit that reduces the taxes they pay on corporate income.
This investment tax credit will induce the firms to increase the investment so as to reduce their tax liability.
Investment is a component of IS curve.
So, this increase in investment will shift the IS curve to the right.
(b)
A booming economy in Europe leads to an unexpected increase in demand for US goods from European consumers.
This unexpected increase in demand for US goods from European consumers would increase the US exports.
Given the imports, this increase in exports will lead to increase in net exports.
Net exports is a component of IS curve.
So, this increase in net exports will shift the IS curve to the right.
(c)
US consumers develop an infatuation will all things made in New Zealand and sharply increase their imports from that country.
This sharp increase in imports from New Zealand will increase the overall imports of US.
Given the exports, this increase in imports will lead to decrease in net exports.
Net exports is a component of IS curve.
So, this decrease in net exports will shift the IS curve to the left.
(d)
A housing bubble bursts so that housing prices fall by 20% and new home sales drop sharply.
Fall in housing prices will create negative wealth effect which in turn will result in a decrease in consumption in economy.
New home sales are included in investment. Drop in new home sales will lead to decrease in investment.
Consumption and investment are component of IS curve.
So, this decrease in consumption and investment will shift the IS curve to the left.
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