Question

Suppose initially the economy is in equilibrium in a flexible exchange rate regime. Now there is a sudden decrease in investment confidence such that investment decreases at the same level of output Y and interest rate, i. How will this change affect the IS-LM-UIP diagram?

a. The IS curve shifts to the right; the LM curve remains the same; the Interest Parity curve remains the same.
b. The IS curve shifts to the left; the LM curve remains the same; the Interest Parity curve shifts to the left.
c. The IS curve shifts to the left; the LM curve shifts up; the Interest Parity curve remains the same.
d. The IS curve shifts to the left; the LM curve remains the same; the. Interest Parity curve remains the same.
e. The IS curve shifts to the left; the LM curve shifts down; the Interest Parity curve remains the same.

Answer 1

A decrease in investment confidence results in the IS curve shifting to the left, with no changes to the LM and UIP curves, reflecting lower output which may lead to increased unemployment without changes in money supply or foreign exchange expectations. c. The IS curve shifts to the left; the LM curve shifts up; the Interest Parity curve remains the same.

Step-by-step explanation:

When there is a sudden decrease in investment confidence leading to a reduction in investment at a given level of output Y and interest rate, i, in a flexible exchange rate regime, this will impact the IS-LM-UIP diagram in a specific way. The correct answer to how this change affects the IS-LM-UIP diagram is option d. The IS curve shifts to the left, the LM curve remains the same, and the Interest Parity (UIP) curve also remains the same.

The rationale for this is as follows: The IS curve represents the relationship between investment and savings given a certain level of income and interest rates. A decrease in investment confidence will reduce investment spending, leading to a shift in the IS curve to the left as output decreases. The LM curve, which represents the relationship between liquidity preference and money supply, remains unchanged because the scenario does not indicate a change in the money supply or demand for liquidity. Finally, the UIP curve, which depicts the relationship between domestic and foreign interest rates adjusted for expected changes in the exchange rate, remains stable in this particular scenario unless other factors such as changes in expectations about exchange rates or differential interest rates are mentioned.

It is important to note that while the IS curve shifts left, indicators such as investment, unemployment, and inflation rates will also be affected according to macroeconomic principles. A leftward shift in the IS curve, reflecting decreased investment, will likely result in lower output, potentially increasing unemployment. Similar to a leftward shift in aggregate demand, the decrease in output moves the economy away from its potential GDP, thereby affecting these economic indicators.