Final answer:
The IS curve steepens due to the reduced enthusiasm of foreign investors when higher interest rates are expected to lead to currency depreciation, making the income or output of an economy more responsive to changes in interest rates.
Step-by-step explanation:
To explain why the IS curve steepens once we account for the relationships between interest and exchange rates, we must first understand what the IS curve represents.
The IS curve illustrates the negative relationship between interest rates and the level of income that brings the goods market into equilibrium. When we factor in the effects of international trade and capital flows, this relationship is altered.
Higher interest rates in the domestic market typically attract foreign investors, leading to an appreciation of the domestic currency.
This makes domestic goods more expensive for foreign buyers and reduces exports, which causes the IS curve to steepen.
However, if foreign investors expect that the domestic currency will depreciate because of higher interest rates, they may be less enthusiastic about investing.
This diminished enthusiasm for foreign investment, as indicated in Step 4, leads to fewer capital inflows, less foreign demand for domestic currency, and therefore a weaker effect on exchange rates. As a result, the response of income to changes in interest rates becomes more sensitive, steepening the IS curve.
The steepening of the IS curve implies a higher responsiveness of income or output to changes in interest rates when exchange rate dynamics are considered. This contrasts with a situation where capital mobility and exchange rates are not considered, leading to a flatter IS curve.