Suppose that American firms become more optimistic and decide to increase invest

Question

Suppose that American firms become more optimistic and decide to increase investment expenditure today in new factories and office space. Based on the results from an IS- LM-FX model, state the effect of this shock on the following variables (increase, decrease, no change, or ambiguous): real output (Y), nominal interest rate (i), exchange rate (E), consumption (C), investment (I), and the trade balance (TB). Please display the results in an attractive, well-documented table in an MS- Word document.

Explanation / Answer

Higher current investment by firms will increase real output. Higher investment demand will shift the IS curve rightward, which will raise the nominal interest rate. Also, higher real output (higher growth) will raise aggregate demand faster than aggregate supply, necessitating higher imports. As imports rise, demand for foreign currency rises and demand for domestic currency falls, leading to appreciation of foreign currency and depreciation of domestic currency, therefore exchange rate (in terms of foreign currency per unit of domestic currency) rises.

Higher aggregate demand will raise consumption and investment demand too. Finally, as imports rise, trade balance (= Exports - Imports) falls.

Summarized below:

VARIABLE EFFECT Y Increase i Increase E Increase C Increase I Increase TB Decrease

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