Answer to Question #225817 in Macroeconomics for Deema

Question

5. It is possible that the interest rate might affect consumption spending. An increase in the in-

terest rate could, in principle, lead to increases in saving and therefore a reduction in con-

sumption, given the level of income. Suppose that consumption is, in fact, reduced by an 

increase in the interest rate. How will the IS curve be affected?

Answer 1

 Increase in the interest rate makes people save more and consume less as aggregate demand for goods and services falls. In such a situation if output remains at the original level, then this will cause an excess supply of goods and services. So, for the goods market to reach equilibrium, total output has to fall. If this happens then we will move to a point on the is curve with a higher interest rate and lower output. So, the is curve will remain at its original position and there will only be a movement along the curve.