Suppose a global shock temporarily reduces demand for U.S. exports. Use the IS-MP diagram to illustrate both what will happen to the IS-curve and how the Fed can stabilize the economy. Explain your reasoning.

 

what will happen to the IS-curve and how the Fed can stabilize the economy.

• Thus IS and MP curves should be in equilibrium in which IS and LM curve intersects and thus determines level of interest rate and Y level of output and thus if in case global demand shock reduces demand for U.S exports resulting to the reduces net exports of United states thus making Balance of Payments deficit in economy and as a result of this it shifts IS curve to left and therefore rate of interest will fall to r1 and output reduces to Y*
• Fed can stabilize the economy through implementing expansionary monetary policy which reduces interest rate and increase money supply in economy and thus resulting to increasing reserves of commercial banks which behave to reduce lending rate and thus encourages business firms to borrow large amount of loans which raises consumption and investment in economy.
• Also it increases aggregate demand for good and services in economy which helps to shifts both IS and MP curve rightward and keeps interest rate remain same as output increases to Y*