By effectively setting the rate at which people borrow and lend in financial markets, the Fed exerts...
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By effectively setting the rate at which people borrow and lend in financial markets, the Fed exerts a substantial influence on the level of economic activity
By effectively setting the rate at which people borrow and lend
in financial markets, the Fed exerts a substantial influence on the
level of economic activity in the short run The IS curve captures
the relationship between real interest rates and output in the
short run An increase in the interest rate will decrease
investment, which will decrease output: Y = C + I + G + NX The
decrease in output is normally a multiple of the decrease in
investment I down Y down C down Y and C down yet more In Jones
freshwater world, however, C depends on permanent income and doesnt
respond to changes in short-run output and income Changes in I do
not lead in multiplicative changes in Y The IS Curve shows activity
decreasing when interest rates rise and investment spending
declines
Slide 2
CHAPTER 10 The IS Curve
Slide 3
The national income accounting identity implies that the total
resources available to the economy (domestic production, Y, plus
imports, IM) equal total uses (consumption, C, investment, I,
government purchases, G, and exports, EX) The national income
identity is one equation with six unknowns: Y t = C t + I t + G t +
EX t - IM t Thus we need five additional equations to solve the
model consumption, government purchases, exports, and imports each
depend on the economys potential output which is given exogenously
each of these components of GDP is a constant fraction of potential
output where the fraction is a parameter
Slide 4
The Investment Equation The equation includes one term
accounting for the share of potential output that goes to
investment, parameter a i bar It also includes a term weighting the
difference between the real interest rate R t, and the marginal
product of capital, r bar the MPK, r bar, is an exogenous parameter
and is time invariant When the MPK is low relative to the real
interest rate, firms should save their money However, if the MPK is
high relative to the real interest rate, firms should borrow and
invest in capital The sensitivity to the changes in the interest
rate is denoted by parameter b bar in the short-run, the MPK and
the real interest rate can be different because installing new
capital to equate the two takes time For now we take the real
interest rate, R, as given
Slide 5
Slide 6
1. divide the national income accounting identity by potential
output: 2. substitute the five equations into this equation:
Deriving the IS Curve
Slide 7
3. recalling the definition of short-run output, this
simplifies to the equation for the IS curve:
Slide 8
The gap between the real interest rate and the MPK matters for
output fluctuations firms can always earn the MPK on new
investments note as well that the parameter will equal zero when
potential output is equal to actual output the parameter is the sum
of the aggregate demand parameters for consumption, investment,
government purchases, exports and imports minus one and is thus
called the aggregate demand shock
Slide 9
when the aggregate demand shock parameter equals zero, the IS
curve has a short-run output of 0 where the real interest rate is
equal to the long-run value of the MPK when the real interest rate
changes, the economy will move along the IS curve an increase in
the interest rate causes the economy to move up the IS curve and
short-run output will decline the higher interest rate raises
borrowing costs, reduces demand for investment, and reduces output
if the sensitivity to the interest rate were higher, the IS curve
would be flatter and a given change in the interest rate would be
associated with larger changes in output the higher interest rate
raises borrowing costs, reduces demand for investment, and
therefore reduces output below potential
Slide 10
an increase in the interest rate causes the economy to move up
the IS curve and short- run output will decline the higher interest
rate raises borrowing costs, reduces demand for investment, and
reduces output if the sensitivity to the interest rate were higher,
the IS curve would be flatter and a given change in the interest
rate would be associated with larger changes in output the higher
interest rate raises borrowing costs, reduces demand for
investment, and therefore reduces output below potential when the
aggregate demand shock parameter equals zero, the IS curve has a
short-run output of 0 where the real interest rate is equal to the
long-run value of the MPK when the real interest rate changes, the
economy will move along the IS curve
Slide 11
Slide 12
An Aggregate Demand Shock suppose that information technology
improvements create an investment boom: the aggregate demand shock
parameter will increase output is higher at every interest rate and
the IS curve shifts right for any given real interest rate R t,
output is higher when increases
Slide 13
Slide 14
A Shock to Potential Output short-run output is unaffected by a
change in potential output shocks to potential output change actual
output by the same amount in our setup however, some shocks to
potential output, such as an earthquake, may change other
parameters in addition to potential output the earthquake example
reduces actual and potential output by the same amount, but leads
to an increase in short-run output because it also increases the
MPK Other Experiments imagine that Japan enters into a recession
and reduces her imports This, of course, is contrary to Jones
assertion that (Japans) a im bar is a parameter but it makes more
sense than assuming Japans imports are insensitive to her short-run
output and income the aggregate demand parameter for our exports, a
ex bar, declines and our IS curve shifts to the left thus the
Japanese recession has an international effect we could shock any
of the other aggregate demand parameters that are a part of a
bar
Slide 15
Microfoundations of the IS Curve Consumption people seem to
prefer a smooth path for consumption to a path that involves large
fluctuations in consumptions the permanent-income hypothesis
concludes that people base their consumption on an average of their
income over time rather than on their current income the life-cycle
model of consumption suggests that consumption is based on average
lifetime income rather than on income at any given when young,
people borrow to consume more than their income as income rises
over a persons life, consumption rises more slowly and individuals
save more during retirement, individuals live off their accumulated
savings the life-cycle/permanent-income (LC/PI) hypothesis implies
that people smooth their consumption relative to their income this
is why Jones sets consumption proportional to potential output
rather than actual output a strict version of the LC/PI hypothesis
implies that predictable movements in potential output should also
be smoothed
Slide 16
CHAPTER 10 The IS Curve the life-cycle model of consumption:
when young, people borrow to consume more than their income as
income rises over a persons life, consumption rises more slowly and
individuals save more during retirement, individuals live off their
accumulated savings
Slide 17
Slide 18
Multiplier Effects we can modify the consumption equation to
include a term that is proportional to short-run output: solving
for the IS curve yields an equation that is similar to the previous
result, but that now includes a multiplier on the aggregate demand
shock and interest rate terms: the multiplier is larger than one
aggregate demand shocks will increase short-run output by more than
one-for-one in the presence of the multiplier if one section of the
economy is shocked, it will multiply through the economy and will
result in a larger effectif short-run output falls, consumption
falls, which leads to short-run output falling and consumption
falls again in a vicious circle
Slide 19
Investment at the firm level, the gap between the real interest
rate and the MPK determines investment in a simple model, the
return on capital is the MPK minus depreciation a richer framework
includes corporate income taxes, investment tax credits, and
depreciation allowances
Slide 20
a second determinant of investment is the firms cash flow,
which is the amount of internal resources the company has on hand
after paying its expenses it is more expensive to borrow to finance
investment because of agency problems agency problems are when one
party in a transaction has more information than the other
party
Slide 21
adverse selection is the idea that if a firm knows it is
particularly vulnerable, it will want to borrow because if the firm
does well it can pay back the loans. If it fails, the firm cannot
pay back the loan but will instead declare bankruptcy moral hazard
is the idea that a firm that borrows a large sum of money may
undertake riskier investments because if it does well, it can
repay, while if it fails it can declare bankruptcy
Slide 22
the potential output term in the investment equation
incorporates cash flows to a degree cash ow effect can be seen in
the presence of potential output if we wish to add short-run
output, it would provide additional justification for a
multiplier
Slide 23
Government Purchases government purchases can be a source of
short-run fluctuation or an instrument to reduce fluctuations
discretionary fiscal policy includes purchases of additional goods
in addition to the use of tax rates for example, the government can
use the investment tax credit to encourage investment today rather
than later
Slide 24
transfer spending often increases when an economy enters into a
recession automatic stabilizers are programs where additional
spending occurs automatically to help stabilize the economy welfare
programs and Medicaid are two such stabilizer programs that receive
additional funding when the economy weakens
Slide 25
fiscal policys impact depends on two things: 1. The problem of
timing may make it such that discretionary changes are often put
into place with significant delay. 2. The no-free-lunch principle
implies that higher spending today must be paid for, if not today,
some point in the future. Such taxes may offset the impact of the
discretionary spending adjustment.
Slide 26
CHAPTER 10 The IS Curve the permanent-income hypothesis says
that what matters for consumption today is the present discounted
value of your lifetime income, after taxes Ricardian equivalence is
the idea that what matters for consumption is the present value of
what the government takes from the consumers rather than the
specific timing of the taxes
Slide 27
CHAPTER 10 The IS Curve an increase in government purchases
financed by an increase of taxes of the same amount will have a
modest positive impact on the IS curve and will raise output by a
small amount in the short-run an increase in spending today
financed by an unspecified change in taxes and/or spending at some
future date will shift the IS curve out by a moderate amount
perhaps as much as 25 to 50 cents for each dollar
Slide 28
Net Exports the trade balance is the main way that foreign
economies influence the U.S. economy in the short-run if the trade
balance is in surplus, the economy exports more than it imports if
the trade balance is a deficit, the economy imports more than it
exports an increase in the demand of U.S. goods in foreign
countries stimulates the U.S. economy by an outward shift of the IS
curve if Americans shift their demands to imports, the IS curve
shifts left and reduces short-run output
Slide 29
CHAPTER 10 The IS Curve 10.6 Conclusion higher interest rates
raise the cost of borrowing to firms and households and thus reduce
the demand for investment spending lowering short-run output
Slide 30
CHAPTER 10 The IS Curve Summary 1. The IS curve describes how
output in the short run depends on the real interest rate and on
shocks to the aggregate economy. 2. When the real interest rate
rises, the cost of borrowing faced by firms and households
increases, leading them to delay their purchases of new equipment,
factories, and housing. These delays reduce the level of
investment, which in turn lowers output below potential. Therefore,
the IS curve shows a negative relationship between output and the
real interest rate.
Slide 31
CHAPTER 10 The IS Curve 3. Shocks to aggregate demand can shift
the IS curve. These shocks include (a) changes in consumption
relative to potential output, (b) technological improvements that
stimulate investment demand given the current interest rate, (c)
changes in government purchases relative to potential output, and
(d) interactions between the domestic and foreign economies that
affect exports and imports. 4. The life-cycle/permanent-income
hypothesis says that individual consumption depends on average
income over time rather than current income. This serves as the
underlying justification for why we assume consumption depends on
potential output.
Slide 32
CHAPTER 10 The IS Curve 5. The permanent-income theory does not
seem to hold exactly, however, and consumption responds to
temporary movements in income as well. When we include this effect
in our IS curve, a multiplier term appears. That is, a shock that
reduces the aggregate demand parameter by 1 percentage point may
have an even larger effect on short-run output because the initial
reduction in output causes consumption to fall, which further
reduces output.
Slide 33
CHAPTER 10 The IS Curve 6. A consideration of the
microfoundations of the equations that underlie the IS curve
reveals important subtleties. The most important are associated
with the no-free-lunch principle imposed by the governments budget
constraint. The direct effect of changes in government purchases is
to change. However, depending on how these purchases are financed,
they can also affect consumption and investment, partially
mitigating the effects of fiscal policy on short-run output