Greenspan's IS Curve

Question 1

What is the IS Curve? What causes shifts in IS Curves?

Answer 1

• IS Curve illustrates the inverse relationship between real IR and SR output
• AD Shocks can shift the IS curve

Question 2

How can the Fisher Equation help Central Banks deliver on their targets?

Answer 2

• In the SR, Real IR =/= MPk, due to prices and inflation being sticky
• Changes in the Nominal interest rate will therefore affect the real IR, meaning that the Central Bank can influence R by changing i
• BoE targets the bank rate, which is highly correlated with the ST nominal interest rates
• increasing i will increase r, detering investment and hindering SP Output

Question 3

What is the National Income Accounting Identity?

Answer 3

• Yt + IMt = Ct + It + Gt + EXt
• We know that all variables are a componant of Y given the AD formula, therefore: Ct = αcYt
• Therefore, It / Yt = αi - b(Rt - r)

Question 4

What is Potential Output?

Answer 4

• Potential Output= Maximum level of output when all resources are fully utilised
• Smoother than actual GDP as shocks do not affect potential
• Income shocks are smoothed in order to keep consumption steady

Question 5

What is the Marginal Product of Capital (MPk)? How does this relate to the Real IR?

Answer 5

• MPk: Amount of extra output can be returned by increasing k by one unit
• If r<R; Firms should save and this decreases investment
• If r>R; Firms should borrow and this increases investment

Question 6

How can you derive the IS curve?

Answer 6

• Dividing the national income accounting identity by potential output gives the weighting of each componant towards Yt
• If you then look at the output gap and subtract 1 from either side you get:
  Y^t = a - b(Rt-r)
• LR equilibrium means that Y^t = 0, a = 0, b = 0 and Rt=r

Question 7

How can the IS curve be interpreted?

Answer 7

• Investment = Savings
• (Y - T - C) + (T + G) + (IM - EX) = I
• Private savings + Government Savings + Foreign Savings = Investment

Question 8

What happens during a change in the IS curve?

Answer 8

• Increased R will increase the Cost of Borrowing, Decreasing the demand for investment and therefore reducing Yt until Yt < Potential. This causes a movement up the IS curve
• Increased Aggregate Demand will increase Business Confidence and drive up demand for capital. Investment will also rise and thus shifts the IS curve outward
• If Potential increases, then actual will too. However, this leaves the output gap and therefore the IS curve unchanged

Question 9

How do you know if changes in a particular variable are shift factors or movement factors?

Answer 9

• MOVEMENT: Chages in the rate
• SHIFT: Changes in other parameters

Question 10

What are the main theories of consumption behaviour?

Answer 10

• Consumption Smoothing: People smooth consumption over time
• Permenant Income Hypothesis: People base consumption on average of their income over time, not current income decisions
• Life Cycle Model: Consumption based on average lifeyime income, not on a given income

Question 11

Give an example as to why consumption behaviour patterns are believed

Answer 11

• In Alaska, consumption changes with unanticipated income shocks, but does not with anticipated oned
• LC/PIH applies to large and anticipated changes

Question 12

What are multiplier effects?

Answer 12

• If consumption depends on temporary income change, this implies that there is a multiplier effect
• Where Ct = αYt + xYtY^t

Question 13

How do multipliers impact the IS curve?

Answer 13

• The formula becomes: Y^t = [1 / (1-x)] (a - b(Rt-r))
• The multiplier 1/(1-x) >1 for all values of x
• This will make the IS Curve steeper
• AD rises, increasing a, Y^t and Ct. This effect then contintues

Question 14

How can a Government Use Fiscal Policy? Why might it be used?

Answer 14

• G accounts for ~20% of GDP
• Taxes and transfer payments can influence G, I, X, M and Y
• Fiscal Policy can provide or stabilise economic fluctuations

Question 15

What is Discretionary Government Spending?

Answer 15

• Government purchases of new goods/services
• Changes in the tax transfer policy such as VAT cuts or business exemptions

Question 16

What are Automatic Stabilisers?

Answer 16

• Transfer spending programs designed to ease the volatility of the economic cycle
• Universal Credit, JSA
• Increase G or B will lead to greater T in the LR
• Ricardian Equivolence; In the LR, all growth via FP is smoothed as greater G will eventually cause higher T. PV of lifetime income determines decisions

Question 17

What is the Neutral Rate of Interest (r*)?

Answer 17

• r* is the SR rate where Actual Output = Potential Output, making r* = r
• Tells the C.B. whether the current IR is stimulating or restraining the economy
• Cannot observe r* but it can be esitmated

Question 18

What is r* affected by?

Answer 18

• LR Output Growth: MPk is proportional to GDP growth. According to Solow Model, growth slows near the steady state- as exhibited by secular stagnation in OECD countries
• Demographics; Population ageing means that supply of savings during employment must be increased, decreasing r*
• Inequality; Greater inequality since 1980 increases risk for middle-class earners and therefore increases SoSavings, reducing r*
• Global Savings Glut; Ben Bernanke suggested that China flooded Capital Markets, increasing SoSavings and decreasing r*