IS Curve Flashcards
Why does S=I?
Private savings (Y - T - C) + Government savings (T - G) + Foreign savings (IM - EX) = I. In a simple economy, Y - C = I
Why is there an inverse relationship between the interest rate and output?
When I/R increases, the rental rate of capital increases, it becomes more costly to borrow (I falls), more attractive it becomes to save money (C falls)
Why can MPK and r be different in the short run?
Installing new capital to equate the two takes time
In the long run what does It equal and why?
It = a̅iY̅t because profit maximisation & arbitrage causes MPK = r
IS Curve:
Ỹt = a̅ - b̅(Rt - r̅)
Ỹt =
(Yt / Y̅t) - 1
What is b̅ and how does it affect the IS curve?
Investment sensitivity parameter, higher - flatter, smaller - steeper
What kind of shock is a̅
X intercept shock, temporary, a̅ = 0 in L.R.
What kind of shock is MPK
Y intercept shock, an increase in r̅ increases the demand for investment and therefore increase output at any given level of R, therefore the IS curve shifts outwards.
What kind of shock is Y̅
Doesn’t affect IS as shocks to potential affect short run output the same
What is the permanent income hypothesis?
Theory of diminishing marginal utility implies preference of smooth consumption. Hypothesis concludes that people will base their consumption on an average of their income over time rather than on their current income.
What is the Life Cycle Model?
Suggests that consumption is based on average lifetime income rather than on income at any given age
How are PIH and LCM incorporated into the short run model?
C is proportionally to potential output rather than actual output
What is the basic conclusion of both the PIH and LCM?
People smooth their consumption relative to their income, so changes to short run output have little effect on C - small multiplier. People base their consumption on the constant income stream that has the same present discounted value as their actual income stream, aka permanent Income
Ct / Y̅t with the multiplier =
a̅c + x̅Ỹt
IS Curve with C multiplier:
Ỹ = (1/(1-x̅)) x a̅ - b̅(Rt - r̅)
What does the C multiplier imply?
When a boom occurs, consumption rises, by an amount dependant on parameter 1 > x̅ > 0 / Increase in R leads to a decrease in investment which may cost some workers jobs. These workers then reduce their consumption. These firms then lose revenue and their workers have to reduce consumption etc. Vicious or virtuous cycles - a shock to one part of the economy can multiply to create larger effects
What are discretionary policies?
Purchases affecting a̅g, tax cuts, tax credits, transfer spending
What are automatic stabilisers?
Transfers (unemployment, medicare) that automatically adjust to the phase of the business cycle
Is the majority of government policy discretionary or automatic?
The majority of changes in fiscal policy are due to stabilisers, not discretionary policies
What are the policy considerations for government purchases?
- Timing - by the time the policy is in place, the shock it was designed to mitigate may have passed.
- No Free Lunch Principle - Higher spending today must be paid for if not today then at some point in the future.
- Focused demand on particular industry (building) from stimulus measures can affect relative prices and cause inflation
What is the Ricardian Equivalence?
The notion that what matters for consumption is the present value of what the government takes from consumers rather than the specific timing of taxes
What does the Ricardian Equivalence imply about tax cuts?
Tax cuts don’t increase C if people smooth because they know they’ll only have to pay it back in higher taxes later
Why might the Ricardian Equivalence not hold?
Not everyone is that rational/patient. If borrowing constraints exist than consumers are not going to be perfect consumption smoothers.
