Lecture 2: Economy in the short-term/Consumption Theory and IS-Curve

Question 1

What is excluded from the Government component in GDP?

Answer 1

Government transfers (e.g. unemployment benefits)

Question 2

What is Keynes’ consumption function based on?

Answer 2

Consumption depends only on current income.

Question 3

What are the criticisms of Keynes’ consumption function?

Answer 3

Not micro-founded

Ignores life-cycle income changes

No future income expectations

Omits saving/borrowing options and interest rates

Ignores wealth

Question 4

What is the Permanent Income Hypothesis (PIH)?

Answer 4

Households base consumption on expected lifetime income, not just current income.

Question 5

What is disposable income (YD)?

Answer 5

YD = Y - T, where T = Taxes - Government Transfers

Question 6

What does the linear consumption function look like?

Answer 6

C(YD) = C₀ + C₁YD
C₀: Consumption with zero income
C₁: Marginal propensity to consume

Question 7

What is the impact of a lower C₀ in the consumption function?

Answer 7

Shifts the entire consumption function downward.

Question 8

How does interest rate affect consumption (Income Effect)?

Answer 8

For savers: ↑ Interest ⇒ ↑ Future income ⇒ ↑ Current & future consumption

For borrowers: ↑ Interest ⇒ ↓ Income ⇒ ↓ Consumption

Question 9

How does interest rate affect consumption (Substitution Effect)?

Answer 9

Consumption today becomes more expensive

↓ Current consumption, ↑ Future consumption

Question 10

What are the two effects of interest rate changes on consumption?

Answer 10

Income effect and substitution effect

Question 11

Why are private investments important?

Answer 11

Explain GDP fluctuations

Increase productive capital ⇒ Economic growth

Question 12

What two factors determine investment levels?

Answer 12

Interest rate (affects project profitability)

Production level (need for more machines)

Question 13

What is the mathematical form of investment?

Answer 13

I = I(Y, i)
Depends on income (Y) and interest rate (i)

Question 14

What are exogenous and endogenous variables?

Answer 14

Exogenous: Not explained by the model

Endogenous: Determined within the model

Question 15

How does the government influence GDP?

Answer 15

Through taxes (T), transfers, and spending (G)

Fiscal policy includes choices on G and T

Question 16

What is the condition for goods market equilibrium?

Answer 16

Y (production) = Z (demand)

Question 17

What does the IS curve represent?

Answer 17

Equilibrium in the goods market showing the relationship between interest rate and output

Question 18

Why does the IS curve slope downward?

Answer 18

Higher interest rates ⇒ Lower investment ⇒ Lower output (Y)

Question 19

What is the savings identity used in IS curve derivation?

Answer 19

S = Y - T - C

Y = C + I + G

Equilibrium: I = S (private + government savings)

Question 20

What causes movement along the IS curve?

Answer 20

Change in interest rate ⇒ Endogenous change in output

Question 21

What causes the IS curve to shift?

Answer 21

Change in demand at a given interest rate (e.g., ↑ G shifts IS right)

Question 22

What is autonomous consumption?

Answer 22

Spending when income is zero (C₀ in the function C = a + bY)

Question 23

How does the Permanent Income Hypothesis explain stable consumption?

Answer 23

Households smooth consumption based on expected lifetime income

Question 24

Why is a dollar received in the future worth less today?

Answer 24

Due to the opportunity cost of capital and the time value of money.

Question 25

What is the formula for the present value of $1 received one year from now at interest rate i?

Answer 25

1/(1+i)

Question 26

How do higher interest rates affect present value?

Answer 26

They reduce present value by increasing discounting.

Question 27

What is the present value of constant payments 𝑧 forever at constant interest rate 𝑖?

Answer 27

z/i

Question 28

What happens to present value when the interest rate is 0?

Answer 28

Present value becomes the simple sum of expected future payments.

Question 29

What is the difference between nominal and real interest rates?

Answer 29

Nominal rates are in dollar terms; real rates are adjusted for inflation.

Question 30

How can you compute real present value?

Answer 30

Either discount real payments using real interest rates, or nominal payments using nominal rates and divide by today's price level.

Question 31

What are the two basic dimensions of a bond?

Answer 31

Maturity and risk.

Question 32

What determines the price of a bond?

Answer 32

The present value of its future payments.

Question 33

What is a discount bond?

Answer 33

A bond that pays only at maturity.

Question 34

What is a coupon bond?

Answer 34

A bond that makes regular payments (coupons) and a final payment at maturity.

Question 35

Define the coupon rate and current yield.

Answer 35

Coupon rate = Coupons / Face value; Current yield = Coupons / Price

Question 36

What is the yield to maturity?

Answer 36

The average interest rate paid by the bond over its life that equates price to present value of payments.

Question 37

What is the yield curve?

Answer 37

A graph showing yields on bonds of different maturities at a point in time.

Question 38

What does an upward-sloping yield curve imply?

Answer 38

Investors expect future short-term rates to rise; indicates economic growth.

Question 39

What does a downward-sloping (inverted) yield curve signal?

Answer 39

Expected economic slowdown or recession.

Question 40

What is the expectations hypothesis?

Answer 40

Investors base bond purchases on expected returns, assuming they care only about expected value and not risk.

Question 41

What is the term premium?

Answer 41

Extra return investors require for holding long-term bonds due to added risk.

Question 42

How do you approximate the yield on a two-year bond?

Answer 42

Average of current and expected one-year interest rates (plus a risk premium).

Question 43

What is a risk premium?

Answer 43

The difference between a bond's interest rate and that of the safest bond (usually Aaa-rated).

Question 44

What are indexed bonds?

Answer 44

Bonds that adjust payments based on inflation, protecting against inflation risk (e.g., TIPS in the U.S.).

Question 45

How are bonds rated?

Answer 45

Bonds are rated for their default risk (the risk that they will not be repaid) by rating agencies. Bond ratings range from Aaa for bonds with nearly no risk of default, to C for bonds where the default risk is high. Bonds with high default risk are sometimes called junk bonds.

Question 46

What are coupon bonds?

Answer 46

Bonds that promise multiple payments before maturity and one payment at maturity are called coupon bonds. ○ Coupon payments The payments before maturity are called coupon payments. The final payment is called the face value of the bond. ○ Coupon rates The ratio of coupon payments to the face value is called the coupon rate. ○ Current yield The ratio of the coupon payment to the price of the bond.