Lecture 4 - The IS Curve Flashcards
(20 cards)
What is the IS curve?
Shows the inverse relationship between real interest rates (R) and short-run output (Ŷ). Formula: Ŷ = ā - b̄(R - r̄), where ā = aggregate demand shock, b̄ = investment sensitivity, r̄ = MPK.
What drives movement ALONG the IS curve?
Changes in the real interest rate (R). Higher R → lower investment → lower output (move up curve). Lower R → opposite effect.
What causes SHIFTS in the IS curve?
Aggregate demand shocks (changes in ā): e.g., tech optimism (↑I), fiscal policy (↑G), or consumption changes (↑C).
What is the marginal product of capital (MPK)?
Additional output from an extra unit of capital. In long run, MPK = real interest rate (r̄). Short-run deviations drive investment changes.
What is the permanent-income hypothesis (PIH)?
Consumers base spending on lifetime average income, not current income. Explains smooth consumption despite temporary shocks.
What is the life-cycle model of consumption?
People borrow/save to smooth consumption over their lifetime (e.g., dissaving in retirement, saving during peak earnings).
How does the multiplier effect modify the IS curve?
Ŷ = (1/(1-x̄)) × (ā - b̄(R - r̄)). Amplifies shocks because ↑income → ↑consumption → further ↑income (x̄ = marginal propensity to consume).
What is Ricardian equivalence?
Theory that tax cuts financed by future tax hikes don’t boost demand (consumers save extra income to pay future taxes).
What is the neutral rate of interest (r*)?
Real interest rate where output = potential output (Ŷ = 0). Central banks compare policy rates to r* to assess stimulus/restraint.
What factors reduce the neutral rate (r*)?
- Slower growth (↓MPK) 2. Aging populations (↑savings) 3. Inequality (↑precautionary savings) 4. Global savings glut.
How does fiscal policy affect the IS curve?
↑G or tax cuts shift IS right (↑ā). Automatic stabilizers (e.g., unemployment benefits) dampen fluctuations without legislative action.
Why is investment key in the IS model?
Most interest-sensitive component of GDP. I = āiȲ - b̄(R - r̄)Ȳ. Higher R raises borrowing costs, reducing I and output.
What is an aggregate demand shock?
Changes in C, I, G, or NX at given R. Examples: AI boom (↑I), recession abroad (↓EX), or housing crash (↓C).
How do sticky prices relate to the IS curve?
Allow short-run R ≠ MPK. Central banks adjust nominal rates (i) to influence real rates (R ≈ i - π), impacting output.
What happens if potential output (Ȳ) increases?
No IS shift (Ŷ = (Y - Ȳ)/Ȳ remains 0 if Y and Ȳ rise equally). Long-run growth but no short-run fluctuation.
What empirical evidence supports PIH?
Alaska study: Anticipated oil revenue (Permanent Fund) didn’t change consumption, but unanticipated tax refunds did (spent ~30%).
How does the IS curve handle imports/exports?
Included in ā = āc + āi + āg + (āex - āim) - 1. Trade deficits (āim > āex) reduce ā, shifting IS left.
What is the difference between IS and LM curves?
IS: Links R and Ŷ via investment. LM: Links R and Ŷ via money demand/supply. Together they determine equilibrium (IS-LM model).
Why might the IS curve be flat?
If investment is insensitive to R (b̄ ≈ 0), Ŷ ≈ ā. Fiscal policy becomes more effective than monetary policy.
How did the 2008 financial crisis illustrate IS mechanics?
Fed cut rates to 0% to boost I, but weak ā (housing crash) kept ŷ negative. Multipliers amplified the shock’s persistence.
