1 - The Demand Side

Question 1

The IS Curve

Answer 1

The IS curve is a way of summarising diagrammatically the demand side relationship between output and the interest rate.
OUTPUT AND INTEREST RATE

Question 2

Why does the IS curve slope downwards

Answer 2

When the interest rate is high, so is the cost of credit and investment will therefore be low.
Low interest rates are associated with greater spending (higher investment/output)

Question 3

IS curve and an increase in autonomous consumption

Answer 3

Upwards shift

Question 4

IS curve and a decrease in the interest sensitivity of investment

Answer 4

The multiplier and interest sensitivity of investment affect the slope of the IS curve.
A rise in the Marginal Propensity to Consume (MPC) and the interest rate sensitivity of investment makes the IS curve flatter.

Question 5

IS curve and an increase in the marginal rate of taxation

Answer 5

K=1/(1-C1(1-t))

Increase in the multiplier makes the IS curve flatter.

Question 6

Keynesian Cross to show the effect of a decrease in autonomous investment on the economy

Answer 6

The decrease in autonomous investment shifts the IS curve downwards. Output now exceeds Aggregate Demand. Production therefore decreases, which lowers income. This decreases consumption which further reduced Aggregate Demand. Process continues until the new goods equilibrium is reached.

Question 7

Keynesian cross and the paradox of thrift

Answer 7

The paradox of thrift: if a policy that encourages savings in introduced, with the aim of boosting investment, this will be counteracted by the fact that consumption will fall.
-government spending and investment are autonomous, they are not influenced by saving.
C+S=1
An increase in the marginal propensity to save S implies a fall in the marginal propensity to consume C.
A rise in investment shifts the flatter IS curve upwards.

Question 8

Permanent Income Hypothesis (PIH)

Answer 8

Anticipated changes in income have no effect on consumption. Unanticipated changed in income should affect consumption. The magnitude depends if they are permanent or temporary. Temporary increases in income should have little effect on consumption, as their effect on lifetime wealth is small.

Question 9

PIH calculations

Answer 9

Lifetime wealth
(1+r)figure
Consumption
r/1+r * (1+r)figure

Discounted
1/1+r

Question 10

Under the PIH, households smooth their consumption.

Answer 10

The ability to borrow freely is a crucial assumption required by the PIH.

Question 11

PIH and Excess Sensitivity

Answer 11

Excess Sensitivity: means that consumption reacts more than predicted by the PIH after a change in income
Example: retirement
Observed when income falls, consumption falls.
-consumption was linked with being at work

Question 12

PIH and Excess Smoothness

-3 reasons why PIH fails

Answer 12

1. Credit Constraints
   Affects households with little wealth or collateral
   -banks prevent borrowing
2. Impatience
   Prevents some households from saving
3. Uncertainty about future income
   Explains precautionary saving over PIH level

Question 13

Tobin’s q

Answer 13

Tobin’s q theory of investment is forward looking: firms choose the amount of investment to undertake with a view of maximising the expected discounted profits over the lifetime of the project.

Question 14

When should a firm invest

Tobin’s q

Answer 14

A firm should invest when the marginal benefit of investment exceed marginal cost.
This happens when: price of output increases, marginal productivity of capital increases, reduction in the rate of interest and depreciation.

Question 15

What is the key problem with measuring marginal q

Answer 15

Marginal q is hard to measure as you cannot observe marginal product of capital.
Average Q can be used instead:
Q= Market value of firm
Replacement cost of capital