11 The IS Curve

Question 1

What is the basic relationship between the interest rate and investment and output? Why?

Answer 1

↑ Interest rate ⇒ ↓ investment ⇒ ↓ output

Rise in interest rates raises the cost of borrowing so firms are less willing to invest and consumers reduce borrowing for housing, decreasing both investment and consumption, reducing output.

Question 2

Plot the IS curve.

What are the axes?

Answer 2

Y: interest rate

X: short-run output gap

Question 3

What equations do we use for each element of output?

Answer 3

Question 4

Assumption of the IS curve model

Answer 4

That Y (bar) is constant, determined by the long-run model. It is potential output.

That r (bar) is constant, also determined by the long-run.

Question 5

How do we view investment in the short-run?

Answer 5

Question 6

What is (R_t - r) and how is this different from the long-run?

Answer 6

The difference between the interest rate and the marginal product of capital. In the long run, they are equal.

Question 7

5 steps in deriving the IS curve

Answer 7

Question 8

What is the default for a (bar)? How could we illustrate a demand shock?

Answer 8

As all the share parameters must add up to 1. In the long run, we assume a (bar) = 0.

Aggregate demand shock: a sudden push away a (bar) = 0.

Question 9

Default position on the IS curve

Answer 9

Question 10

Increase in the real interest rate on the IS curve

Answer 10

Question 11

What happens if a (bar) increases?

+ diagram

Answer 11

A positive aggregate demand shock.

Question 12

What causes movements along and movements of the curve?

Answer 12

Movements along: change in R

Movements of: change in any other parameter

Question 13

How do shocks to potential output impact short-run output? Why?

Answer 13

Question 14

What is observed about consumptions when there are changes to interest rates?

Answer 14

People seem to prefer a smooth path of consumption to large movements. This is the application of diminishing marginal utility.

Question 15

Define permanent-income hypothesis

Answer 15

It applies diminishing marginal utility to conclude that people will base their consumption on an average of their income over time, rather than their current income.

Question 16

Define life-cycle model of consumption

Answer 16

Applies the permanent-income reasoning to a person’s whole lifetime.

Question 17

How do we modify the consumption equation for the multiplier?

Answer 17

Question 18

Equation for short-run output involving the multiplier

Answer 18

Question 19

What does the multiplier mean?

Answer 19

Aggregate demand shocks have a greater or smaller impact on short-run output as determined by the multiplier.

Question 20

What is the economic intuition behind the multiplier?

Question 21

What are the two main determinants of investment for firms?

Answer 21

1. The difference between the real interest rate and MPK
2. A firm’s cash flow

Question 22

Define cash flow

Answer 22

The amount of internal resources the company has on hand after paying its expenses.

Question 23

When do agency problems occur?

Answer 23

When one party in a transaction holds information that the other party does not.

Question 24

What is adverse selection?

Answer 24

When buyers or sellers are able to use their private knowledge of risk factors involved in a transactions to maximise their outcomes, at the expense of other parties.

Question 25

What is moral hazard?

Answer 25

When borrowing money incentivises riskier behaviour of the firm.

Question 26

How do we write the investment equation to incorporate cash flow?

Answer 26

Question 27

How might a government use discretionary fiscal policy tools to counter aggregate demand shocks?

Answer 27

Question 28

How else might a government counter aggregate demand shocks?

Answer 28

Using automatic stabilisers such as transfer payments.

Question 29

What are two considerations that must be made about fiscal policy?

Answer 29

Timing: Legislation must be drafted and enacted. Despite payments can be made, their effect will experience a time lag.

The no-free-lunch principle: If the government increases spending now, it will have to decrease it later.

Question 30

What is Ricardian equivalence?

Answer 30

What matters for consumption is the present value of what the government takes from consumers rather than the specific timing of the taxes.