Chapter 9 - IS-IC Model Flashcards
What does the IS curve show?
The equilibrium in the goods market, where planned expenditure = output
What does the IC curve show?
The long-term interest rate
What is aggregate expenditure?
The sum of all demand
What is the sum of all production?
Output
What is the equation for planned expenditure?
E = C + I + G + EX + IM
What is the model of the goods market based on?
Planned aggregate expenditure with actual level of output
What is an ex ante comparison?
The comparison of planned expenditure and what firms want to produce
What is an ex post comparison?
The comparison of actual expenditure and output
What is the ex-post equation?
Y = E + unplanned inventory investment
What is the ex post output equal to? Why does the ex post equation include unplanned inventory investment?
Ex-post output = E (expenditure)
Y = E + unplanned inventory is due to any difference ex ante is unplanned
What is the goods market equilibrium?
Where ex ante planned expenditure = output and no unplanned inventory investment
What are the components of planned expenditure?
Consumption, investment, government purchases, and exports - imports
What are the 3 types of investment?
Building/machines/equipment, inventory investment, and residential housing
What does investment depend on?
r - the real interest rate
What does consumption depend on and what is the consumption linear relationship equation?
Consumption depends on disposable income (income net of taxes)
C = a + MPC (Y-T)
Where T = tax rate
Y = income
What is the investment equation and the linear investment equation?
I = I (r)
Linear: I = I0 - k * r
Where k = sensitivity of investment to real interest rate
What is the linear equation for net exports?
NX = NX0 + x(Y-T)* - (n)(r) - MPI (1-t)Y
Where * = foreign values and MPI = marginal propensity to import (increase in Canadian imports for a unit increase in disposable income)
What is the equation for taxes?
T = t (Y - Y0)
Where Y0 = tax free amount
Income above Y0 taxes at constant rate of t
What is the slope of the consumption function?
MPC (1 - t)
What happens to expenditure as the real interest rate increases?
Expenditure declines because investment and net exports fall
Why do net exports fall when the real interest rate rises?
Higher real exchange rate due to higher interest, increasing relative price of exports and reducing relative price of imports
What is the effect of higher disposable income on planned expenditure?
Raises consumption and imports - imports rise due to additional consumption spent on imported goods/services
If MPC > MPI, what does this suggest happened to disposable income?
Suggests that disposable income increased
What is the linear equation for expenditure?
E = A + (MPC - MPI) (1-t) Y - (k+n) r + G + x (Y-T)*
Where:
Constant term: A = a + I0 + NX0
Term depending on after tax income: (MPC-MPI)(Y-T)
Term depending on real interest rate: - (k + n) r
Term depending on foreign disposable income x(Y-T)
Lmfao like I’m memorizing this, byeeeee
What is the slope of E for the linear version?
MPC-MPI
In the linear equation for expenditure, what does the constant term depend on?
(says in textbook to remember this)
The tax rate, t
As real interest increases, what happens to investment and net exports?
Investment and net exports fall
As foreign income increases, exports:
Increase
What does the IS model show?
All combinations of output and the real interest rate such that the goods market is in equilibrium where planned expenditure = actual output
What way does the IS curve slope?
Down
What happens along the IS curve?
Goods market is in equilibrium where E = Y
What happens to the right (above) the IS curve?
There is an excess supply of goods where E < Y
What happens to the left (below) the IS curve?
There is excess demand for goods where E > Y
When does the IS curve shift right?
When expenditure increases (any change in variables affecting expenditure)
When does the IS curve shift left?
When expenditure decreases (any change in variables affecting expenditure)
As you move vertically down below the IS curve, what happens to expenditure and output? Why?
Expenditure is higher and output doesn’t change because the real interest rate is lower, meaning higher investment and net exports
As you move horizontally to the right of the IS curve, what happens to expenditure, income, and output? What increases more? What does this mean about the real interest rate?
Output increases, as does expenditure since consumption rises by MPC and imports rise by MPI. Expenditure = MPC - MPI, therefore expenditure increases by less than 1. Thus income increases more than expenditure. Real interest rate stays the same.
What factors related to macroeconomic policy would shift the IS curve to the right?
Taxes, expected taxes, and government purchases
What factors unrelated to macroeconomic policy would shift the IS curve to the right?
Consumption, investment, net exports
How can taxes affect the IS curve?
If taxes are lower, disposable income is higher, increasing consumption/imports - effect on consumption is stronger, so shift IS curve right
How can expected taxes affect the IS curve?
Lower expectations = higher current expenditure, shifting IS curve right
How can government purchases affect the IS curve?
Higher government purchases = higher expenditure, shifting the IS curve right
How can consumption affect the IS curve?
If expected future income rises or expected/current future wealth increases, IS will shift right
How can investment affect the IS curve?
Expected real interest rate fall, expected productivity of investment increases, or expectations about future state of economy improve
How can net exports affect the IS curve?
Foreign disposable income increases, foreign real interest increases causing dollar to depreciate, expected future income falls, and current/expected future wealth falls
What is the term structure of interest rates?
The relationship between term (length of loan) to maturity and interest rate
What happens if you move up and to the left along the IS curve?
With lower level of income, higher level of the real interest rate is needed for goods market equilibrium
What are the two characteristics of a bond?
Interest rate and term to maturity
Are bonds transferrable? What happens when a bond is defaulted?
Yes they are transferrable. When defaulted, the current owner loses the money.
What is the difference between a bond when it is announced vs a bond when issued?
The face value and interest rate become irrelevant when the bond is issued
Bond prices and interest rates are:
inversely related (when bond price is higher, interest is lower; when bond price is lower, interest is higher)
Assume a bond that never matures (consol) has a face value of $100, with a 5% interest rate (pays $5 a year forever).
If you buy it for $125, what is the interest rate now?
Assume the interest is 10%, how much would you pay for it then?
If you buy it for $125, the interest is 5/125 = 4%
If you buy it with 10% interest, the price would be the amount it would take to earn $5 when at 10% = 5 * .1 = $50
What is the expectations theory?
Says that a long term rate is the average of expected short term rates assuming bond buyers are indifferent to risk and the term of the loan
What is return risk?
Long-term bonds are riskier than short term bonds
What is default risk?
Risk of defaulting is higher when the term of a bond is longer
What is liquidity in terms of bonds? What is liquidity premium?
Refers to the ease that bonds of various maturities can be sold. Liquidity premium refers to bond buyers accepting lower rates on short term bonds rather than on long term bonds, because short term are more liquid.
What does term structure depend on?
The expectations of interest rates in the future
Why did interest rates fall so much for Greek government bonds in 2020?
In 2012, Greek government has very high risk to not pay back lenders due to economic crisis, so to compensate for the risk interest was 18%. By 2020 when crisis ended, Greek bonds were less risky, so the interest fell to 1.7%.
What occurs in the reversal of term structure?
The longer the term, the higher the interest rates, except for in very high maturity of 20+ years, which then sees the interest start to fall again.
What direction (slope) is the IC curve?
Horizontal
Where is the IC curve located?
At the real interest rate the Bank of Canada targets
What reasons shift the IC curve?
Monetary policy and credit market behaviour
What monetary policies will shift IC and how?
Expansionary shifts IC down, contractionary shifts IC up
When would the credit market shift the IC up?
When expectations of future interest rates increase, interest rates become less stable and return risk premium increases, default risk increases, volume of long-term bond market falls and liquidity premium rises, and expected rate of inflation falls
What is equilibrium in the IS IC model? Where is unemployment?
Where the IS and IC curves intersect, related to potential output produced when economy fully uses production capacity. Unemployment is at the natural rate.
What is the natural rate of unemployment and the spare capacity rate in the IS-IC model?
Unemployment: 6-7%
Capacity: 12-14%
What changes would occur in expected disposable income and future wealth that would cause the IS curve to shift left?
Disposable income falls and current/expected future wealth falls
(reduce level of income = IS shifts left)
What changes would occur in the real interest rate and expected productivity that would cause the IS curve to shift left?
Expected real interest increases, and expected productivity of investment falls
(reduce level of income = IS shifts left)
What changes would occur in the expectations about the economy, foreign disposable income, and foreign real interest rates that would cause the IS curve to shift left?
Expectations worsen, foreign disposable income falls, foreign real interest rates fall
(reduce level of income = IS shifts left)
Is shifting the IS curve left good or bad for economy? Why?
Bad, want to shift it back to the right because left = high unemployment, low capacity utilization, and falling inflation
How can the IS curve be shifted to the right using fiscal policy?
Increase of government spending or increase in taxes shift the IS curve right and raise level of income
Besides monetary policy, what causes long-term real interest rates to rise?
Expectations of future interest rates increase, return risk premium increases, default risk increases, liquidity premium increases, and expected rate of inflation falls
What causes the IC curve to shift up?
Factors other than monetary policy + increased interest rate due to monetary policy
How could the central bank offset changes in the IC curve shifting up?
Lower the short-term nominal interest rate to shift it back down
What model is used to derive the IS curve?
Keynesian
Can nominal interest rates on long-term bonds be negative?
Yes
What way did the IS curve shift during the Great Recession? Explain
Shifted left - occurs when expenditure falls; housing market crashes, expected/current future wealth fell, expectations of economy and productivity fell, US dollar appreciated as institutions switched to short-term bonds, reducing US net exports
