IS Curve Flashcards
Why does S=I?
Private savings (Y - T - C) + Government savings (T - G) + Foreign savings (IM - EX) = I. In a simple economy, Y - C = I
Why is there an inverse relationship between the interest rate and output?
When I/R increases, the rental rate of capital increases, it becomes more costly to borrow (I falls), more attractive it becomes to save money (C falls)
Why can MPK and r be different in the short run?
Installing new capital to equate the two takes time
In the long run what does It equal and why?
It = a̅iY̅t because profit maximisation & arbitrage causes MPK = r
IS Curve:
Ỹt = a̅ - b̅(Rt - r̅)
Ỹt =
(Yt / Y̅t) - 1
What is b̅ and how does it affect the IS curve?
Investment sensitivity parameter, higher - flatter, smaller - steeper
What kind of shock is a̅
X intercept shock, temporary, a̅ = 0 in L.R.
What kind of shock is MPK
Y intercept shock, an increase in r̅ increases the demand for investment and therefore increase output at any given level of R, therefore the IS curve shifts outwards.
What kind of shock is Y̅
Doesn’t affect IS as shocks to potential affect short run output the same
What is the permanent income hypothesis?
Theory of diminishing marginal utility implies preference of smooth consumption. Hypothesis concludes that people will base their consumption on an average of their income over time rather than on their current income.
What is the Life Cycle Model?
Suggests that consumption is based on average lifetime income rather than on income at any given age
How are PIH and LCM incorporated into the short run model?
C is proportionally to potential output rather than actual output
What is the basic conclusion of both the PIH and LCM?
People smooth their consumption relative to their income, so changes to short run output have little effect on C - small multiplier. People base their consumption on the constant income stream that has the same present discounted value as their actual income stream, aka permanent Income
Ct / Y̅t with the multiplier =
a̅c + x̅Ỹt
IS Curve with C multiplier:
Ỹ = (1/(1-x̅)) x a̅ - b̅(Rt - r̅)
What does the C multiplier imply?
When a boom occurs, consumption rises, by an amount dependant on parameter 1 > x̅ > 0 / Increase in R leads to a decrease in investment which may cost some workers jobs. These workers then reduce their consumption. These firms then lose revenue and their workers have to reduce consumption etc. Vicious or virtuous cycles - a shock to one part of the economy can multiply to create larger effects
What are discretionary policies?
Purchases affecting a̅g, tax cuts, tax credits, transfer spending
What are automatic stabilisers?
Transfers (unemployment, medicare) that automatically adjust to the phase of the business cycle
Is the majority of government policy discretionary or automatic?
The majority of changes in fiscal policy are due to stabilisers, not discretionary policies
What are the policy considerations for government purchases?
- Timing - by the time the policy is in place, the shock it was designed to mitigate may have passed.
- No Free Lunch Principle - Higher spending today must be paid for if not today then at some point in the future.
- Focused demand on particular industry (building) from stimulus measures can affect relative prices and cause inflation
What is the Ricardian Equivalence?
The notion that what matters for consumption is the present value of what the government takes from consumers rather than the specific timing of taxes
What does the Ricardian Equivalence imply about tax cuts?
Tax cuts don’t increase C if people smooth because they know they’ll only have to pay it back in higher taxes later
Why might the Ricardian Equivalence not hold?
Not everyone is that rational/patient. If borrowing constraints exist than consumers are not going to be perfect consumption smoothers.
When is the Paradox of Thrift most poignant and why?
During a recession/liquidity trap. In this situation investment is very muted and additional savings is unlikely to generate additional investment.
What is the Paradox of Thrift?
Attempts by all people simultaneous to save more may lead both to a decline in output and to unchanged savings
What is the rational for the Paradox of Thrift?
If sufficient households all at the same time decrease consumption, because they’re trying to save more - they want to de-lever (get rid of debt), YD will fall, causing a fall in Ys and a fall in overall output
If the economy is booming, is the Paradox of Thrift likely to hold?
No, If booming, C falling because savings increase might lead to no change in Y because savings = investment and investment will increase to pick up slack
Is the Paradox of Thrift valid?
No conclusive evidence for paradox, depends on state of business cycle and leveraging of economy
What are the criticism of the Paradox of Thrift?
- If AD falls as a result of increased savings, lower prices (barring G intervention) will spurn higher demand, albeit inciting lower profits and wages.
- When savings increases, the interest rate will fall as the market for money clears and this will stimulate borrowing leading to investment
- If one nation increases savings, this can be offset by trading partners consuming a greater amount of imports
Why might the Paradox of Thrift be valid in a liquidity trap?
When savings increases, the interest rate will fall as the market for money clears and this will stimulate borrowing leading to investment. When interest rates are already low (liquidity trap) i.e. during a recession and can fall no lower this cannot happen, so paradox might exist in this instance
What is Say’s Law?
A Neoclassical view that an aggregate supply creates an aggregate demand. Therefore it is the total potential of the economy to produce which drives overall output, so if consumption falls, in order for Ys = YD = Y, a compensation by either I, G or NX must take place
What parameter does a housing bubble affect?
ai
What happens if G increases and the Ricardian Equivalence holds?
ac falls slightly (because of smoothing), ag increases - when financed does not matter
What happens if G increases, financed by a tax increase and the Ricardian Equivalence does not hold?
ag increases, ac decreases = marginal output increase, nearly cancels out
If the Ricardian Equivalence holds does it matter when the spending/tax cut is financed?
NO!
What happens if G increases, not financed by a tax increase and the Ricardian Equivalence does not hold?
ag increases, ac no change
What happens if Gov’t transfers increase, not financed by a tax increase and the Ricardian Equivalence does not hold?
Recipients ac increase, payers ac no change
What happens if Gov’t transfers increase, financed by a tax increase and the Ricardian Equivalence does not hold?
Recipients ac increase, payers ac decrease = no effect
What happens if Gov’t transfers increase and the Ricardian Equivalence holds?
Recipients ac increase, payers ac decrease = no effect (if the transfer change is permanent)
What is the effect of a disaster on Y, Y̅ and Ỹ?
MPK increases so Ỹ increases.
There is less K so Y̅ decreases
Y is ambiguous, depends how poor people become/K stock reduction
(ac - consumption as a factor of Y̅ does not change)
IS curve with an import multiplier:
Ỹ = (1/(1+n)) x a̅ - b̅(Rt - r̅)
IS curve with a consumption interest rate component:
Ỹ = a̅ - (b̅+bc)(Rt - r̅)
What is the effect of a IS curve consumption interest rate component?
R decrease = I increase + C increase - IS is flatter. Because an increase in R will make future income worth less and decrease C (PDV under LC-PIH model)
Assuming PIH, how much will personal C increase when income increases by x?
i/r x $x
Assuming PIH, how much will personal C increase when income increases by x in t years?
($x/(1.i/r)^t) x i/r
