IS-MP Flashcards
what is aggregate expenditure?
the total amount of goods and services that people want to buy across the whole economy
what is the formula for aggregate expenditure?
AE = C + I + G + NX
what are the four components of AE?
Consumption: when households buy goods and services
Planned Investment: when businesses purchase new capital, excluding unplanned changes in inventories
Gov. Purchases: when gov. buys goods and services
Net Exports: spending by foreigners on Canadian made exports, less spending by Canadians on foreign-made imports
what is macroeconomic equilibrium?
occurs when the quantity of output that buyers collectively want to purchase is equal to the quantity of output that suppliers collectively produce
Y = AE
what happens to inventories when output is greater than expenditure?
inventories increase
what happens to inventories when output is less than expenditure?
inventories decrease
what determines output in the short run?
demand conditions
what determines output in the long run?
supply
what happens when actual GDP > potential GDP?
the economy will overheat as it exceeds the economy’s max. sustainable output
what is potential output?
the level of GDP at which all resources are fully employed. it is determined by the available supply of labour, human and physical capital, and technological progress
what is actual output?
the actual level of GDP
this may fail to meet the potential as AE ebbs and flows
what is the output gap?
the difference between actual and potential output, measured as a percentage of potential output
what is the formula for output gap?
( actual - potential ) / potential * 100
when is there a + gap?
when actual > potential
when is there a - gap?
when actual < potential
what is equilibrium GDP?
describes the level of GDP at the point of macroeconomic equilibrium
what is potential GDP?
the economy’s highest sustainable level of production and is determined by available inputs
what is real interest rate?
- may be the most important price in the economy
- represents the opportunity cost of spending
- is the price that determines this year’s AE
- is a lever policy makers use to influence the economy
what do low interest rates boost?
low interest rates increase consumption, investment, government purchases, net exports.
therefore, low interest rates increase aggregate expenditure, and therefore increase GDP, and ultimately increase the output gap
what is the IS curve?
illustrates how lower real interest rates raise spending and hence GDP, leading to a more positive output gap
what is on either axis of the IS curve?
vertical axis - real interest rate
horizontal axis - output gap
what type of slope is the IS curve?
downward sloping
how do changing interest rates affect the IS curve?
leads to a movement along the IS curve
as interest rate decreases, moves right along the curve
as interest rate increases, moves left along the curve
what is monetary policy?
the process of setting interest rates in an effort to influence economic conditions
what is risk-free interest rate?
the interest rate on a loan that involves no risk
the federal reserve sets the nominal interest rate to influence the real interest rate
what is risk premium?
the extra interest that lenders charge to account for the risk of loaning money
what is risk premium?
the extra interest that lenders charge to account for the risk of loaning money
what is the formula for real interest rate?
real interest rate = risk-free interest rate + risk premium
real interest rate = nominal interest rate - inflation rate + risk premium
what is the MP curve?
illustrates the current real interest rate, which is shaped by monetary policy and the risk premium
who sets the interest rate?
the central bank/ federal reserve
how can you determine macroeconomic eqm from a IS-MP graph?
the point where IS curve and MP curve intersect
what is a recession in terms of AE?
declining expenditure
what is a expansion in terms of AE?
increasing expenditure
what is an optimistic IS curve?
strong aggregate expenditure leads to a booming economy and full employment
describes spending plans in good times when people are optimistic about their economic future
what is a pessimistic IS curve?
insufficient demand can lead to an economic slump and unemployment
people are pessimistic about their future, so they cut back on how much they plan to spend at any given interest rate, and businesses will respond by cutting production. this decrease in output shifts the IS curve to the left
what shifts the MP curve?
monetary policy shifts the MP curve
the shift in the MP curve leads to a new eqm
what is recessionary eqm?
GDP is less than potential GDP
what happens to the MP curve when real interest rate decreases?
the MP curve shifts down
what happens to federal fund rate when real interest rate increases?
increase in federal funds rate
what happens to federal fund rate when real interest rate decreases?
decrease in federal funds rate
what is fiscal policy?
the gov. use of spending and tax policies to attempt to stabilize the economy
what happens to the IS curve when fiscal policy is adjusted?
expansionary fiscal policy = increasing AE = IS curve shifts right
what is the multiplier?
a measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending
what is the formula for multiplier?
delta GDP = delta spending * multiplier
how does increased government spending affect the IS curve?
the IS curve shifts right
it has a multiplied effect, and so shifts by DG * multiplier
this leads the economy to shift to a new equilibrium
this new equilibrium involves higher GDP, and an unchanged interest rate
which policy shifts the MP curve?
monetary policy
which policy shifts the IS curve?
fiscal policy
what determines how far the IS curve shifts?
the multiplier
what is a spending shock?
any change in AE at a given real interest rate and level of income
spending shocks shift the IS curve
what are the types of spending shocks?
- consumption
- investment
- government
- net exports
describe consumption as a spending shock
consumption increases if people feel more prosperous
causes include:
- increases in wealth
- increases in consumer confidence
- increases in government assistance
- reductions in taxes
- reductions in inequality
describe investment as a spending shock
investment increases if it is profitable to expand production
causes include:
- an expanding economy
- increases in business confidence
- increases in investment tax credits
- reductions in corporate taxes
- easier lending standards and increased cash reserves
- reduced uncertainty
describe government as a spending shock
government shocks increase in response to fiscal policy
causes include:
- spending bills
- automatic stabilizers
but not transfer payments
what is an automatic stabilizer?
automatically increasing spending when economy is weak
describe net exports as a spending shock
net exports increase in response to global factors
causes include:
- increases in global GDP growth
- reduced value of the US dollar
- reduced trade barrier in foreign markets
- increased trade barrier in US markets
what is a financial shock?
any changes in borrowing conditions that change the real interest rate at which people can borrow
financial shocks shift the MP curve
what are the types of financial shocks?
- monetary policy
- risk
describe monetary policy as a financial shock
changes in monetary policy can raise interest rates by increasing
- the risk free rate
- expected future interest rates
describe risk as a financial shock
a higher risk premium will raise interest rates due to increased
- default risk
- liquidity risk
- interest rate risk
- risk aversion
