L19 - Investment,Interest and GDP: The IS curve Flashcards
What is Investment?
changes in real stock of capital in the economy.
What can Investment do in the Short run?
- changes in investment affect aggregate spending and
- hence the employment of existing resources
- and thus the size of the GDP gap
What can Investment do in the Long Run?
investment increases the capital stock and hence the
size of potential GDP
What are the two forms of domestic savings?
- retained profits and households savings
- borrowing of savings that have been made abroad
What are the two ways of financing investment?
- Retained Profits
- Loans
Firm’s invest due to expectation of profits providing basic motive.
What are the factors affecting expected profitability?
- Price and Productivity of Capital Goods
- Expectations about future demand for the output to
be produced by capital goods and about costs of
producing that output (Expected future demand)
(Biggest) - Development of new techniques of production and of
new products - Profits previously earned by firms and available for
reinvestment - Real rate of Interest (2nd Biggest)
What does the desired level of spending depend on?
Desired level of spending depend on real rate of interest not nominal rate
What does the real rate of interest measure?
Measures the opportunity cost of capital to the firm.
i.e P> r or P< r
-Where P is the marginal efficiency of capital
- Where r is the rate of interest
Measures the interest forgone to invest.
If P> r
- Then interest lower and so greater level of investment and vice versa
(Under ceteris paribus)
What else does investment affect?
Interest payments are a large part of total mortgage payments.
Therefore changes in interest rates can have large effects on the demand for new housing.
A fall in the rate of interest will lead to a rise in investment in building new housing.
A rise in interest rates will reduce the demand for building new housing.
What is the IS Curve?
-Shows all those combinations of GDP and interest rate
for which aggregate desired spending equals actual
output
Why is the IS Curve negatively sloped?
-Because fall in the interest rate increases investment
spending and hence increases equilibrium GDP.
Why was the curve originally called the IS curve?
- That its in a closed economy with no government,
- Represents the combination of GDP and the interest rate for which the sum of all injections equals the sum of all leakages.
- In other words, savings equal investments.
ALL GRAPHS ARE ON NOTES
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