Lent - Lecture 2 - The IS Curve

Question 1

What does expenditure equilibrium require?

Answer 1

Y = (1/(1 - c))(C̅ - cT +I(r) + G)

Question 2

What is the relationship between I and r? Hence, what is the effect on Y due to a reduction in r? So, what is the relationship between Y and r (the IS curve)?

Answer 2

• a reduction in r causes I to increase
• this change in I then causes a change in Y, as Y = (1/(1 - c))(C̅ - cT +I(r) + G)
• ΔY = (1/(1 - c))ΔI
• so there is a negative relationship between r and Y

Question 3

The IS curve plots a locus of points where…?

Answer 3

the IS curve plots a locus of points where goods market equilibrium obtains

Question 4

Show how E = A (planned expenditure equals actual expenditure) implies S = I(r)

Answer 4

• assume a closed economy, where E = A
• Y = C + I(r) + G
• I(r) = ((Y - T) - C) + (T - G)
• I(r) = Sprivate + Spublic
• I(r) = S

Question 5

What is the important, but counterintuitive, lesson from this model?

Answer 5

that investment generates its own saving

Question 6

How is it that in this model, investment generates its own saving?

Answer 6

• a fall in r causes I to rise
• this increases Y
• some of the increase in Y is spent, but some is saved
• output continues to rise until I(r) = S

Question 7

In reference to loanable funds, what is the difference between the Classical model and the Keynesian model?

Answer 7

• in the Classical model there is a fixed supply of loanable funds
• a unique real interest rate equate S with I
• in the Keynesian model: output can vary - therefore so can loanable funds

Question 8

What things will change the position (shift) the IS curve?

Answer 8

• the position of the IS curve will be affected by anything that changes equilibrium Y, given r
• changes in G
• changes in C̅
• shift in investment function I(r)
• these changes are interacted with a multiplier to give shift in IS

Question 9

What two things will determine the slope of the IS curve?

Answer 9

• the sensitivity of I(r) to r
• the size of the multiplier

Question 10

What does a lower c imply for ΔY for a given ΔI? Hence, what does it imply about the slope of the IS curve?

Answer 10

• a lower c implies a smaller ΔY for a given ΔI
• implies a steep IS curve

Question 11

What does a flatter I(r) curve imply for the slope of the IS curve?

Answer 11

a flatter I(r) curve implies a flatter IS curve

Question 12

What does the Keynesian model suggest would happen if the government decides to borrow to increase spending and stimulate the economy?

Answer 12

• fiscal multiplier 1/(1 - c) > 1
• hence, this would be very effective

Question 13

Show that there is no crowding out in the Keynesian model

Answer 13

• suppose G increases, T is kept fixed, consider the effect on S
• S = Y - C - G
• S = Y - C̅ - c(Y - T) - G
• so, dS/dG = dY/dG - c(dY/dG) - 1
• dS/dG = (1 - c)(dY/dG) - 1
• in the Keynesian model: dY/dG = 1/(1 - c) (the multiplier), so:
• dS/dG = (1 - c)/(1 - c) -1
• dS/dG = 0