Download Goods Market Equilibrium

 By effectively setting the rate at which people borrow and lend in financial markets,
the Fed exerts a substantial influence on the level of economic activity in the short
run
 The IS curve captures the relationship between real interest rates and output in the
short run
 An increase in the interest rate will decrease investment, which will decrease output:
Y = C + I + G + NX
 The decrease in output is normally a multiple of the decrease in investment
I down  Y down  C down  Y and C down yet more
 In Jones’ freshwater world, however, C depends on permanent income and doesn’t
respond to changes in short-run output and income
 Changes in I do not lead in multiplicative changes in Y
 The IS Curve shows activity decreasing when interest rates rise and investment
spending declines
CHAPTER 10 The IS Curve
 The national income accounting identity implies that the total resources
available to the economy (domestic production, Y, plus imports, IM) equal total
uses (consumption, C, investment, I, government purchases, G, and exports, EX)
 The national income identity is one equation with six unknowns:
Yt = Ct + It + Gt + EXt - IMt
 Thus we need five additional equations to solve the model
 consumption, government purchases, exports, and
imports each depend on the economy’s potential
output which is given exogenously
 each of these components of GDP is a constant fraction
of potential output – where the fraction is a parameter
The Investment Equation
 The equation includes one term accounting for the share of potential output that goes
to investment, parameter ai bar
 It also includes a term weighting the difference between the real interest rate Rt, and
the marginal product of capital, r bar
 the MPK, r bar, is an exogenous parameter and is time invariant
 When the MPK is low relative to the real interest rate, firms should save their money
 However, if the MPK is high relative to the real interest rate, firms should borrow and
invest in capital
 The sensitivity to the changes in the interest rate is denoted by parameter b bar
 in the short-run, the MPK and the real interest rate can be different because installing
new capital to equate the two takes time
 For now we take the real interest rate, R, as given
Deriving the IS Curve
1. divide the national income accounting identity by
potential output:
2. substitute the five equations into this equation:
3. recalling the definition of short-run output, this
simplifies to the equation for the IS curve:
 The gap between the real interest rate and the MPK matters
for output fluctuations
firms can always earn the MPK on new investments
 note as well that the parameter will equal zero when
potential output is equal to actual output
 the parameter is the sum of the aggregate demand
parameters for consumption, investment, government
purchases, exports and imports minus one and is thus called
the aggregate demand shock
when the aggregate demand shock parameter equals zero, the IS curve has a short-run
output of 0 where the real interest rate is equal to the long-run value of the MPK
 when the real interest rate changes, the economy will move along the IS curve
 an increase in the interest rate causes the economy to move up the IS curve and
short-run output will decline
 the higher interest rate raises borrowing costs, reduces demand for investment, and
reduces output
 if the sensitivity to the interest rate were higher, the IS curve would be flatter and a
given change in the interest rate would be associated with larger changes in output
 the higher interest rate raises borrowing costs, reduces demand for investment, and
therefore reduces output below potential
•
when the aggregate demand
shock parameter equals zero,
the IS curve has a short-run
output of 0 where the real
interest rate is equal to the
long-run value of the MPK
 when the real interest rate
changes, the economy will
move along the IS curve
•
an increase in the interest rate causes the economy to move up the IS curve and shortrun output will decline
 the higher interest rate raises borrowing costs, reduces demand for investment, and
reduces output
 if the sensitivity to the interest rate were higher, the IS curve would be flatter and a
given change in the interest rate would be associated with larger changes in output
 the higher interest rate raises borrowing costs, reduces demand for investment, and
therefore reduces output below potential
An Aggregate Demand Shock
 suppose that information technology improvements
create an investment boom:
 the aggregate demand shock parameter will increase
 output is higher at every interest rate and the IS curve
shifts right
 for any given real interest rate Rt, output is higher
when increases
A Shock to Potential Output
 short-run output is unaffected by a change in potential output
 shocks to potential output change actual output by the same amount in our setup
 however, some shocks to potential output, such as an earthquake, may change other
parameters in addition to potential output
 the earthquake example reduces actual and potential output by the same amount, but
leads to an increase in short-run output because it also increases the MPK
Other Experiments
 imagine that Japan enters into a recession and reduces her imports
 This, of course, is contrary to Jones’ assertion that (Japan’s) aim bar is a parameter
…but it makes more sense than assuming Japan’s imports are insensitive to her
short-run output and income
 the aggregate demand parameter for our exports, aex bar, declines and our IS curve
shifts to the left
 thus the Japanese recession has an international effect
 we could shock any of the other aggregate demand parameters that are a part of a bar
Microfoundations of the IS Curve
Consumption

people seem to prefer a smooth path for consumption to a path that involves large
fluctuations in consumptions
 the permanent-income hypothesis concludes that people base their consumption on
an average of their income over time rather than on their current income
 the life-cycle model of consumption suggests that consumption is based on average
lifetime income rather than on income at any given
 when young, people borrow to consume more than their income
 as income rises over a person’s life, consumption rises more slowly and individuals
save more
 during retirement, individuals live off their accumulated savings
 the life-cycle/permanent-income (LC/PI) hypothesis implies that people smooth their
consumption relative to their income
 this is why Jones sets consumption proportional to potential output rather than actual
output
 a strict version of the LC/PI hypothesis implies that predictable movements in
potential output should also be smoothed
 the life-cycle model of consumption:
when young, people borrow to consume more than
their income
 as income rises over a person’s life, consumption
rises more slowly and individuals save more
 during retirement, individuals live off their
accumulated savings
CHAPTER 10 The IS Curve
Multiplier Effects
 we can modify the consumption equation to include a term that is proportional to
short-run output:
 solving for the IS curve yields an equation that is similar to the previous result, but
that now includes a multiplier on the aggregate demand shock and interest rate terms:
 the multiplier is larger than one
 aggregate demand shocks will increase short-run output by more than one-for-one in
the presence of the multiplier
 if one section of the economy is shocked, it will “multiply” through the economy and
will result in a larger effect…if short-run output falls, consumption falls, which leads
to short-run output falling and consumption falls again in a “vicious circle”
Investment
 at the firm level, the gap between the real interest rate
and the MPK determines investment
 in a simple model, the return on capital is the MPK
minus depreciation
 a richer framework includes corporate income taxes,
investment tax credits, and depreciation allowances
 a second determinant of investment is the firm’s cash
flow, which is the amount of internal resources the
company has on hand after paying its expenses
 it is more expensive to borrow to finance investment
because of agency problems
 agency problems are when one party in a transaction
has more information than the other party
 adverse selection is the idea that if a firm knows it is
particularly vulnerable, it will want to borrow
because if the firm does well it can pay back the
loans. If it fails, the firm cannot pay back the loan but
will instead declare bankruptcy
 moral hazard is the idea that a firm that borrows a
large sum of money may undertake riskier
investments because if it does well, it can repay,
while if it fails it can declare bankruptcy
 the potential output term in the investment equation
incorporates cash flows to a degree
 cash flow effect can be seen in the presence of
potential output
 if we wish to add short-run output , it would
provide additional justification for a multiplier
Government Purchases
 government purchases can be a source of short-run
fluctuation or an instrument to reduce fluctuations
 discretionary fiscal policy includes purchases of
additional goods in addition to the use of tax rates
 for example, the government can use the investment
tax credit to encourage investment today rather than
later
 transfer spending often increases when an economy
enters into a recession
 automatic stabilizers are programs where additional
spending occurs automatically to help stabilize the
economy
 welfare programs and Medicaid are two such
stabilizer programs that receive additional funding
when the economy weakens
 fiscal policy’s impact depends on two things:
1. The problem of timing may make it such that
discretionary changes are often put into place with
significant delay.
2. The no-free-lunch principle implies that higher
spending today must be paid for, if not today, some
point in the future. Such taxes may offset the impact
of the discretionary spending adjustment.
 the permanent-income hypothesis says that what
matters for consumption today is the present
discounted value of your lifetime income, after taxes
 Ricardian equivalence is the idea that what matters
for consumption is the present value of what the
government takes from the consumers rather than the
specific timing of the taxes
CHAPTER 10 The IS Curve
 an increase in government purchases financed by an
increase of taxes of the same amount will have a
modest positive impact on the IS curve and will raise
output by a small amount in the short-run
 an increase in spending today financed by an
unspecified change in taxes and/or spending at some
future date will shift the IS curve out by a moderate
amount – perhaps as much as 25 to 50 cents for each
dollar
CHAPTER 10 The IS Curve
Net Exports
if the trade balance is a deficit,
the economy imports more
than it exports
if the trade balance is in
surplus, the economy exports
more than it imports
if Americans shift their
demands to imports, the IS
curve shifts left and reduces
short-run output
an increase in the demand of
U.S. goods in foreign countries
stimulates the U.S. economy
by an outward shift of the IS
curve
 the trade balance is the main way that foreign economies
influence the U.S. economy in the short-run
10.6 Conclusion
 higher interest rates raise the cost of borrowing to
firms and households and thus reduce the demand for
investment spending – lowering short-run output
CHAPTER 10 The IS Curve
Summary
1. The IS curve describes how output in the short run depends
on the real interest rate and on shocks to the aggregate
economy.
2. When the real interest rate rises, the cost of borrowing
faced by firms and households increases, leading them to
delay their purchases of new equipment, factories, and
housing. These delays reduce the level of investment,
which in turn lowers output below potential. Therefore, the
IS curve shows a negative relationship between output and
the real interest rate.
CHAPTER 10 The IS Curve
3. Shocks to aggregate demand can shift the IS curve.
These shocks include (a) changes in consumption
relative to potential output, (b) technological
improvements that stimulate investment demand
given the current interest rate, (c) changes in
government purchases relative to potential output,
and (d) interactions between the domestic and foreign
economies that affect exports and imports.
4. The life-cycle/permanent-income hypothesis says
that individual consumption depends on average
income over time rather than current income. This
serves as the underlying justification for why we
assume consumption depends on potential output.
CHAPTER 10 The IS Curve
5. The permanent-income theory does not seem to hold
exactly, however, and consumption responds to
temporary movements in income as well. When we
include this effect in our IS curve, a multiplier term
appears. That is, a shock that reduces the aggregate
demand parameter by 1 percentage point may have
an even larger effect on short-run output because the
initial reduction in output causes consumption to fall,
which further reduces output.
CHAPTER 10 The IS Curve
6. A consideration of the microfoundations of the
equations that underlie the IS curve reveals important
subtleties. The most important are associated with
the no-free-lunch principle imposed by the
government’s budget constraint. The direct effect of
changes in government purchases is to change
.
However, depending on how these purchases are
financed, they can also affect consumption and
investment, partially mitigating the effects of fiscal
policy on short-run output
CHAPTER 10 The IS Curve