Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
ISLM: The Engine Room Chapter 7 The IS Curve A curve in (i, Y) space comprising all points where the goods market is in equilibrium. Y=C+I+G Earlier, we defined: C = C + bY and I = I - fi Thus, Y = (C + bY) + ( I – fi) + G Let A = C + I + G, we have Y = A + bY – fi fi = A – Y + bY Solving for i we get i = A/f – Y(1 – b)/f (This is an equation of a straight line with intercept equal to A/f and slope equal to – (1 – b)/f [Negative slope] Applications (fig. 7.2) 1. 2. 3. IS curve response to a collapse in investor confidence (I). IS curve response to a collapse in consumer confidence (C). IS curve response to a change in government spending (G). How do taxes affect the IS curve? CT = C – bYD YD = Y(1 – t) CT = C + bY(1 – t) Using the equilibrium condition in the goods market Y = CT + I + G (with the after–tax C function) and solving for i we get i = A/f – [1– b(1– t)]Y/f Now the slope is – [1– b(1– t)]/f (the IS curve becomes steeper; fig. 7.3) Applications (fig. 7.4 and 7.5) 1. 2. The tax rate increases from 35% to 43%. The tax rate increases in an economy struggling to recover from a prolonged recession (examples: tax increases in Japan in 1996, doubling of tax rates in the U.S. during the great depression, and state taxes in 1990-91.) The LM Curve A curve in (i, Y) space comprising all points where the money market is in equilibrium. Money supply = Money demand Earlier (chapter 4), we defined: Money demand = kY – hi M/P = kY – hi Solving for i we get i = (k/h)Y – (1/h)M/P (This is an equation of a straight line with intercept equal to – (1/h)M/P and slope equal to (k/h) [positive slope] Fig. 7.6 Factors that shift the LM curve (fig. 7.7) A change in the nominal money stock, M. 2. A change in the price level, P. 1. ISLM – ADAS policy applications Survival guide to ISLM-ADAS analysis Make all moves in (i,Y) space first. Go to (P,Y) space and adjust AD to make Y consistent with Y in the (i,Y) space. Has P changed? If ‘no’, go to step 4. If ‘yes’, go to (i,Y) space and adjust LM. Close the goods markets (and the labor market, to be incorporated in chapter 8). How do the final values of C and I compare with the initial values? Analyze the implications of your results. ISLM – ADAS policy experiment I (fig. 7.10) Initial state of the economy: Low GDP growth rate Y0. Assume government spending increases from G0 to G1 (spending on infrastructure, defense, …). Step 1: As G increases, the IS curve [(i,Y) space] shifts to the right (intercept increases). Step 2: In the (P,Y) space, the AD curve shifts to the right (upward). Step 3: P did not change we go to step 4. Step 4: The equilibrium in the goods market is consistent with Y1 in the (i,Y) and (P,Y) spaces We know that C1 > C0 since Y1 > Y0 but what about investment, I? Recall that I = I - fi So I0 = I - fi0 But the new interest rate is higher as a result of higher government borrowing. So I1 < I0 Step 5: An increase in G causes an increase in the rate of growth of Y and a decrease in private capital investment (crowding out effect). ISLM – ADAS policy experiment II The Fed increases money growth. Step 1: LM curve shifts to the right. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: Shift (upward) the expenditure line in the goods market. Is C1> C0? Yes (since Y1> Y0). Is I1> I0? Yes (since interest rate i1 < i0). Step 5: An increase in money supply leads to a decrease in interest rate, and increase in investment, consumption, and Y. ISLM – ADAS policy experiment III Country K has been struggling to come out of a recession and the budget deficit is very high. Policymakers decide to increase taxes (T = tY). Step 1: IS curve pivots clockwise. C and I fall. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: Shift (down) the expenditure line in the goods market. Is C1> C0? No (since Y1< Y0) and C is lower) Is I1> I0? (i1 < i0 but I1 < Io (investor confidence is lower). If the macroeconomic outlook is dismal and investors expect further tax increases (investment) I will not rise (liquidity trap; U.S. economy in 2008; Japan and Argentina in early 2000s). Step 5: Y, C, I and interest rates (i) fall. Policy Challenges in China Bao ba (guaranteed 8%) growth policy Low MPC (small multiplier) IS curves for the Western and Central regions in China ISLM – ADAS policy experiment IV: Fine tuning Country K increases G and M (to avoid crowding out private investment) Step 1: As G increases, IS curve shifts up (right). As M increases, LM curve shifts to the right. Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space. Step 3: P has not changed. Step 4: We Adjust the expenditure line in the goods market to be consistent with Y1. Is C1> C0? Yes, since Y1> Y0 Is I1> I0? In this example, no change in the interest rate, i so I1 = Io (assume investor confidence is the same). Step 5: Y and C increase. The Global IS Curve Y = C + I + G + (EX – IM) i = [A/f + (EX – IM)/f] – Y(1 – b)/f The intercept: A/f + (EX – IM)/f An increase in exports causes the IS curve to shift upward (right). A recession in a large foreign economy causes foreign national income to fall and causes foreign demand for domestic country’s exports to decline (contagion). Effects of the home currency depreciation or devaluation (China and U.S.).