ECO 3311 Ch 8: The IS curve. Introduction. by effectively setting the rate at which people borrow and lend in financial markets, the Federal Reserve exerts a substantial influence on the level of economic activity in the short run.
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Ch 8: The IS curve
1. divide the national income accounting identity by potential output:
2. substitute the five equations into this equation:
The Basic IS Curve
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.
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
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
if Americans shift their demands to imports, the IS curve shifts left and reduces short-run output
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.
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.