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.
Ch 8: 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 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.
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.
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.
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