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## PowerPoint Slideshow about '3. Goods market equilibrium: the IS curve.' - penelope-ardelis

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I. Consumption and Saving (Sec. 4.1)

- A) The importance of consumption and saving
- 1. Desired consumption: consumption amount desired by households
- 2. Desired national saving: level of national saving when consumption is at its desired level

Sd = Y – Cd – G

(Note that NFP=0, Y=GDP=GNP due to the closed economy assumption)

I. Consumption and Saving (cont.)

- B) The consumption and saving decision of an individual
- 1. A person can consume less than current income (saving is positive)
- 2. A person can consume more than current income (saving is negative)
- 3. Trade-off between current consumption and future consumption
- a. The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate
- b. Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time

I. Consumption and Saving (cont.)

- C) Effect of changes in current income
- 1. Increase in current income: both consumption and saving increase (vice versa for decrease in current income)
- 2. Marginal propensity to consume (MPC) = fraction of additional current income consumed in current period.
- 3. Aggregate level: When current income (Y) rises, Cd rises, but not by as much as Y, so Sd also rises. MPC between 0 and 1.
- 4. Keynesian consumption equation
- Cd=C0+C1(Y-T),

Sd = Y – Cd – G= Y – C0– C1(Y-T) – G

Sd =-(C0+G- C1T)+ (1– C1)Y

I. Consumption and Saving (cont.)

- D) Effect of changes in expected future income
- 1. Higher expected future income leads to more consumption today, so saving falls
- 2. Application: consumer sentiment and the 1990–91 recession; sharp contraction in consumer sentiment in 1990 led to fall in consumer spending
- E) Effect of changes in wealth
- 1. Increase in wealth raises current consumption, so lowers current saving

I. Consumption and Saving (cont.)

- F) Effect of changes in real interest rate
- 1. Increased real interest rate has two opposing effects
- a. Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving
- b. Income effect
- (1) For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving)
- (2) For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth
- c. Empirical studies have mixed results; probably a slight increase in aggregate saving
- 2. Taxes and the real return to saving
- a. Expected after-tax real interest rate:
- rat = (1 – t)i – e
- b. Simple examples: i = 5%, e = 2%; if t = 30%, rat= 1.5%; if t = 20%, rat= 2%

I. Consumption and Saving (cont.)

- G) Fiscal policy
- 1. Affects desired consumption through changes in current and expected future income.
- 2. Directly affects desired national saving, Sd = Y – Cd – G
- 3. Government purchases (temporary increase)
- a. Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption Cd=C0+C1(Y-T), by less than the decline in current income
- b. Even true if financed by higher future taxes, if people realize how future incomes are affected
- c. Since Cd declines less than G rises, national saving declines

Sd =-(C0+G- C1T)+ (1– C1)Y

- d. So government purchases reduce both desired consumption and desired national saving
- 4. Taxes
- a. Lump-sum tax cut today, financed by higher future taxes
- b. Decline in future income may offset increase in current income; desired consumption could rise or fall
- c. Ricardian equivalence proposition
- (1) If future income loss exactly offsets current income gain, no change in consumption
- (2) Tax change affects only the timing of taxes, not their ultimate amount (present value)
- (3) In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads to increased desired consumption and reduced desired national saving

II. Investment (Sec. 4.2)

- A) Why is investment important?
- 1. Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle
- 2. Investment plays a crucial role in economic growth

II. Investment (cont.)

- B) The desired capital stock
- 1. Desired capital stock is the amount of capital that allows firms to earn the largest expected profit
- 2. Desired capital stock depends on costs and benefits of additional capital
- 3. Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf)
- 4. The user cost of capital
- a. Examples of Kyle’s Bakery (textbook) and vending machines (class)
- b. User cost of capital = real cost of using a unit of capital for a specified period of time
- c. uc = rpK + dpK = (r + d)pK

II. Investment (cont.). Determining the desired capital stock

- a. Desired capital stock is the level of capital stock at which MPKf = uc
- b. MPKf falls as K rises due to diminishing marginal productivity
- c. uc doesn’t vary with K, so is a horizontal line
- d. If MPKf > uc, profits rise as K is added (marginal benefits > marginal costs)
- e. If MPKfuc, profits rise as K is reduced (marginal benefits < marginal costs)
- f. Profits are maximized where MPKf = uc

II. Investment (cont.)

- C) Changes in the desired capital stock
- 1. Factors that shift the MPKf curve or change the user cost of capital cause the desired capital stock to change
- 2. These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf (text Figure 4.3 shows effect of change in uc)
- 3. Taxes and the desired capital stock
- a. With taxes, the return to capital is only (1 – )MPKf
- b. Setting the return equal to the user cost gives

MPKf = uc/(1 – ) = (r + d)pK/(1 – )

- c. Tax-adjusted user cost of capital is uc/(1 – )
- d. An increase in τ raises the tax-adjusted user cost and reduces the desired capital stock

II. Investment (cont.)

- D) From the desired capital stock to investment
- 1. The capital stock changes from two opposing channels
- a. New capital increases the capital stock; this is gross investment
- b. The capital stock depreciates, which reduces the capital stock
- c. Net investment = gross investment (I) minus depreciation:

Kt+1 – Kt = It – dKt (4.5)

where net investment equals the change in the capital stock

- 2. Rewriting (4.5) gives It = Kt+1 – Kt + dKt
- a. If firms can change their capital stocks in one period, then the desired capital stock (K*) = Kt+1
- b. So It = K* – Kt + dKt (4.6)
- c. Thus investment has two parts
- (1) Desired net increase in the capital stock over the year (K* – Kt)
- (2) Investment needed to replace depreciated capital (dKt)
- 3. Lags and investment
- a. Some capital can be constructed easily, but other capital may take years to put in place

III. Goods Market Equilibrium (Sec. 4.3)

- A) The real interest rate adjusts to bring the goods market into equilibrium, Y = AD, in a closed economy without rest of the world (NX=NFP=0)
- 1. Y = AD = Cd + Id + G goods market equilibrium condition
- 2. Differs from income-expenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market won’t be in equilibrium
- 3. Alternative representation from National Saving definition:
- Sd = Y – Cd – G andY=AD leads to

Sd = Id

III. Goods Market Equilibrium (cont.)

- 1. Equilibrium where Sd = Id
- 2. How to reach equilibrium? Adjustment of r
- 3. Shifts of the saving curve

a.Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect)

- b. Example: Temporary increase in government purchases shifts S left
- c. Result of lower savings: higher r, causing crowding out of I
- 4. Shifts of the investment curve
- a. Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital
- b. Result of increased investment: higher r, higher S and I

B)The saving-investment diagram

IV. The IS Curve: Equilibrium in the Goods Market (Sec. 9.2)

- A) The goods market clears when desired investment equals desired national saving
- 1. Adjustments in the real interest rate bring about equilibrium
- 2. For any level of output Y, the IS curve shows the real interest rate r for which the goods market is in equilibrium
- 3. Derivation of the IS curve from the saving-investment diagram (Figure 9.2)
- In situations of disequilibrium adjustment between desired amounts and effective amounts takes place through inventory investment
- C=Cd I=Id+Inventory investment.
- As a result: Excess Supply is absorved as inventory investment:
- Y-AD=C+I+G –Cd-Id-G=Inventory investment

IV.The IS Curve: Equilibrium in the Goods Market (cont)

B) Derivation of the IS curve from the saving-investment diagram

(1) The saving curve slopes upward because a higher real interest rate increases saving (SE>IE)

- (2) The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing investment
- (3) An increase in output shifts the saving curve to the right, because people save more when their income is higher
- (4) Since the investment curve is downward sloping, equilibrium at the higher level of output has a lower real interest rate
- (5) Thus a higher level of output must lead to a lower real interest rate, so the IS curve slopes downward

IV.The IS Curve: Equilibrium in the Goods Market (cont)

- C) Result:
- The IS curve shows the relationship between the real interest rate and output for which desired investment equals desired saving.
- Alternatively, The IS curve is the set of combinations (r,Y) that clear the goods market.

IV.The IS Curve: Equilibrium in the Goods Market (cont)

- D) Alternative interpretation in terms of goods market equilibrium (Y=AD)
- (1) Beginning at a point of equilibrium, suppose the real interest rate rises
- (2) The increased real interest rate causes people to increase desired saving and thus reduce consumption, and causes firms to reduce desired investment
- (3) So the quantity of goods demanded declines
- (4) To restore equilibrium, the quantity of goods supplied would have to decline
- (5) So higher real interest rates are associated with lower output, that is, the IS curve slopes downward

IV.The IS Curve: Equilibrium in the Goods Market (cont)

- E) Factors that shift the IS curve
- 1.Any change that reduces desired national saving relative to desired investment shifts the IS curve to the right
- a. Intuitively, imagine constant output, so a reduction in saving (e.g. due to an increase in wealth) means more investment relative to saving; the interest rate must rise to reduce investment and increase saving (see Figure in classroom blackboard)
- 2. Similarly, a change that increases desired national saving relative to desired investment shifts the IS curve to the left
- 3. An alternative way of stating this is that a change that increases aggregate demand for goods shifts the IS curve to the right
- a. In this case, the increase in aggregate demand for goods exceeds the supply
- b. The real interest rate must rise to reduce desired consumption and investment and restore equilibrium
- c. Verify this result graphically for the three components of AD

IV.The IS Curve: Equilibrium in the Goods Market (cont)

- F) Summary. Table 12 in page 315 of the textbook lists the factors that shift the IS curve
- a. The IS curve shifts to the right because of
- (1) an increase in expected future output
- (2) an increase in wealth
- (3) a temporary increase in government purchases
- (4) a decline in taxes (if Ricardian equivalence doesn’t hold)
- (5) an increase in the expected future marginal product of capital
- (6) a decrease in the effective tax rate on capital
- b. The IS curve shifts to the left when the opposite happens to the six factors above

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