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Unformatted text preview: EC 400 1 The IS Curve This lecture covers the derivation of This lecture covers the derivation of the IS curve. It also discusses its properties. The IS Curve Combinations of the rate of interest and the level of real GDP at which total expenditure is equal to output. The IS Curve Combinations of the rate of interest and the level of real GDP at which total expenditure is equal to output. Why do we want to fool with this? EC 400 2 The IS Curve The equilibrium level of income depends on the real rate of interest. This IS curve summarizes the relationship between the equilibrium level of income (in the Keynesian Cross model) and the real rate of interest. There are some advantages to this. The real and nominal rates of interest There are two types of interest rates Nominal and real The real and nominal rates of interest There are two types of interest rates Nominal and real Nominal interest rates have not been adjusted for inflation. One dollar saved at a 5% nominal rate for one One dollar saved at a 5% nominal rate for one year yields to the lender $1.05 in one year regardless of what has happened to prices. The lenders purchasing power would not have increased at all if prices after one year are 5% higher. EC 400 3 The real and nominal rates of interest There are two types of interest rates Nominal and real Nominal interest rates have not been adjusted for inflation. Real interest rates take into account expected inflation One dollar saved at a 5% real rate for one year yields to the lender a 5% increase in purchasing power as long as the price level increases at whatever rate was expected. The real and nominal rates of interest Let i = nominal rate of interest. Let r = real rate of interest. Let e be the expected rate of inflation Then the following relationship holds between the real and nominal rates of interest: i = r + e i = r + e For the time being we have a constant price level, so there is no difference between the real and nominal rates of interest. Hence in todays discussion of the IS curve we Hence in todays discussion of the IS curve we will use the real rate of interest. Later on, we will change it to the nominal rate of interest. EC 400 4 E E Y EC 400 5 E Y E Y E=Y E Y E=Y E(r ) EC 400 6 E Y E=Y E(r ) E Y E=Y E(r ) Y E Y E=Y E(r ) Y EC 400 7 E Y E=Y E(r ) Y E Y E=Y E(r ) Y Y r E Y E=Y E(r ) Y r Y r EC 400 8 E Y E=Y E(r ) Y Y r Y E Y E=Y E(r ) Y Y r Y E Y E=Y E(r ) r Y Y r Y r EC 400 9 E Y E=Y E(r ) Y Y r Y r E Y E=Y E(r ) Y Y r Y r r 1 E Y E=Y E(r ) r Y E(r 1 ) Y r Y r r 1 EC 400 10 E Y E=Y E(r ) Y E(r 1 ) Y r Y r r 1 E Y E=Y E(r ) Y E(r 1 ) Y 1 Y r Y r r 1 1 Y 1 E Y E=Y E(r ) r Y E(r 1 ) Y 1 Y r Y r r 1 Y 1 1 EC 400 11 E Y E=Y E(r ) Y E(r 1 ) Y 1 Y r Y r r 1 Y 1 1 E Y E=Y E(r ) Y E(r 1 ) Y 1 Y r Y r r 1 Y 1 1 E Y E=Y E(r ) r Y E(r 1 ) Y 1 Y r Y r r 1 Y 1 1 IS EC 400 12 E Y E=Y E(r ) Y E(r 1 ) Y 1 Y r Y r r 1 Y 1 1 IS E Y E=Y E(r ) Y Y r Y r IS...
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This note was uploaded on 09/14/2009 for the course EC 400 taught by Professor Cover during the Spring '09 term at Alabama.
 Spring '09
 Cover

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