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Unformatted text preview: 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 the IS curve captures the relationship between interest rates and output in the short run an increase in the interest rate will decrease investment, which will decrease output there is a negative relationship between the interest rate and shortrun output the IS Curve shows activity decreasing when interest rates rise Setting Up the Economy the national income accounting identity implies that the total resources available to the economy (production plus imports) equal total uses (consumption, investment, government purchases, and exports). the national income accounting identity is one equation with six unknowns: thus we will need five additional equations to solve the model Consumption and Friends consumption, government purchases, exports, and imports each depend on the economys potential output level of potential output is given exogenously each of these components of GDP is a constant fraction of potential output where the fraction is a parameter because potential output is smoother than actual GDP, a shock to actual GDP will leave potential output unchanged thus, because the equation depends on potential output, it will imply that shocks to income are smoothed to keep consumption steady The Investment Equation the equation includes one term accounting for the share of potential output that goes to investment it also includes a term weighting the difference between the real interest rate and the marginal product of capital the MPK is an exogenous parameter and is time invariant the MPK is low relative to the real interest rate, firms should save their money however, if the MPK is high relative to the real interest rate, firms should borrow and invest in capital the sensitivity to the changes in the interest rate is denoted in the shortrun, the MPK and the real interest rate can be different because installing new capital to equate the two takes time this chapter takes the real interest rate as given, but will be endogenized next chapter 1. divide the national income accounting identity by potential output: 2. substitute the five equations into this equation: Deriving the IS Curve 3. recalling the definition of shortrun output, this simplifies to the equation for the IS curve: note that it is the gap between the real interest rate and the MPK that matters for output fluctuations because firms can always earn the MPK on new investments note as well that the parameter will equal zero when potential output is equal to actual output the parameter is the sum of the aggregate demand parameters for consumption, investment, government purchases, exports and imports minus one and is thus called the aggregate demand shock Using the IS Curve...
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This note was uploaded on 02/27/2011 for the course ECO 3311 taught by Professor Staff during the Spring '08 term at Texas Tech.
 Spring '08
 Staff

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