Chapter 11

Chapter 11 - 6/23/2011 11.1 Introduction In this chapter,...

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6/23/2011 1 Chapter 11 The IS Curve Charles I. Jones 11.1 Introduction • In this chapter, we learn – the first building block of our short-run model: the IS curve • describes the effect of changes in the real interest rate on output in the short run interest rate on output in the short run. – how shocks to consumption, investment, government purchases, or net exports — “aggregate demand shocks” — can shift the IS curve. – a theory of consumption called the life- cycle/permanent-income hypothesis. – that investment is the key channel through which changes in real interest rates affect GDP in the short run. • The Federal Reserve exerts a substantial influence on the level of economic activity in the short run – sets the rate at which people borrow and lend in financial markets • The basic story is this: • The IS curve – captures the relationship between interest rates and output in the short run – there is a negative relationship between the interest rate and short-run output – an increase in the interest rate will decrease investment, which will decrease output
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6/23/2011 2 11.2 Setting Up the Economy • The national income accounting identity – implies that the total resources available to the economy equal total uses – one equation with six unknowns Investmen Government Production Imports Consumption Investment Purchases Exports • We need five additional equations to solve the model: Consumption and Friends • Level of potential output is given exogenously – consumption C , government purchases G , exports EX , and imports IM depend on the economy’s potential output – each of these components of GDP is a constant fraction of potential output • the fraction is a parameter • Potential output is smoother than actual GDP – a shock to actual GDP will leave potential output unchanged • The equation depends on potential output – shocks to income are “smoothed” to keep consumption steady The Investment Equation a term weighting the difference between the real interest rate and the MPK Marginal Product of Capital (MPK) the share of potential output that goes to investment Real interest rate
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6/23/2011 3 • The MPK – is an exogenous parameter – is time invariant • If the MPK is low relative to the real interest rate – firms should save money and not invest in capital • If the MPK is high relative to the real interest rate – firms should borrow and invest in capital • In the short-run, the MPK and the real interest rate can be different – Installing capital to equate the two takes time 1. divide the national income accounting identity by potential output 11.3 Deriving the IS Curve 2. substitute the five equations into this equation 3. recall the definition of short-run output. Simplifies the equation for the IS curve:
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Chapter 11 - 6/23/2011 11.1 Introduction In this chapter,...

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