# Chapter 11 - 11.1 Introduction In this chapter we learn...

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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 Investment Government Production Imports Consumption 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