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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
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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