interm macro midterm 2 ch 11

as b bar increases, what happens to the slope of the IS curve

it decreases and the curve becomes flatter

what will changing the real interest rate do graphically (IS curve)?

- changing real IR will cause movement along curve - shock to AD will shift curve - neg AD shock = shift left pos AD shock = shift right

in the long run, MPK = r, and r is...

1) exogenous 2) time invariant

2 main determinants of investment at the firm level

1) gap between real interest rate and MPK 2) cash flow

if home prices fall by 15%, what happens to SR output?

When home prices fall by 15%, the wealth value of properties in the U.S. housing market goes down. This would cause consumers to consume less since their homes are now worth less than before and they will be de-incentivized from spending since they feel less wealthy. This produces a negative shock in the economy and the IS curve shifts in and leftward. The parameter a̅c (the parameter for consumption) would decrease since consumption would decrease, thereby causing Ỹ to decrease.

when Yt = Ybart, then...

abar = 0 and Rt = rbar

life-cycle model of consumption

consumption is based on average lifetime income rather than on income at any given age

if sensitivity to interest rate b bar were higher, the IS curve would be...

flatter because change in interest rate would be associated with larger changes in output

potential output

highest level of real GDP that can be sustained over long term; is smoother than actual GDP - a shock to actual GDP will leave potential output unchanged

what does the national income accounting identity imply

implies that the total resources available to the economy = total uses

what does IS stand for

investment = savings

what is x bar

parameter that determines how much consumption rises when economy expands

return on capital =

MPK - depreciation

what is the relationship between the real interest rate and the output gap in the IS curve?

IS curve illustrates the inverse or negative relationship between real interest rates and short run output. It shows that when the real interest rate is higher, real output is lower, thereby leading to a lower output gap - output is inversely related to the interest rate, but positively related to the output gap. Alternatively, the lower the interest rate, the higher real output is, leading to a higher output gap. This occurs because when the interest rate goes up, the investment rate goes down, causing GDP to fall and the output gap to shrink; people will borrow less money since borrowing would be more expensive.

What happens to short-run output if a̅g falls by 5%?

If a̅g falls by 5%, government spending would decrease, thereby reducing aggregate demand and causing a negative aggregate demand shock since a̅ would decrease (a̅ being the parameter that stands for the aggregate demand shock). When a̅ decreases, short run output decreases, so the IS curve would shift in and leftward. The growth of real GDP would slow and decrease workers' disposable income, causing people to save more and consume less goods and services.

what does the IS curve illustrate?

Illustrates the negative relationship between interest rates and short-run output; IS stands for "investments = savings" - A change in the real interest rate moves the economy along the IS curve As output increases, so does the demand for money, leading to upward pressure on the interest rate

when lenders reduce interest rates by 2%, what happens to SR output?

When lenders reduce interest rates by 2%, there will be a rightward movement along the IS curve because changing interest rates causes movement along the curve. As the real interest rate decreases, the cost of borrowing decreases, so people and firms would be more incentivized to take out loans and increase their investments. R would decrease because R represents the real interest rate, while Ỹ would increase due to the increase in borrowing, which would in turn cause an increase in spending and consumption since financing their consumption is now cheaper.

when the long-run interest rate falls, what happens to SR output?

When the long-run interest rate falls, investors anticipate that inflation will decline and output will continue growing. Since R is equal to the real interest rate and r̅ represents the long run marginal product of capital, and r̅ is subject to diminishing marginal returns, R and r̅ would decrease. Initially, R = r̅1, but after a decline in the long-run interest rate, r̅1 > r̅2. However, output would remain the same because although capital is producing output at a decreasing rate, lower interest rates mean cheaper financing/increased consumption which would encourage increased production. The IS curve would thus shift down (inward and leftward) to stay at the same level of output, Ỹ1 = 0

What happens to short-run output if the marginal product of capital rises to 6%? What might lead this to happen?

When the marginal product of capital rises to 6%, total product or output increases. According to the IS curve function, it would increase by 1.5%. Short run output would initially increase at an increasing rate because in the short run, new capital does not face depreciation and would produce at its highest levels of productivity; however, in the long run, capital would face diminishing marginal returns and output would only increase at a decreasing rate. Therefore, capital that has a marginal return of 6% would net a 1.5% increase in productivity or output in the long run. The IS curve would shift outward and rightward.

If the real interest rate rises to 4% what happens to short-run output, ceterus paribus?

When the real interest rate rises to 4%, short-run output decreases because the real interest rate and short-run output have an inverse relationship assuming ceteris paribus (that all other conditions remain the same). Essentially, the increase in the interest rate would increase borrowing costs, in turn decreasing demand for investments and causing output to decrease so that actual output would exceed potential. There would be a leftward shift along the IS curve, indicating that short run output would decrease. Since short-run output is negative, the economy is experiencing a negative output gap; in other words, the economy is producing less than full employment output and is in a recession.

if there is a deep recession in China, what happens to SR output?

When there is a deep recession in China, households in China will consume less because of decreases in income. Because of the decrease in consumption, China will import less goods and services from the U.S., causing the parameter a̅ex (the parameter for exports) to decrease and producing a negative demand shock in the economy. The IS curve thereby shifts in and leftward.

change in R =

movement along IS curve

a change in the real interest rate...

moves economy along IS curve - increases IR - increases borrowing costs - depresses investment demand - output goes down so actual < potential

permanent-income hypothesis

people's consumption depends on their long-run expected permanent income rather than their current income

Explain how the permanent-income hypothesis can explain the "multiplier effects" we discussed in class.

permanent-income hypothesis is the hypothesis that consumers will spend money according to what they anticipate their long-term average income to be instead of based on their current income. Essentially, they treat their expected long-term income as the level of "permanent" income that they believe they can spend safely and will spend at a level relative to the total average income of their time. Due to this consumer trend, even if successful economic policies are implemented, an increase in income in the economy will not produce a multiplier effect with increased consumer spending. Instead, this trend means that consumption will not increase unless consumers change their expectations about what their future incomes will be. The multiplier effect can be illustrated by the equation: MPC Multiplier = Ỹ = 1/ (1 - x̅), where x̅ is the marginal propensity to consume. When people spend a part of their income then x̅ is greater than zero, and the size of the demand shock is determined by x̅; and as seen by the equation, a shift in income and/or spending causes a larger degree of change than that initial shift (changes in Ỹ exceed changes in x̅). We see the multiplier effect take place in the permanent-income hypothesis because changes in what people anticipate their long-term average income to be affect changes in consumption not only in the future but at present (hence, "permanent" - people feel safer spending more now because they believe their future incomes will support the costs of their current spending later on). Therefore, changes in consumption would be more significant.

what determines output fluctuations

the gap between the real interest rate and the MPK

what does the IS curve tell you

the level of short run output that corresponds to any interest rate

what causes the IS curve to shift

when equilibrium output changes at each given real interest rate; in other terms, any other change in the parameters of the short run model (a bar, b bar)