IS Curve

Higher Interest Rates

1. Raise the cost of borrowing to firms and households 2. reduce demand for investment spending 3. Decrease short run output

IS Curve

Demand Shock = 0 so the Short run output = 0 when the real interest rate changes the economy will move along the IS curve

investment equation

Determined by the gap between real interest rate and MPK yt=Ct+It+Gt+NXt divide by y bar and subtract by 1 (y/y)-1= y/y - y/y yields ~y remember It/yt= ai - b (Rt - r) -b=multiplier, R=real interest rate, r=MPK -(Rt - r) controls the output fluctuations if r is low than firms should save, if r is high then firms should invest or borrow

Aggregate Demand Shock

Technology Improvements Create Investment boom so output is higher and shifts to the right

National Income Accounting Identity

Yt + IMt = Ct - It +Gt +EXt remember: Ct = ac yt Gt = ag yt EXt= aex yt IMt= aim yt It/yt= a - b (Rt- r)

Deriving the IS Curve

Yt = Ct + It + Gt + (EXt - IMt) divide by yt and substitute in the five equations from the income identity simplifies to ~yt = (yt - yt) / yt ; a (bar) = a (bar) c, i , g, ex, im, -1 a (bar) is the parameter also known as the demand shock, will equal 0 as potential output = actual output

Increasing

____ing the Interest Rate - causes economy to move up the IS Curve - Short Run output declines

IS Curve

portrays short run output of and economy, depends negatively on real interest rate an Increase in interest rate will Decrease investment which will Decrease output

Multiplier Effects

~yt= 1/(1 - x) multiplied by (a - b (Rt-r) 1/ (1 - x) is the multiplier (a - b(Rt - r)) is the original IS Curve With the multiplier aggregate demand shocks will increase short run output If Short Run output falls with a multiplier consumption will fall along with short run output