Chapter 18: IS-MP Analysis: Interest Rates & Output

Low interest rate make the US dollar cheaper

and this increases net exports (exports-imports)

Lower interest rates ______ net exports

boost

potential output is determined by long-run factors that are unaffected by these

business cycle changes

When output is less than aggregate expenditure,

businesses will ramp up production so as not to miss out on profitable sales

aggregate expenditure is boosted

by lower real interest rates

Potential GDP is unchanged so

changes in GDP translate to change in the output GAP

In short run, changes in demand drives

changes in output

Lower interest rates boost

consumption

On average, lower interest rates lead to more

consumption

In the short run, ________ conditions determines output

demand

The IS curve is like a macroeconomic

demand curve

Equilibrium GDP

describes the level of GDP at the point of macroeconomic equilibrium - the point at which the economy will come to rest (output level - aggregate expenditures)

High interest rates

discourage spending

The opportunity cost principle tells you

if you should invest or save

government purchases are boosted by

lower interest rates

An economic slump can be in equilibrium because

businesses don't want to produce output that people won't buy, and people don't want to spend more because the economy is weak

The key idea is that when the total quantity of output exceeds aggregate expenditure,

businesses will cut back their production

The real interest. rate represents the opportunity cost of boosting this year's

consumption spending

Lower real interest rates yield more

consumption, investment, government purchases, and net exports

The IS curve is _________ because lower interest rates boost aggregate expenditures, which leads. to a higher level of GDP, and hence a more positive output gap.

downward sloping

The IS curve is valuable tool in forecasting

economic conditions

Low interest rates

encourage spending

Businesses adjust output to meet demand to be in

equilibrium

Aggregate expenditure describes

everyone's spending plans

Supply driven long-run analysis

explains the economy's potential output

The IS curve shows that lower interest rates lead to

higher real GDP and a more positive output GAP

When the Federal Reserve wants to stimulate spending

it lowers the real interest rate

Lower interest rates lead to increased government spending because the government is spending ______ on interest

less

A ________________ in the US leads international money managers to send their funds to other countries that other better returns. This means ______ dollars are need to invest in overseas funds. The dollar becomes ______. So initial effect of a _________ is that it takes fewer yen, euros, pesos, yuan to buy US $

low real interest rate, fewer, cheaper, lower interest rate

______ interest rates lead to a cheaper dollar, causing exports to _______ and imports to ________ and hence _______ net exports.

lower, rise, fall, higher

Output gap

measures the gap between actual and potential output as a percentage of potential output

Low interest rates leads to

more consumption

Real interest rate is

nominal interest rate adjusted for inflation

The real interest rate is central to your spending decisions as a consumer because of the ___________. You save and earn interest on any income you don't spend

opportunity cost principle

Since potential is unchanged, the interest-rate-induced increase in output also increases

output relative to potential output, leading to a more positive output gap

As with the demand. curve, the vertical axis shows ______ and the horizontal axis shows _______, the output gap (quantity of goods and services purchased across the whole economy relative to potential output)

price, quantity

The cheaper dollar _____ imports and _______ exports

reduces, increases

Equilibrium GDP describes the economy's _________ while potential GDP is where _______ wishes it would rest

resting point, Goldilocks

The supply side typically grows _____ over time

smoothly

potential output describes

the economy's maximum sustainable rate of output

On the IS curve graph, the output gap, which is on ___________ measures output relative to potential GDP

the horizontal

If the real interest rate is low, people will by cars with loans because

the interest will be low

The lower the real interest rate is,

the lower the opportunity cost

The aggregate expenditure equation simply states that across the whole economy, businesses will adapt their production so that

total output matches total spending

Analysis of Business Cycles

focus on demand side of economy first

Long-run economic growth

focuses on the supply side of the economy. It is a period spanning a decade or more

The IS curve is called the IS curve because it describes investment and spending decisions __________________ of output

interest sensitive

The boost of investment is usually the most important because

investment is particularly sensitive to the interest rate

actual output

may fail to meet the potential output as aggregate expenditure ebbs and flows

When output goes from -2% to -3% below potential output, it is a more ______ output gap

negative

macroeconomic equilibrium

occurs when the quantity of output that buyers collectively want to purchase is equal to the quantity of output that suppliers collectively produce

When output is below ______, the economy is running too cold. When the output exceeds potential, it risks ______. Only when output is equal to potential output will __________ declare that business cycle conditions are just right

potential, overheating, Goldilocks

Focusing on the output gap is helpful because it provides a way to disentangle the roles of

the demand and supply side determinants of GDP

_____________ may be to most important price in the economy beach it represent the opportunity cost of spending

the real interest rate

The IS curve describes the link between

the real interest rate and the output

Business do more capital spending/investment in machinery and equipment/buildings if

the real interest rates are low because the cost of capital is cheaper

aggregate expenditure

the total amount of goods and services that people want to buy across the whole economy

On the IS curve graph, the real interest rate is on

the vertical axis

short-run refers to

the year-to-year ups and downs of the business cycle

The only time low interest rates don't spur government spending is when

they decided to pay government debt

Everyone spends more when there are low interest rates except the elderly because

they rely on high interest rates to give them interest on their retirement funds (there only source of income

If you can predict demand you can do a great job

forecasting short run fluctuations

Forecasting GDO is all about

forecasting what will happen to each component of aggregate expenditure

Aggregate expenditures can differ from _______ if people purchase less than they produce, the extra goods are kept in _______. This is not an ______ because managers will respond by cutting back production

outputs, inventories, equilibrium

When output goes from -3% to -2% below potential output, it is a more ______ output gap

positive

Do not confuse equilibrium GDP with

potential GDP

The supply side determines

potential output

The real interest rate, which is denoted by r, tells you

how large this opportunity cost is

IS curve

illustrates how lower interest rates raise spending and hence GDP, leading to a more positive output gap

supply side of the economy

is the available supply of labor, capital, and human capital, plus the production function that summarizes the state of technological progress

Potential GDP

is the economy's highest sustainable level of production, and it determined by available inputs

output =

((Actual output - potential output) / potential output) x 100

Y / AE (Aggregate Expenditure) =

C (Consumption) + I (Planned Investment) + G (Government) + NX (Net Exports)

_____________ factors can drive actual GDP to deviate substantially from potential GDP and the actual output gap can fluctuate ________

Demand side, widely

IS curve means

Investment and Spending decisions

You can forecast the output gap based on

a real interest rate

GDP =

aggregate expenditure

output is the same as

aggregate expenditure

potential output is the level at which

all resources are fully employed

Real interest rate

determines this years aggregate expenditures

Lower interest rates boost

investment

When actual GDP exceeds potential GDP, the economy will

overheat

planned investment

when businesses purchase new capital

consumption

when households buy goods and services

The output gap focuses on

the balance between supply and demand

consumption =

Planned Investment+Government Purchases + Net exports

The federal Reserve raises the real intent rate, which ___________ the opportunity cost of spending when it wants to induce people to spend ________

increases, less

Lower interest rates reduce the cost of _______ on government debt. As a result the government has more of its _______ for spending on roads, bridges, etc.

interest payments, budget

potential output

is the economy's maximum sustainable level of output

A rise in aggregate expenditures is matched by a rise in _________ hence GDP

production

Aggregate expenditures might be greater than production if

sales exceed inventories and companies need to ramp up production

government purchases

when the government buys goods and services

potential output definition

is determined by the available supply of labor, human, and physical capital, and technological progress

The real interest rate is also critical because its

one of the levers (tools) policy makers (The Federal Reserve) use to influence the economy

demand side

short-run focuses on aggregate expenditures and its components

In order to keep up with demand, companies must defer maintenance on machinery ____________. But producing at this level is not ___________ and the pressures will spark _______

so they can run extra overnight shifts and running overtime, sustainable, inflation

net exports

spending by foreigners on American-made exports, less spending on foreign-made imports

The real interest rate is the opportunity cost of

spending money this year

Output may be less than potential and still be in equilibrium if

suppliers adjust their production lines (shut id inventories are high enough to cover demand) based on demand)

The real interest is also

the cost of borrowing