Transcript A curve in

ISLM: The Engine Room
Chapter 7
The IS Curve
A curve in (i, Y) space comprising all points where the
goods market is in equilibrium.
Y=C+I+G
Earlier, we defined: C = C + bY and I = I - fi
Thus, Y = (C + bY) + ( I – fi) + G
Let A = C + I + G, we have
Y = A + bY – fi
fi = A – Y + bY
Solving for i we get
i = A/f – Y(1 – b)/f
(This is an equation of a straight line with intercept equal to
A/f and slope equal to – (1 – b)/f [Negative slope]
Applications
(fig. 7.2)
1.
2.
3.
IS curve response to a collapse in investor
confidence (I).
IS curve response to a collapse in consumer
confidence (C).
IS curve response to a change in government
spending (G).
How do taxes affect the IS
curve?
CT = C – bYD
YD = Y(1 – t)
CT = C + bY(1 – t)
Using the equilibrium condition in the goods market
Y = CT + I + G
(with the after–tax C function) and
solving for i we get
i = A/f – [1– b(1– t)]Y/f
Now the slope is – [1– b(1– t)]/f (the IS curve
becomes steeper; fig. 7.3)
Applications
(fig. 7.4 and 7.5)
1.
2.
The tax rate increases from 35% to 43%.
The tax rate increases in an economy
struggling to recover from a prolonged
recession (examples: tax increases in
Japan in 1996, doubling of tax rates in
the U.S. during the great depression, and
state taxes in 1990-91.)
The LM Curve
A curve in (i, Y) space comprising all points where the money market
is in equilibrium.
Money supply = Money demand
Earlier (chapter 4), we defined: Money demand = kY – hi
M/P = kY – hi
Solving for i we get
i = (k/h)Y – (1/h)M/P
(This is an equation of a straight line with intercept
equal to – (1/h)M/P and slope equal to (k/h) [positive
slope]
Fig. 7.6
Factors that shift the LM curve
(fig. 7.7)
A change in the nominal money
stock, M.
2. A change in the price level, P.
1.
ISLM – ADAS policy applications
Survival guide to ISLM-ADAS analysis
 Make all moves in (i,Y) space first.
 Go to (P,Y) space and adjust AD to make Y
consistent with Y in the (i,Y) space.
 Has P changed? If ‘no’, go to step 4. If ‘yes’,
go to (i,Y) space and adjust LM.
 Close the goods markets (and the labor
market, to be incorporated in chapter 8). How
do the final values of C and I compare with
the initial values?
 Analyze the implications of your results.
ISLM – ADAS policy experiment I
(fig. 7.10)
Initial state of the economy: Low GDP growth rate Y0.
Assume government spending increases from G0
to G1 (spending on infrastructure, defense, …).
Step 1: As G increases, the IS curve [(i,Y) space] shifts to
the right (intercept increases).
Step 2: In the (P,Y) space, the AD curve shifts to the right
(upward).
Step 3: P did not change we go to step 4.
Step 4: The equilibrium in the goods market is consistent
with Y1 in the (i,Y) and (P,Y) spaces
We know that C1 > C0 since Y1 > Y0 but what about
investment, I?
 Recall
that I = I - fi
So I0 = I - fi0
But the new interest rate is higher as a
result of higher government borrowing.
So I1 < I0
Step 5: An increase in G causes an
increase in the rate of growth of Y and
a decrease in private capital investment
(crowding out effect).
ISLM – ADAS policy experiment II
The Fed increases money growth.
Step 1: LM curve shifts to the right.
Step 2: We adjust the AD curve in the (P,Y) space to
ensure that Y is consistent with Y in the (i,Y) space.
Step 3: P has not changed.
Step 4: Shift (upward) the expenditure line in the goods
market. Is C1> C0? Yes (since Y1> Y0).
Is I1> I0? Yes (since interest rate i1 < i0).
Step 5: An increase in money supply leads to a
decrease in interest rate, and increase in
investment, consumption, and Y.
ISLM – ADAS policy experiment III
Country K has been struggling to come out of a recession
and the budget deficit is very high. Policymakers decide to
increase taxes (T = tY).
Step 1: IS curve pivots clockwise. C and I fall.
Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is
consistent with Y in the (i,Y) space.
Step 3: P has not changed.
Step 4: Shift (down) the expenditure line in the goods market. Is C1>
C0? No (since Y1< Y0) and C is lower)
Is I1> I0? (i1 < i0 but I1 < Io (investor confidence is lower). If the
macroeconomic outlook is dismal and investors expect further tax
increases (investment) I will not rise (liquidity trap; U.S. economy in
2008; Japan and Argentina in early 2000s).
Step 5: Y, C, I and interest rates (i) fall.
Policy Challenges in China
 Bao
ba (guaranteed 8%) growth policy
 Low MPC (small multiplier)
 IS curves for the Western and Central
regions in China
ISLM – ADAS policy experiment IV:
Fine tuning
Country K increases G and M (to avoid
crowding out private investment)
Step 1: As G increases, IS curve shifts up (right). As M
increases, LM curve shifts to the right.
Step 2: We adjust the AD curve in the (P,Y) space to
ensure that Y is consistent with Y in the (i,Y) space.
Step 3: P has not changed.
Step 4: We Adjust the expenditure line in the goods
market to be consistent with Y1. Is C1> C0? Yes,
since Y1> Y0
Is I1> I0? In this example, no change in the interest
rate, i so I1 = Io (assume investor confidence is the
same).
Step 5: Y and C increase.
The Global IS Curve
Y = C + I + G + (EX – IM)
i = [A/f + (EX – IM)/f] – Y(1 – b)/f
The intercept: A/f + (EX – IM)/f
 An increase in exports causes the IS curve to shift
upward (right).
 A recession in a large foreign economy causes
foreign national income to fall and causes foreign
demand for domestic country’s exports to decline
(contagion).
 Effects of the home currency depreciation or
devaluation (China and U.S.).