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.).