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Session 6 Is Curve
Session 6 Is Curve
Macroeconomics
11th Edition: chapter 14 ( page 347 to 352), chapter 10: ( page 220 to 232)
12th Edition: chapter 15 ( page 352 to 357), chapter 11: ( page 223 to 236)
Investment
• Links the present to the future
– Through enhancing capital stock leading to economic growth
• Case 1:
• Sales fall to 25 cars/month due to demand shock, and you take one month to
respond/adjust to the change in demand.
• Your inventory increases to 35 but the new desired inventory level is 25 cars.
• You produce only 25 – (35- 25) = 15 cars.
(New inventory demand – (existing stock – sale))
– Fall in production could be higher than fall in demand.
– Once the inventories are brought down to desired level production goes upto 25
cars.
• Case 2
• What if the sales again recover to 30 cars.
• Production 25, sales 30, inventory declines to 20.
• Target inventory is 30. So you produce 30 – (20 – 30) = 40
• Once inventories are brought up to desired level production stabilizes at 30
cars.
The Desired Capital Stock
• Firms use capital, along with labor and other resources, to
produce output
𝑟𝑐=𝑟 + 𝑑=𝑖 − 𝜋 + 𝑑
– Where
rc= rental (user) cost of capital
r = real rate of interest
d = rate of depreciation
= rate of inflation
The Desired Stock of Capital
• Firms add capital until the
marginal product of the last
unit = rental cost of capital
• Rate of depreciation is a
technical parameter
• Replacement demand
– Higher level of capital stock would lead to higher level
of depreciation, which in turn create higher
replacement demand.
10-14
Investment and Interest Rate
• Investment is no longer treated as
exogenous, but dependent upon interest
rates (endogenous)
¿[𝐶
¯ +𝑐𝑇 ¯ 𝑐( 1− 𝑡 )𝑌 ] +( 𝐼¯0 − 𝑏𝑖)+ 𝐺
¯ 𝑅+ ¯
¯ + 𝑐 (1 − 𝑡 ) 𝑌 −
𝐴 (2) 𝑏𝑖
• An increase in i reduces AD
• At any given level of i, we can determine the equilibrium level of
income and output
• A change in i will change the equilibrium
is autonomous component of the investment (non-interest rate sensitive)
10-19
The Interest Rate and AD AD=Y
Aggregate demand
AD: The IS Curve
Ā+c(1-t)Y-bi1
AD A c(1 t )Y bi (2)
Ā-bi1
E1
Derive the IS curve
• For a given interest rate, i1, the Y
last term of RHS in equation (2) Y1
Income, output
is constant can draw the AD (a)
function with an intercept of i
A bi1
• The equilibrium level of Interest rate i1 E1
income is Y1 at point E1
Y1 Y
Income, output (b)
The Interest Rate and AD AD=Y
Aggregate demand
Ā+c(1-t)Y-bi2
AD: The IS Curve E2
Ā-bi2 Ā+c(1-t)Y-bi1
Consider a lower interest rate,
i2 Ā-bi1
E1
Shifts the AD curve upward to i2< i1
AD’¯with an intercept of Y
𝐴 − 𝑏 𝑖2 Y1 Y2
Income, output
(a)
Given the increase in AD, the i
equilibrium shifts to point E2,
Interest rate i1 E1
with an associated income
level of Y2 E2
i2
Plot the pair (i2, Y2) in panel
(b) for another point IS
IS curve: combination of i and Y1 Y2 Y
Y that clears the goods market Income, output (b)
DERIVATION OF THE IS CURVE
The Interest Rate and AD AD=Y
Aggregate demand
Ā+c(1-t)Y-bi2
AD: The IS Curve E2
Ā-bi2 Ā+c(1-t)Y-bi1
We can apply the same
Ā-bi1
procedure to all levels of i to E1
generate additional points i2< i1
on the IS curve Y1 Y2 Y
Income, output
All points on the IS curve
(a)
represent combinations of i i
and income at which the
goods market clears goods Interest rate i1 E1
market equilibrium schedule
Notice the negative i2 E2
relationship between i and Y
Downward sloping IS curve IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
The Interest Rate and AD: The IS Curve
• We can also derive the IS curve using the goods
market equilibrium condition:
𝑌 = 𝐴𝐷 = 𝐴 ¯ +𝑐 (1− 𝑡)𝑌 −𝑏𝑖(3)
𝑌 − 𝑐 (1− 𝑡 )𝑌 = 𝐴 ¯ − 𝑏𝑖
¯ −𝑏𝑖
𝑌 (1 −𝑐 (1 −𝑡 ))= 𝐴
¯ − 𝑏𝑖)
𝑌 = 𝛼𝐺 ( 𝐴 (4)
1
where G
(1 c(1 t ))
, the multiplier from Chapter 10
Equation (4) is the equation for the IS curve.
10-23
AD AD=Y
Aggregate demand
E2 Ā+c(1-t)Y-bi2
E4
Ā-bi2 Ā+c(1-t)Y-bi1
At E3, demand is lower
than output, hence firms E3
Ā-bi1 E1
will cut down the
production Y
Y1 Y2
Income, output
(a)
i2< i1
At E4, demand is greater i
than output, hence firms Interest rate E3
i1 E1
will raise output
i2 E2
E4
IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
The Slope of the IS Curve
• The steepness of the IS curve depends on:
– How sensitive investment spending is to changes in i b
– The multiplier G
• Suppose investment spending is very sensitive to i the
slope, b, is large
– A given change in i produces a large change in AD (large shift)
– A large shift in AD produces a large change in Y
– A large change in Y resulting from a given change in i IS curve
is relatively flat
• If investment spending is not very sensitive to i, the IS
curve is relatively steep
10-25
AD=Y
AD A̅ +c’(1-t)Y-bi2
Aggregate demand
A̅ +c(1-t)Y-bi2
A̅ +c’(1-t)Y-bi1
A̅ +c(1-t)Y-bi1
c’> c
-b ∆i
Y1 Y’1 Y2 Y’2 Y
Income, output
(a)
i
Interest rate
i1
i2
IS’
IS
Y1 Y’1 Y2 Y’2 Y
Income, output (b)
EFFECT OF THE MULTIPLIER ON THE SLOPE OF THE IS CURVE
The Role of the Multiplier
c’> c
• Notice the changes in i2< i1
interest rate and multiplier
and their impact on AD
curves
– The coefficient c on the solid
black AD curve is smaller
than that on the dashed AD
curve multiplier larger on
the dashed AD curves
• A given reduction in i to i2
raises the intercept of the
AD curves by the same
vertical distance
– Because of the different
multipliers, income rises to
Y’2 on the dashed line and Y2
on the solid line
10-27
The Role of the Multiplier
• The smaller the sensitivity of investment
spending to the interest rate AND the smaller
the multiplier, the steeper the IS curve
– This can be seen in equation (5): Y G ( A bi )
• We can solve equation (5) for i:
For a given change in Y, the
associated change in i will be 𝑌 −𝛼𝐺 𝐴¯
larger in size as b is smaller 𝑖=
− 𝛼𝐺 𝑏
and as the multiplier is smaller.
𝐴 𝑌
𝑖= −
𝑏 𝛼𝐺 𝑏
10-28
AD AD=Y
Aggregate demand
E2 Ā’+c(1-t)Y-bi1
A’ Ā+c(1-t)Y-bi1
∆A̅
A E1
∆Y=αG ∆A̅
Y1 Y2 Y
Income, output
(a)
i
Interest rate
E1 E2
i1
∆Y=αG ∆A̅
IS’
IS
Y1 Y2 Y
Income, output (b)