IS Curve

8 Key excerpts on "IS Curve"

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  eBook - ePub

  Macroeconomic Systems

  • Krish Bhaskar, David F. Murray(Authors)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  0 , will bring the goods market to equilibrium. This procedure may be repeated for each value of real income to obtain corresponding values of interest rate which will ensure equality of savings and investment. The line joining these pairs of values is the IS Curve and it is defined as the locus of combinations of real income and interest rate which will bring the goods market to equilibrium. Mathematically the IS Curve is simply the solution of equation 5.3 for R in terms of Y.

  The possibility that investment might be interest inelastic during periods of severe depression was mentioned earlier and it is important at this stage to consider the implications of this for the IS Curve. The derivation is shown in Figure 5.2 and it can be seen that in this case whatever the interest rate there is only one value of investment, I0 , which in turn means that there is only one value of savings, S0 , which will ensure an equilibrium in the goods market. Corresponding to this level of savings is real income, Y0 , so it is clear that any rate of interest combined with real income, Y0 , brings the goods market to equilibrium and the IS Curve in this situation is, therefore, a vertical line.

  Figure 5.2 Derivation of the IS Curve with interest inelastic investment

  Introduction of fiscal policy instruments

  The introduction of government expenditure, G, and taxation, T, into the goods market is the next step. The first modification to incorporate is that savings must now be considered to be determined by disposable real income, Yd

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  Financial Markets and the Macroeconomy

  A Keynesian Perspective

  • Carl Chiarella, Peter Flaschel, Reiner Franke, Willi Semmler(Authors)
  • 2009(Publication Date)
  • Taylor & Francis

    (Publisher)

  As q impacts positively on aggregate demand (while in the familiar textbook story the interest rate impacts negatively on Y d), this IS Curve is upward-sloping (rather than downward-sloping, when Y d depends on i). In addition, if q is held constant, then all non-equilibrium points are attracted by the IS Curve. These features are illustrated in Figure 2.4. Note that the IS Curve must cut the horizontal axis at a positive value, since the autonomous term in the aggregate demand function has been assumed as positive (representing basically the in”uence of “scal policy on aggregate demand). The IS Curve will shift to the right if”scal policy is expansionary and it will be steeper with smaller a y, the value of the marginal propensity to spend. Figure 2.4 The IS Curve (representing goods market equilibrium). 2.3.3 The LM Curve: q̇ = 0 In analogy to the treatment in the previous subsection, the second law of motion may be set to rest. This means that the stock market is in temporary equilibrium… in conjunction with money market equilibrium, which by (2.2) and i(Y) entering (2.8) is presupposed anyway. Although i (Y) was said to derive from a familiar LM condition, it will be convenient from now on to call the locus of pairs (Y, q) giving rise to (2.8) = 0 an LM curve. We stress that the LM curve of this chapter represents money market and stock market equilibrium and is thus more complex than the usual LM curve of the textbook literature (and in particular, not always positively sloped as in the case of the simple money market LM curve, see below). ThIS Curve, however, is unstable. Suppose share prices and, thus, Tobin•s q are so high that i (Y) q – r (Y) > 0, which says that the short-term interest rate i exceeds the direct returns r p K from holding equities when these are related to the value of shares (this rate of return being given by rpK/p e E = r/q). In this situation share prices are driven up even higher, according to q̇ > 0 in (2.8)

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  Monetary Economics in Developing Countries

  • Subrata Ghatak, José R. Sánchez-Fung(Authors)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  The equilibrium r thus falls to r 2 . If we then join all the points of equilibrium between S and I , we obtain an IS Curve which depicts an inverse relationship between r and Y . It is clear that every point on the IS Curve is a point of equilibrium between I and S . This is shown in Figure 5.7. In the money market, following Keynes, let us assume that the equilibrium interest rate, r 0 , is determined where M d = M s , as shown in Figure 5.8. Let us think that this M d is given by income Y 0 (say, 100 billion rupees). If Y rises from Y 0 to Y 1 M d 0 also rises, and this is shown by the shift of the M d curve from M d 0 to M d 1 . The equilibrium r now rises from r 0 (say, 4 per cent) to r 1 (say 5 per cent). If Y rises further, to Y 2 ( Y 2 = 300 billion rupees), M d 1 shifts upwards to M d 2 and equilibrium r rises from r 1 to r 2 (that is, say, from 5 per cent to 6 per cent). If we now join all the points of equilibrium between M d and M s with a rise in income, we trace out an upward-sloping curve, which has been called LM . Once again, the LM curve depicts the relationship between r and Y when the money market is in equilibrium (that is, M d = M s ). If we now combine the two curves .............................................................. Keynesian and monetarist views on money 75 Rate of interest Savings and investment r r 0 S 0 Y 0 S 1 Y 1 S 2 Y 2 I S, I r 1 r 2 Figure 5.7 Savings, investment and the interest rate (Hicksian framework) 0 r Rate of interest Money demand and supply M s M s r 0 (4%) r 1 (5%) r 2 (6%) M d , M s M d 0 Y 0 (Rs 100 bn) M d 1 Y 1 ( Y 1 = Rs 200 bn) M d 2 Y 2 ( Y 2 = Rs 300 bn) Figure 5.8 Money demand, supply and the interest rate (numerical example) together, as in Figure 5.9, we obtain ‘the’ equilibrium rate of interest, r ∗ (say, 5 per cent). It can be checked easily that the equilibrium r ∗ is stable. In simple terms, a general equilibrium theory of interest rate determination should include the following factors:

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  Asymmetry and Aggregation in the EU

  • D. Mayes, Matti Virén(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The IS Curve itself is not of itself our main interest. Thus, our main concern is not so much to test different versions of the IS Curve against each other as to see whether the role of the policy variables is robust over different specifications. Obviously, the interpretation of the old-fashioned backward-looking IS Curve and the Euler equation are quite different. Thus, with the Euler equa- tion, the coefficient of the interest rate reflects intertemporal sub- stitution rather than the impulse response of the policy rate. In the context of the Euler equation, the interpretation of the real exchange rate and the asset prices is also a bit tedious e.g. because we can- not really distinguish anticipated and unanticipated parts of these variables/shocks. 3.1 Monetary conditions Our primary concern in this chapter is more with aggregation than asymmetry. As we have just noted, there is a lot of variation in the openness of the EU countries not just generally but to each other and to the euro area. Monetary policy in the euro area is set with regard to future inflation in the area as a whole. While the impact of monetary policy on the real exchange rate and the impact of the real exchange rate on inflation at the aggregate level will be taken into account, the impact on the individual countries will be very different. In Mayes and Virén (2000b) we explored this in some detail using data from before the start of the euro area. Our primary concern was to consider the relative importance of the influence of the real exchange rate and the real interest rate in affecting output, i.e. â 3 /â 4 = λ in terms of equations (3.1) to (3.4). Thus for example if λ = 2, a one percentage point increase in the real Aggregate Supply and Demand in an Open Economy 45 interest rate has the same impact as a 2 per cent increase in the real exchange rate.

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  Prosperity and Public Spending (Routledge Revivals)

  Transformational growth and the role of government

  • Edward Nell(Author)
  • 2009(Publication Date)
  • Routledge

    (Publisher)

  The value of the multiplier will now depend on the state’s welfare policy, as well as upon the real wage and the productivity of labor. Clearly a realistic theory will require still further extensions, but the principles upon which these should be based ought by now to be apparent.

  VI The Markets for Funds

  In conventional theory, households make savings decisions, based on their income and the interest rate, while businesses make investment decisions, based on their sales receipts and the interest rate. The IS Curve is then defined as the locus of all combinations of income and the interest rate for which household saving equals business investment. This is then put together with the locus of all combinations of income and interest for which the supply and demand for money are equal, to determine overall macroeconomic equilibrium. The interest rate, then, functions as a neo-Classical ‘price’, helping to equate supply and demand, in two markets: for investible funds, and for money to hold.

  But when the theory of effective demand is based firmly on Classical-Marxian foundations, no such markets exist. Withdrawals as well as injections are determined on the business side of the social accounts. Households are purely passive; they simply pass along their wage income as consumption expenditure. There are no savings, and no saving decisions, by households; so there is no market in which the rate of interest could play the role of a price.11 The forces of productivity and thrift’, in the neo-Classical sense, are not there. The funds to underwrite investment are generated by employment, since employment, because it produces a surplus over the real wage bill, creates the ‘withdrawals’ or ‘leakages’ required.

  Not only is there no loanable funds market here, there is no supply and demand market for money either. When employment increases, businesses draw on their lines of credit, previously established to provide the working capital necessary to operate their productive capacity. Using this credit they pay the higher wage bill. The wage payments are deposited, then spent and redeposited as sales proceeds. Since the wage bill in the investment goods sector generates the profit in consumer goods, it provides the finance for that sector’s purchases of investment goods, while the investment goods sector’s own purchases of its products can be financed by borrowing against investment goods inventory. So bank deposits and hence ‘the money supply’ automatically increase as employment increases. Note that this is consistent with the banking system being fully ‘loaned up’ both at low levels and at high levels of activity. At low levels deposits are low, but so is the volume of loans. Established lines of credit lie unused. But when they are drawn on, wage payments and consumption (and therefore bank deposits) rise. Loans and deposits rise and fall together reflecting changes in economic activity. The supply of money for transactions—current deposits—adapts to the demand for it, once we grant that the banking system will provide business with credit lines equal to the working capital required to operate existing productive capacity.12

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  Macroeconomics without the Errors of Keynes

  The Quantity Theory of Money, Saving, and Policy

  • James C. W. Ahiakpor(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  There is no one market on which AS and AD curves determine the price level independently of those determined on individual markets. Thus, the objections of some analysts to calling the AD curve, derived from the IS-LM model, a “demand curve” appear well founded. For instance, Colander and Gamber (2002: 304) write: “The aggregate demand (AD) curve shows the com-binations of price levels and income levels at which both the goods market and the money market are in equilibrium. It really isn’t an aggregate demand curve at all – it’s a goods market/money market equilibrium curve.” 8 Furthermore, the de fi nition of money employed in modern macroeconomics to derive the LM curve, such as M1 or M2, includes the public’s savings. Thus, the LM curve may shift to the right because of increased savings – increased acquisi-tion of bank fi nancial assets, such as savings deposits, time deposits, money market deposit accounts, and money market mutual fund shares – by the public, without a fall in the level of commodity prices. Unless banks increased their rate of cash hoarding or their excess reserves-deposit ratio, increased savings does not change total spending or the level of prices in the short run; borrowers from banks spend the loaned-out savings. 9 Also, the rightward shift of the IS Curve inferred from increased government or private investment spending in the Keynesian cross model (Y = E = C + I + G) for a closed economy is inaccurate. The model assumes that government spending and parts of private investment and consumption spending are autonomous; that is, they do not depend upon current income. Thus, the argument goes, increased government spending increases total spending. But government spending must be fi nanced either through taxes and/or borrowing (G = tY + ∆ B g , where B g = government bonds) – assuming no borrowing from the central bank.

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  Macroeconomic Theory and Macroeconomic Pedagogy

  • G. Fontana, M. Setterfield, G. Fontana, M. Setterfield(Authors)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  We shall now go on to examine the meaning of the individual equations. Relation (15.4) is a simple version of the so-called ‘Taylor rule’ and constitutes a hypothesis about the behaviour of the central bank. It is assumed that the monetary authority sets a real interest rate r that is higher than the rate r n , correspond- ing to the full-employment equilibrium, to the extent that the current rate of inflation π is higher than a target rate of inflation π T (set by the central bank or the political institutions of the country). In other words, the central bank believes that it can influence economic activity and hence also price dynam- ics through action on the interest rate r . This conjecture is borne out by the other two equations of the model. Equation (15.5) is a simple expression of the traditional IS Curve. It tells us that the interest rate has a negative influence on aggregate demand and hence also on the degree of effective utilization u of productive capacity. The effective degree u indicates deviations from the rate u n deriving from more or less intensive utilization of capital and thus Emiliano Brancaccio 301 implying variations in per capita output y with respect to per capita capital k. In examining this equation, it should also be borne in mind that only the rate r n is capable of generating demand and a degree of utilization u corresponding to the level u n consistent with full-employment equilibrium. Finally, (15.6) is a simple derivation of the Phillips curve indicating that upward or down- ward variation in inflation depends on the difference between the effective degree of utilization, u, and the degree of utilization corresponding to the full-employment equilibrium (u n ). The system therefore comprises three equations and three unknowns, r , u, and π.

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  The Macroeconomic Environment of Business

  Core Concepts and Curious Connections

  • Maurice D Levi(Author)
  • 2014(Publication Date)
  • WSPC

    (Publisher)

  Fig. 7.7. The market interest rate.The market interest rate balances loanable funds demand with loanable funds supply. This is not the equilibrium rate if at that rate savings, S, are not equal to investment, I.

  The market interest rate equates the supply of and demand for loanable funds.

  As well as showing LS and LD , Fig. 7.7 also shows the curves behind the supply of and demand for loanable funds. Because LS is the horizontal sum of ΔMS and S, and LD is the horizontal sum of ΔMD and I, i.e., LS = ΔMS + S and LD = ΔMD + I, at the market interest rate:

  We see that there is no requirement at the market interest rate for savings to be equal to investment, because the change in the supply of and demand for money may not be equal. For example, if ΔMS is larger than ΔMD , then Eq. (7.1) tells us that at the market interest rate, I exceeds S. Indeed, the extent to which the change in money supply exceeds the change in money demand is equal to the extent investment exceeds savings. This is the situation shown in Fig. 7.7 . From examination of the figure, we can see that at the market interest rate the excess of ΔMS over ΔMD is equal to the excess of I over S.

  With it being possible for S to differ from I at rM the market interest rate is not an equilibrium rate. This is because if, e.g., I exceeds S at rM ,so that injections into the circular flow of income exceeds withdrawals, then ceteris paribus, the GDP will increase to a higher level. The increase in GDP will shift the savings curve to the right until S = I.6 With S = I, and also with the market interest rate such that LS = LD , i.e.,

  it must also be the case that ΔMS = ΔMD . This rate of interest at which S = I and ΔMS = ΔMD is called the equilibrium interest rate.

  The equilibrium interest rate equates savings and investment. Over time, the market interest rate moves towards the equilibrium interest rate via adjustments in GDP

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