L19 - Investment, Interest and GDP: The IS Curve Flashcards Preview

18ECA001 - Principles of Macroeconomics > L19 - Investment, Interest and GDP: The IS Curve > Flashcards

Flashcards in L19 - Investment, Interest and GDP: The IS Curve Deck (22)
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1
Q

What is Investment?

A
  • Investment (flow variable) is changes in stock (stock variable) of capital in the economy.
  • In the long run, investment increases the capital stock and hence the size of potential GDP.
  • In the short run, changes in investment affect aggregate spending and
    hence the employment of existing resources and thus the size of the GDP gap
2
Q

How are investments financed?

A

-There are two ultimate sources of funds for this.
- These are domestic savings in the form of:
1 - firms’ retained profits (best way of investing) and households’ savings
2 - borrowing of savings that have been made abroad.

3
Q

Why do firms want to increase their investments?

A
  • The expectation of profits provides the basic motive determining the
    investment decisions of private sector firms.
  • Firms will buy new plant and equipment if they expect the investment
    to add value to the firm.
4
Q

What factors affect the expected profitability of investment?

A

The factors that affect expected profitability determine the amount of
planned investment spending in the economy as a whole are:
- the price and the productivity of capital goods;
- expectations about the future demand for the output to be produced
by the capital goods, and about the costs of producing that output;
- the development of new techniques of production and of new products;
- profits previously earned by firms and available for reinvestment;
- the real rate of interest.

5
Q

What does the Real Rate of Interest measure?

A
  • The real rate of interest measures the opportunity cost of capital to
    the firm.
  • If the firm borrows to spend on investment, it must pay interest to its
    creditors.
  • If the firm uses its own funds, it must forgo the revenue that it could
    have obtained by lending those funds to others.
  • Desired investment spending depends on the real not the nominal interest rate.
6
Q

How does Real Interest Rate affect investment?

A
  • All Other things being equal:
  • the lower is the rate of interest, the greater the number of investment
    opportunities that will be profitable and therefore
  • the greater the investment spending that firms will wish to undertake
  • if the marginal efficiency of capital (ρ) or return on that capital is greater than the Long Bond interest rate you would invest in it but if the return is smaller you would simply invest in the bonds instead
7
Q

What is the Opportunity Costs of holding Inventory?

A
  • The opportunity cost of holding inventories (also known as stocks) of
    finished goods or raw materials is what the firm could earn by selling
    the inventories and investing their value in something else.
  • A measure of this is the interest rate,
  • Since the firm could certainly lend out its funds and earn the market
    rate of interest.
  • A fall in the rate of interest leads to a temporary spurt of inventory investment while the inventories are being increased.
  • A rise in the rate of interest leads to a temporary spurt of inventory disinvestment while the inventories are being decreased.
8
Q

How does investment Rates affect housing?

A
  • Interest payments are a large part of total mortgage payments.
  • Therefore changes in interest rates can have large effects on the
    demand for new housing.
    A fall in the rate of interest will lead to a rise in investment in
    building new housing.
  • A rise in interest rates will reduce the demand for building new housing
9
Q

What is the Investment demand curve and what does it look like of a graph?

A
  • it relates the quantity of desired investment spending to the cost of
    capital, as proxied by the real interest rate
  • With Real interest rate (r) on the y-axis and Desired Investment Expenditure (I) on the x-axis
  • A negative gradient curve of the Demand Function
  • this demand function can be shifted by businesses expectations –> in a boom the demand function will shift to the right as there would be more investment at every level of interest rate
10
Q

What does the IS curve show?

A
  • The IS curve shows all those combinations of GDP and interest rate for which aggregate desired spending equals actual output.
  • Recall that aggregate spending is:
    AE = C + I + G
  • where C is consumption, I represents investment and G denotes government spendings.
  • Equilibrium occurs where aggregate desired spending, AE equals actual output:
    AE = Y .
11
Q

How can you derive the IS curve from the Aggregate Demand Curve?

A
  • Draw the Aggregate Demand model of C+I+G with the 45 degree line of AE=Y
  • draw a set of axis with Real interest rate (r) on the y-axis and Real GDP (Y) on the x-axis
  • at the initial intercept of planned expenditure and the 45 degree line draw down to the graph below and at that level of output create a point at that rate of interest at the time
  • say there was a decrease in the interest rate –> this would lead to a increase in investment –> this would shift the AE line upwards increase overall output
  • now at the new equilibrium output draw down to the IS model and draw a point at that output and corresponding interest rate
  • if you do this for each different level of interest rate and plot the points and connect them this will create the IS curve
  • Anything that is exogenous in the AE model that will shift the line will also shift the IS curve
12
Q

Why does the IS curve have a negative interest rate?

A

because a fall in the interest rate increases investment spending and hence increases equilibrium GDP

13
Q

Why was it original referred to the IS model?

A
  • The reason why the curve was originally called the IS is that in a closed economy with no government,
  • it represents the combination of GDP and the interest rate for which
    the sum of all injections equals the sum of all leakages.
  • In other words, savings equal investments.
14
Q

How can you Algebraically derive the IS curve?

A
  • Remember consumption is positively associated with GDP while investment is negatively associated with interest rate.
    These can be expressed as:
    AE = d + cY - fr
  • d represents the positive constant on the consumption function,
  • c represents propensity to consume
  • f is a positive parameter relating the interest rate and the desired investment spending.

The equilibrium condition is
AE = Y

15
Q

How can we find Output from the Algebraic equation of the IS curve?

A

sub AE = Y into AE = d + cY - fr to give you:

d + cY - fr = Y

and rearranging gives
Y - cY = d - fr.

Factoring the Y and dividing through will give you:

Y= (d/1-c) - r(f/1-c)

16
Q

What does it mean when you are away from the IS curve?

A
  • If you are above the curve –> There is excess supply as interest rate is high and demand for investments are low
  • if you are below the curve –> there is excess demand as interest rate is lower and
    demand for investments are high
17
Q

What are the different points on the IS and LM curve called?

A
  • We call the points on the IS curve points of spending equilibrium
  • The points on the lM curve are points of monetary equilibrium
18
Q

What causes shifts in the IS curve?

A
  1. Changes in Fiscal Policy
  2. Change in Consumer Savings Rates
  3. Changes in Investment
  4. Changes in Private Fixed Investment
19
Q

How can Changes in Fiscal Policy cause a shift in the IS curve?

A
  • The government can either increase government spending (shifting IS right) or decrease government spending (shifting IS left).
  • The government can also increase taxes which lowers consumer spending (shifting IS left) or decrease taxes which increases consumer spending (shifting IS right).
20
Q

How can Changes in Cosumers Savings Rate cause a shift in the IS curve?

A
  • If consumers decide to save more (which means that marginal propensity to consume declines) then consumer spending declines and the IS curve shifts left.
  • If consumers decide to save less (so marginal propensity to consume rises) then consumer spending increases and the IS curve shifts right.
21
Q

How can changes in Net Exports cause a shift in the Is curve?

A

DONT THINK THIS IS INCLUDED AS WE USE A CLOSED MODEL?

  • If exports increase (normally due to currency depreciation) we will see the IS curve shift right.
  • If exports decrease (due to currency appreciation) we will see the IS curve shift left.

Important Note: Imports are endogenous in the model (they are a function of Y) so generally change in imports has no effect on the IS curve. However, depending on your professor, a change in imports will have the opposite effect on the IS curve that exports has, so a decrease in imports shifts IS right, and an increase shifts IS left

22
Q

How can changes in Private Fixed Investment cause a shift in the IS curve?

A
  • If consumers/firms feel more confident about the future, they may invest more regardless of the interest rate. This will cause an increase in investment (IS shifts right).
  • If consumers/firms feel less confident about the future, they may invest less regardless of the interest rate. This will cause a decrease in investment (IS shifts left).