Econ 208 Week 3

IS stands for 'investment' and 'saving'. The curve plots the relationship between the interest level and the level of income.

• Actual expenditure- amount households, firms and governments spend on goods/services.
• Planned exenditure- amount households, firms and governments would like to spend. E=C+I+G
• Add the consumption function    C = C(Y-T) - consumption depends on disposable income(Y-T)
• Investment, government spending and tax is fixed.     E = C(Y-T) + I + G.

Planned Expenditure slopes upwards because higher income leads to higher consumption.

The slope is MPC - marginal propensity to consume.

The economy is in equilibrium when Actual Expenditure = Planned Expenditure.   Y = E

This diagram is The Keynesian Cross.

The Keynesian Cross shows how income is determined for given levels of planned investment, government spending and taxes.

Assumes planned investment is fixed  

• We add in the relationship between interest rates r and planned investment I.    I = I(r)
• a) The investment function slopes down because an increase in the interest rate decreased planned investment.
• We combine The Investment function (a) with The Keynesian Cross (b) to see how income changes when the interest rate changes. The fall from I1 to I2 causes the planned expenditure function to shift downwards. Causing a fall in incomes from Y1 to Y2
• The IS curve summarises these changes.

The IS Curve is negatively sloped because a fall in the interest rate motivates firms to increase investment, which drives up planned expenditure. To restore equilibrium output Y must increase.

• Government spending increases - expansionary fiscal policy.
• This raises the planned expenditure curve and income from Y1 to Y2
• IS Curve shifts to the right. The interest rate is fixed.   r

How the interest rate is determined in the short run. The interest rate adjusts to the supply and demand of money.

M - supply of money. P - price level.   

M/P is the supply of real money balances. (M/P) = M/P As the supply and price level are fixed the money supply is a vertical line.

The interest rate is the opportunity cost of holding money, you lose interest. As the interst rate rises, people want to hold less of their money. Demand for money  (M/P)  = L(r). The demand curve slopes downwards because higher interest rates reduce the quantity demanded of real money.

The LM Curve is a graph of all combinations of r and Y that equate the supply and demand for money.  

M/P = L(r,Y)

• An income increase from Y1 to Y2 increase the demand for money and shifts the money demand curve to the right.
• With the supply unchanged, interest rate increases from r1 to r2.
• The LM curve shows that at higher income levels leads to a higher interest rate.

• The central bank reduces the money supply from M1 to M2.
• This raises the interest rate from r1 to r2.
• Keeping income fixed, this shifts the LM Curve upwards.

IS        Y = C(Y-T) + R(r) + G

LM       M/P = L(r,Y)

The intersection of the curves represnts simultanous equilibrium in the market for goods and services and in the market for real money balances for given values of gov spending, taxes, the money supply and the price level.

Fiscal Policy

• An increase in government purchases.
• The Keynsian Cross Multiplier tells us that this shifts the IS curve right by :
• This causes output and incomes to rise. 
• This raises money demand, causing interest rates to rise.
• This reduces investment. 
• So the final increase in output is smaller than : 

Fiscal Policy

• A tax cut
• Consumers save (1-MPC) of the tax cut, the initial boost in spending is smaller for a change in taxes than for an equal change in government spending.
• The Keynesian Tax Multiplier tells us that the IS curve will shift rightwards by:
• The tax cut raises both income and the interest rate.
• This reduces investment and the increase in output is smaller.
• The effect on the interest rate and income are smaller for a change in tax than for an equal change in government spending

Monetary policy

• A monetary expansion
• Causes the LM curve down
• Interest rate falls
• Increases investment, causing output and income to rise.

The Central Bank's response to increase in gov spending.

1. Hold M Constant

• If the government increases spending the IS curve shifts to the right.
• The central banks holds M constant so the LM curve doesnt shift
• Income increases from Y1 to Y2
• Interest rate increases from r1 to r2.

The Central Bank's Response to an Increase in Gov Spending

2. Hold r contanst

• An increase in gov spending shifts the IS curve to the right
• To keep the interest rate constant the central bank increases the money supply M to shift the LM curve to the right
• Income increases from Y1 to Y3.
• There is no change in the interest rate

The Central Bank's Response to an Increase in Gov Spending

3. Hold Y constant

• An increase in gov spending shifts the IS curve to the right.
• To keep Y constant the central bank reduces the money supply M to shift the LM curve to the left.
• There is no change in income
• Interest rate increases from Y1 to Y3.