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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 1 The Goods Market and the IS Curve Summary so far: –We are using the IS-LM model to derive the aggregate demand curve to study economic fluctuations in the economy in the short run –IS-LM model is an interpretation of John Maynard Keyne’s theory on aggregate demand –We need to first derive the IS Curve, which relates to the goods market. IS = Investment and Saving –To derive the IS Curve we use the Keynesian Cross –From the Keynesian Cross, we studied the Government purchases multiplier and the tax multiplier (you need to know the formulae for these)

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 2 The Goods Market and the IS Curve The IS Curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services The Keynesian Cross is one part of deriving the IS Curve, i.e. it will give us the level of income The Investment function as the other part of deriving the IS Curve, i.e. it will give us the interest rate

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 3 The Goods Market and the IS Curve Investment function: We write the level of planned investment as : I = I(r) where, I = Investment, r = real interest rate Because the interest rate is the cost of borrowing to finance investment projects, an increase in the interest rate reduces planned investment

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 4 The Goods Market and the IS Curve Investment Function: Investment function slopes downward Negative relationship between investment and the real interest rate Note: we met the investment function already in chapter on income See graph on investment function

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 5 Investment Function Interest rate (r) Investment (I) I (r) r1r1 I(r 1 )

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 6 The Goods Market and the IS Curve To derive the IS Curve we use: –The Keynesian Cross and –The Investment Function

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 7

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8 The Goods Market and the IS Curve Deriving the IS Curve (see previous graph): Initially we start with interest rate r 1 This gives us a quantity of investment of I(r 1 ) At this amount of investment, the planned expenditure line crosses actual expenditure in the Keynesian cross to give an income level of Y 1 in the economy

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 9 The Goods Market and the IS Curve Deriving the IS Curve: Therefore, at interest rate r 1,income is Y 1 Plot this as one point showing the relationship between interest rates and income in the goods market Then assume the interest rate rises to r 2 and see what happens to income If the interest rate rises, investment falls to I(r 2 )

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve Deriving the IS Curve: If investment falls, the planned expenditure line must shift downward because at any level of income, expenditure is now lower than it was before – this is represented by a shift downward of the planned expenditure line E (Planned Expenditure) = C(Y-T) + I + G New line crosses 45 degree line (actual expenditure) and this shift causes income to fall to Y 2

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve Deriving the IS Curve: Therefore, at interest rate r 2, income is Y 2 An increase in interest rate led to a decrease in income Plot this as another point showing the relationship between interest rates and income in the goods market Join the two dots together and you get a downward sloping IS Curve

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve IS Curve: summarises this relationship between interest rates and income Because an increase in the interest rate causes planned investment to fall, which in turn causes income to fall, the IS Curve slopes downward.

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: Fiscal policy means a change in Government Purchases or taxes When we constructed the IS Curve we held G and T fixed What if government purchases increase from G 1 to G 2 (assume r and therefore I are held constant) We saw already that this would cause the planned expenditure line to shift upwards

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: This upward shift in the expenditure line would result in higher income: from Y 1 to Y 2 Interest rates have stayed the same, but income has increased, therefore, this would be represented by a shift outward of the IS curve: from IS 1 to IS 2 See Graph

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10 15

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Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: In summary: Expansionary Fiscal Policy (increase in Government Purchases or decrease in taxes) will shift the IS Curve to the right

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