Macroeconomics: Macroeconomics Lecture 4 The IS curve


Outline of this lecture: Outline of this lecture Keynesian Cross model. Economic policy. The IS curve representation of the market for goods and services. Comparison of the Keynesian Cross and the Classical model.


Income determination: Income determination Assume that all prices (P, r, e) are fixed. Equilibrium m=0 M=X=0 Closed economy:


Active Fiscal Policy: Active Fiscal Policy The government budget constraint: deficit Government deficit (D>0) is financed by sale of government bonds to the private sector (borrowing). Government surplus (D Empirical estimates MP=1.5-3


Slide5: Savings leakage c m=t=0 The balanced budget multiplier


Automatic Stabilizers: Automatic Stabilizers Automatic stabilizers are mechanisms in the economy that reduce the response of income to (demand) shocks. They do not requires active government intervention, but kick in so to speak automatically when a boom or a recession hits the economy. Unemployment benefit Income related taxes


Slide7: income output, Y E E=Y


Slide8: time Boom Recession Economy with no automatic stabilizers Economy with automatic stabilizers The Cycle and Automatic Stabilizers Surplus Deficit


Golden rules and Growth andStability: Golden rules and Growth and Stability Golden rule (medium run) the budget should be balanced over the cycle, i.e., all current spending should be financed out of current revenues Public sector investment can be financed by issuing bonds. Growth and stability pact of the EMU: max deficit = 3% of GDP. Debt/GDP ratio less than 60% More reliance on automatic stabilizers. Less reliance on active intervention.


The IS curve: The IS curve Investment Savings Combinations of Y and r at which the goods market as described by the Keynesian Cross model is at equilibrium. Planned expenditure = income Total savings = investments


Slide11: Y=E B C B’ C’ -1


The slope of the IS: The slope of the IS The IS curve is flat (in Y,r) space when: Investments are very sensitive to the interest rate. The Keynesian multiplier is larger Small t Large c


The location of the IS curve: The location of the IS curve Y=E B C B’ C’


The location of the IS: The location of the IS Government spending increases (G) A reduction in the lump sum tax (T). Positive shock to investments or consumption ( or ). The IS curve shifts out if A fall in the proportional tax (t) changes its slope (rotating the IS curve out).


The Keynesian vs. the Classical model: The Keynesian vs. the Classical model Keynesian cross Classical model Fixed prices Flexible prices Income determined by level of effective demand Income determined by technology and endowments Equilibrating mechanism: Y Equilibrating mechanism: r


Slide16: The Keynesian vs. the Classical model Keynesian cross Classical model Crowding out Multiplier


What is next?: What is next? Financial markets The LM curve Something on interests rates and monetary policy.


The balanced budget multiplier: The balanced budget multiplier Why does a balanced budget expansion of the spending lead to higher equilibrium income?


The government budget and the cycle: The government budget and the cycle time Surplus Deficit Boom Recession Economy with no automatic stabilizers Economy with automatic stabilizers Golden rule: Ds=0