Lecture 4

• a change in interest rates by the central bank will cause a movement along the IS curve.
• a change in interest rates is shown on the IS curve using firms and investment as the transmission mechanism
• an aggregate demand shock will cause a shift of the IS curve, despite no change in interest rate
• any change in parameter aside from a change in Interest Rate will cause a shift in the IS curve
• the discovery of new technology cannot be shown through the IS curve
• new technology cannot be shown on the IS curve, as there is no change to the output gap, as both potential and actual output increases
• recently, government purchases have been about 20% GDP
• In the Long-run, spending must be funded via taxes - Ricardian Equivalence
• [[Ricardian Equivalence]] states that any change in G is met with a compensating change in C, so a does not change. this suggests fiscal policy does not work to increase output
• the permenant income hypothesis states that consumption only depends on potential output
• if there is Ricardian Equivalence and Permanent income hypothesis, the fiscal policy multiplier is 0
• if there is pemanent income hypothesis but no Ricardian Equivalence, the fiscal pplicy multiplier is 1
• if there is no permanent income hypothesis, and no Ricardian Equivalence, the fiscal policy multiplier is more than 1
• microfoundations explain the microeconomic behaviour that explains the assumed demands of C, I, G, EX and IM
• the two microfoundation theories are permanent income hypothesis and the life-cycle model of consumption
• One microfoundation theory of the IS curve is permanent income hypothesis
• permanent income hypothesis assumes that people will base their consumption of an average of their income over time, rather than on their current income
• permanent income hypothesis involves maximising utility from consumption
• the Life-Cycle model assumes that consumption is based on average lifetime income rather than income at any given age
• in the long run, MPK = r
• r is exogenous and time invariant
• a microfoundation theory of the IS curve is the Life-cycle model of consumption
• if MPK is less than Rt, firms should save and not invest in capital
• when MPK is less than Rt, investment will decline
• when MPK is higher than Rt, firms should borrow and invest in capital
• when MPK is higher than Rt, investment will increase
• if consumption also depends on temporary changes in income, a multiplier effect is produced
• X bar is a parameter that determines how much consumption rises when the economy expands
• the multiplier shows that changes to the original IS curve will have a higher impact on income
• Investment is most variable, as interest rates fluctuate as well as long term potential output
• the National Income Accounting Identity assumes output + imports = Consumption + investment+ government Purchases + exports
• the national income accounting identity implies that total resources available to be used in the economy is equal to total uses
• in Alaska, an unexpected income through a tax refund causes consumption to change, while changes to the permanent income does not impact consumption, as they are announced 6 months before they are released
• permanent income hypothesis holds in Alaska, where consumers respond differently to different changes in income
• potential output is denoted with Y bar
• potential output is smoother than actual GDP
• shocks to income are smoothed to keep consumption steady, and shocks to actual output do not change potential output
• the Ricardian Equivalence is analgous to the permanent income hypothesis
• the Ricardian Equivalence states that the timing of tax changes does not matter for consumer behaviour
• the ricardian equivalence states that the present value of government tax collection determines behaviour