Changes in Equilibrium Income and Interest Rate

Summary

This lecture explores the impact of changes in autonomous investment spending on equilibrium income and interest rates. When autonomous investment increases, the IS curve shifts right, leading to a higher equilibrium output and interest rate. However, the increase in equilibrium income is smaller than the shift in the IS curve due to the inverse relationship between interest rates and investment. This interaction between income and interest rates explains why the change in equilibrium income is less than the direct horizontal shift of the IS curve. The lecture emphasizes the multiplier effect and the dynamic between the IS and LM curves in determining economic equilibrium.

Takeaways

• 😀 Equilibrium income and interest rates change when either the IS or LM curve shifts.
• 😀 An increase in autonomous investment spending shifts the IS curve to the right.
• 😀 The intersection of the IS and LM curves determines the equilibrium interest rate and output.
• 😀 The equilibrium interest rate increases as the IS curve shifts rightward due to higher investment spending.
• 😀 Similarly, equilibrium output increases when autonomous investment spending rises.
• 😀 The change in equilibrium income is less than the horizontal shift of the IS curve.
• 😀 The horizontal shift of the IS curve is calculated as the multiplier times the change in autonomous investment spending.
• 😀 The increase in equilibrium income is smaller than the shift of the IS curve due to the feedback effects on the money market.
• 😀 An increase in income leads to a higher demand for real balances, causing excess demand for money.
• 😀 To restore equilibrium in the money market, the interest rate rises, which in turn reduces investment spending, dampening the increase in output.
• 😀 The final result shows that both equilibrium income and interest rates increase, but the change in income is less than the initial shift of the IS curve due to the counteracting effects in the economy.

Q & A

What does the IS curve represent in the IS-LM model?

The IS curve represents combinations of income (output) and interest rates where the goods market is in equilibrium, meaning investment equals saving.

What does the LM curve represent in the IS-LM model?

The LM curve represents combinations of income (output) and interest rates where the money market is in equilibrium, meaning money demand equals money supply.

What happens when autonomous investment spending increases?

An increase in autonomous investment spending leads to an increase in overall demand, causing the IS curve to shift to the right. This results in a higher equilibrium output and a higher equilibrium interest rate.

How is the horizontal shift of the IS curve related to the increase in autonomous investment spending?

The horizontal shift of the IS curve is equal to the multiplier times the change in autonomous investment spending. The multiplier effect amplifies the impact of the initial change in investment on equilibrium output.

Why is the change in equilibrium income less than the horizontal shift of the IS curve?

The change in equilibrium income is smaller than the horizontal shift of the IS curve because the increase in income raises the demand for money. This leads to higher interest rates, which in turn reduce investment spending and dampen the overall increase in income.

What is the role of interest rates in the IS-LM model when autonomous investment increases?

When autonomous investment increases, it leads to higher income, which raises the demand for money. This creates excess demand for money, causing interest rates to increase. Higher interest rates then reduce investment spending, which partly offsets the increase in income.

What is the relationship between investment and interest rates in the IS-LM model?

There is a negative relationship between investment and interest rates in the IS-LM model. As interest rates increase, the cost of borrowing rises, which leads to a decrease in investment spending.

What does the multiplier effect refer to in the context of the IS-LM model?

The multiplier effect refers to the magnification of the initial increase in autonomous spending (such as investment) on overall output. The multiplier effect is the ratio of the change in income to the initial change in spending.

How does an increase in autonomous investment spending affect the interest rate and income in the IS-LM model?

An increase in autonomous investment spending leads to a rightward shift of the IS curve, increasing both the equilibrium income and the interest rate. The increased income raises the demand for money, which pushes interest rates higher, potentially reducing some of the investment's positive effects on income.

Why does the change in equilibrium income take both the increase in investment and the decrease in investment into account?

The change in equilibrium income accounts for both the increase in investment due to the initial shift in the IS curve and the subsequent decrease in investment caused by higher interest rates. This results in a smaller overall increase in income than the initial shift in the IS curve would suggest.