ECON 101B Chapter 10: Chapter 10

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31 May 2018

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Chapter 10: Investment, Net Exports, and Interest Rates

10.1 Interest Rates and Aggregate Demand

● The Importance of Investment

○ The Role of investment

■ Real interest rate was the market clearing price, it was pushed up or down

by supply and demand to equate the flow of savings into financial markets

to the flow of investment funding out of financial markets

■ In the flex price model the level of savings determined the level of

investment and the strength of investment demand determined the interest

rate

■ In the sticky price model the interest rate is not set by loanable funds

market instead it is set directly by the ventral bank or indirectly by the

examination of the stock of money and the liquidity preference of

households and businesses

● The interest rate then determines the level of investment which

then play key role in autonomous spending

● Together autonomous spending and the multiplier determine the

level of output

● Businesses match the quantity they produce to aggregate demand

automatically creates balance in the financial market no matter

what the interest rate is

○ Sources of fluctuations in investment

■ Fluctuations in investment has 2 sources

● Some are triggered by changes in the real interest rate r a lower

interest rate mean higher investment spending and vice versa

● Also some are triggered by shifts in investors’ expectations about

future growth , profits, and risk

● Investment function: I =I_o - I_r * r

● Both are important none is stronger than the other

● Investment and the Real Interest Rate

○ The long term interest rate

■ Interest rate on a long term loan for a period of a decade or more

■ Term premium: the premium in the interest rate that the market charges on

long term loans vis a vis short term loans

■ Inverted term structure: when they expect short term interest rates to fall

steeply the term premium is negative (rarely happens)

○ The real interest rate

■ Real interest rate: relevant for investment spending decisions

○ The risky interest rate

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■ Financial institutions lending money are keenly interested in the financial

health of those whole they lend

■ The risker thy believe the loan is the larger the possibility of bankruptcy or

debt rescheduling appears to be

■ Risk premium: the premium that lenders charge for loans to companies

rather than to safe government borrowers

■ The risky interest rate does not move in step with the safe interest rate

● Exports and Autonomous Spending

○ Planned expenditure function E= A + MPE*Y

○ Autonomous spending A= C_o + I + G +GX

○ Higher domestic interest rate reduced exports bc => higher real interest rate maes

investing in the home country more attractive: foreign exchange speculators try to

take advantage of this opportunity to earn higher returns by shifting their portfolio

holdings to include more home currency denominated assets

■ The increase in demand for home currency denominated assets and

decrease in demand for foreign currency

○ A lower value for foreign currency makes exports more expensive to foreigners:

their currency buys less here bc it is less valuable it diminishes their ability to

purchase exports and since exports are part of autonomous spending a rise in the

real interest rate dominoes autonomous spending through this channel as well

10.2 The Curve

● Autonomous Spending and the Real Interest Rate

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● From the Interest rate to Investment to Aggregate Demand

○ IS Curve : investment saving curve => workhorse tool that macro use very

frequently

○ Autonomous spending as a function of the real interest rate

■ The level of autonomous spending depends on the real interest rate: the

higher the real interest rate the lower the autonomous spending. The slope

of the line depends not just on the interest sensitivity of investment

spending but also on the interest rate sensitivity of exports - the sensitivity

of exports to changes in the exchange rate times the sensitivity of the

exchange rate to changes in the interest rate

○ The IS curve:

■ For each possible value of the real interest rate, there is a different level of

autonomous spending. For each level of autonomous spending the income-

expenditure process generates a different equilibrium level of real GDP.

the IS curve tells us what equilibrium level of real GDP corresponds to

each possible value of the real interest rate

● The Slope and Position of the IS Curve

○ The position of the IS curve

■

■ Where

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Document Summary

Chapter 10: investment, net exports, and interest rates. Real interest rate was the market clearing price, it was pushed up or down by supply and demand to equate the flow of savings into financial markets to the flow of investment funding out of financial markets. In the flex price model the level of savings determined the level of investment and the strength of investment demand determined the interest rate. The interest rate then determines the level of investment which then play key role in autonomous spending. Together autonomous spending and the multiplier determine the level of output. Businesses match the quantity they produce to aggregate demand automatically creates balance in the financial market no matter what the interest rate is. Some are triggered by changes in the real interest rate r a lower interest rate mean higher investment spending and vice versa. Also some are triggered by shifts in investors" expectations about future growth , profits, and risk.

Related Questions

Please help wtih these economics questions. I'll give the best answer to the person who justifies their answer.. or someone who does well in economics and knows the subject area well.

Which of the following statements is not true about Say's Law?

A. People produce more goods than they want for their own use only if they seek to trade them for other goods.

B. Markets would be regularly hit by severe shortages and surpluses.

C. Desired expenditures will equal actual expenditures.

D. Surpluses will be eliminated by falling prices and shortages will be eliminated by increasing prices.

Which of the following is not an assumption of the classical model?

A. Buyers and sellers react to changes in relative prices.

B. Households want to maximize economic well being.

C. Wages and prices will move freely in the upward direction but not the downward direction.

D. No single buyer or seller of a commodity can affect its price.

Money illusion is

A. when people think they are better off when their income increases even though prices have increased by the same amount.

B. when people are motivated by self-interest.

C. could not exist if the economy did not have competitive markets.

D. a basic condition that all classical economists assume people have.

Saving is not a problem in the classical model because

A. interest rates were flexible and savings were channeled into investment.

B. savers and investors were the same people.

C. the classical economists assumed that saving was beneficial to people for retirement.

D. saving would be spent by consumers eventually.

Which of the following statements is true?

A. There is an inverse relationship between investment and the interest rate.

B. There is no relationship between investment and the interest rate.

C. There is a direct relationship between investment and the interest rate.

D. Investment is always less than savings.

In the classical model, high unemployment due to either a demand or a supply shock

A. will return to its normal level quickly as wages adjust.

B. will persist if due to a supply shock but not if due to a demand shock.

C. can persist for an indefinite period of time.

D. never exists because unemployment can never deviate from its normal level.

The classical model makes little distinction between the long-run and short-run because

A. the model has not been fully developed yet.

B. prices adjust so fast that the economy is quickly moving towards the long-run.

C. the classical economists knew that we are always operating in the short run.

D. current changes influence the long run, so it is not possible to plan for the future.

In the classical model

A. the level of real GDP per year does not depend on the level of aggregate demand.

B. the level of GDP is demand determined.

C. the level of GDP determines prices independent of demand.

D. changes in aggregate supply affect the price level, not real GDP.

Which of the following is a true statement?

A. Classical economists believed output adjusted more than prices when aggregate demand fell while Keynes believed prices adjusted more than output.

B. Classical economists believed price adjusted more than output when aggregate demand fell while Keynes believed output adjusted more than prices.

C. A decrease in aggregate demand has no short-run effects according to the classical economists, but had significant effects according to Keynes.

D. A decrease in aggregate demand was not possible according to the classical economists, but was possible according to Keynes.

Which of the following is not a reason why GDP can be expanded beyond a level consistent with its long-run growth path in modern Keynesian analysis?

A. Prices and wages are flexible allowing for needed adjustments.

B. In the short-run existing workers can work more hours.

C. The existing capital stock can be used more intensively.

D. Higher prices induce firms to hire more workers.

A recessionary gap can be caused by

A. a decrease in aggregate supply holding aggregate demand constant.

B. an increase in aggregate demand holding aggregate supply constant.

C. an increase in the long run aggregate supply curve holding the aggregate demand constant.

D. a decrease in both aggregate demand and aggregate supply.

lemonpug153

1. The multiplier helps explain

A. why a decrease in taxes causes real Gross Domestic Product (GDP) to fall by more than the amount of the decrease in taxes.

B. why a fall in investment cause real Gross Domestic Product (GDP) to rise by more than the amount of the decrease in investment.

C. why a rise in government expenditures causes real Gross Domestic Product (GDP) to rise by more than the amount of the increase in government spending.

D. why an increase in disposable income causes real Gross Domestic Product (GDP) to rise by less than the amount of the increase in disposable income.

2. If the marginal propensity to save (MPS) increases, the multiplier

A. decreases.

B. can either increase or decrease, depending on what happens to the marginal propensity to consume (MPC).

C. stays the same.

D. increases.

QUESTION 60

The investment function will shift when there is a change in

		A. the opportunity cost of retained earnings.
		B. firms' profit expectations.
		C. the cost of borrowing.
		D. the interest rate.

1.43 points

QUESTION 61

In the Keynesian model, whenever planned saving exceeds planned investment,

		A. there will be unplanned inventory accumulation.
		B. real GDP will not be influenced.
		C. the interest rate will remain unchanged.
		D. there will be unplanned inventory depletion.

1.43 points

QUESTION 62

In the Keynesian model, whenever planned saving is less than planned investment,

		A. there will be unplanned inventory depletion.
		B. the interest rate will remain unchanged.
		C. there will be unplanned inventory accumulation.
		D. real GDP will not be influenced.

1.43 points

QUESTION 63

Government purchases

		A. are determined by the political process.
		B. are determined by the public.
		C. are influenced by interest rates.
		D. are determined by suppliers.

1.43 points

QUESTION 64

If, at some level of output, total planned real expenditures are less than real Gross Domestic Product (GDP),

		A. real GDP will either fall or remain unchanged, depending on the MPC.
		B. real GDP will rise.
		C. real GDP remains unchanged.
		D. unplanned inventories will increase and real GDP will fall.

1.43 points

QUESTION 65

When the economy is operating at the equilibrium level of GDP, we know that

		A. total planned real expenditures equal real GDP.
		B. real net exports equal inventory changes.
		C. planned real investment spending equals real net exports of zero.
		D. total planned real consumption expenditures equal real GDP.

1.43 points

QUESTION 66

One divided by the marginal propensity to save (MPS) is the formula for

		A. the inverse of the multiplier.
		B. the multiplier.
		C. one minus the multiplier.
		D. autonomous consumption.

QUESTION 67

Thinking like an economist would, which is true of investment?

		A. Investment represents spending on capital goods.
		B. Investment is a stock concept.
		C. Investment is putting money into stocks and bonds.
		D. It is the portion of disposable income that is not used for consumption or saving.

QUESTION 68

Other things being equal, if input prices rise in a country, then there would be

		A. cost-push inflation.
		B. demand-pull inflation.
		C. cost-pull deflation.
		D. more production and a lower price level.

QUESTION 69

In the short run, if the price level rises, then the overall economy can temporarily produce beyond its nominal capacity. One reason for this is that

		A. existing capital equipment can be used more intensively.
		B. wage rates rise almost simultaneously with the price level.
		C. the unemployment rate usually rises dramatically along with the price level.
		D. workers can be switched from counted to uncounted production.

fuchsiaclam197

Classical or Keynesian? Put a âCâ for Classical or a âKâ for Keynesian in the space provided.

_____A. Believed the total money supply in an economy was fixed and controlled by the central bank. _____B. Believed in fiscal policy as a tool to manipulate the performance of the economy.

_____C. Stressed the self-adjusting tendencies of the economy.

_____D. Believed in the flexibility of wages and prices.

_____E. Believed the aggregate supply curve for output was completely fixed.

_____F. Believed output was solely determined by supply factors.

_____G. Viewed the economy as unstable as a result of the instability of aggregate demand.

_____H. Believed that if economy was left alone to operate full employment would be reached.

_____I. Would argue for wage-price controls as a governmental policy for manipulating the economy. _____J. Believed governmental policy could bring about equilibrium in the money and output markets. _____K. Believed money wages would adjust quickly to equate supply and demand.

_____L. Believed consumer and laborer has complete knowledge on real price levels and can make rational decisions.

_____M. Believed supply factors more important controlling factors in the economy than demand factors. _____N. Believed that âin the long-run we are all dead!â

_____O. Aggregate demand affects output and employment.

_____ P. Believed that workers know the price level , the money wage, and therefore know the real wage. _____Q. Believed that interest rates would adjust to keep shocks from affecting aggregate demand. _____R. Believed that changes in desired business investment expenditures were one of the major factors responsible for changes in income.

_____S. Believed that consumption was dependent on the level of income plotted graphically on a consumption function.

_____T. Stressed business expectations as a factor in determining the level of investment.

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ECON 101B Chapter 10: Chapter 10

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