Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9781292094182

11th Edition

614 Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

The section explains that aggregate demand, or planned expenditure, is determined by consumption, investment, government spending, and net exports. By applying functions such as the consumption function and investment function, we derive the goods market equilibrium condition from which the IS curve is developed. The IS curve shows how equilibrium output is negatively related to the real interest rate and shifts in response to changes in autonomous spending components—highlighting the interplay between fiscal policy, consumer behavior, investment decisions, and external factors such as financial frictions.

Learning Objectives

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Key Concepts

CONCEPT

DEFINITION

Definition: The study of how equilibrium levels of output and inflation are determined by the interaction of aggregate demand (planned spending) and aggregate supply (the economy’s capacity).

The study of how equilibrium levels of output and inflation are determined by the interaction of aggregate demand (planned spending) and aggregate supply (the economy’s capacity). •

Example Problems

Example 1

"When the stock market rises, investment spending is increasing." Is this statement true, false, or uncertain? Explain your answer.

Example 2

Why is inventory investment counted as part of aggregate spending if it isn't actually sold to the final end user?

Example 3

"since inventories can be costly to hold, firms' planned inventory investment should be zero, and firms should acquire inventory only through unplanned inventory accumulation." Is this statement true, false, or uncertain? Explain your answer.

Example 4

During and in the aftermath of the financial crisis of $2007-2009,$ planned investment fell substantially despite significant decreases in the real interest rate. What factors related to the planned investment function could explain this?

Example 5

If households and firms believe the economy will be in a recession in the future, will this necessarily cause a recession, or have any impact on output at all?
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Step-by-Step Explanations

QUESTION

How do we derive the IS curve from the goods market equilibrium condition given the aggregate demand components?\nStep-by-step Answer:\nStep 1: Start with the aggregate demand (planned expenditure) equation: Yad = C + I + G + NX.\nStep 2: Substitute the consumption function (C = C\u2080 + mpc * (Y - T)), the investment function (I = I\u2080 - d(r + f)), and the net export function (NX = NX\u2080 - x*r) into the aggregate demand equation.\nStep 3: Set aggregate output (Y) equal to aggregate demand for equilibrium: Y = C\u2080 + mpc*(Y - T) + I\u2080 - d(r + f) + G + NX\u2080 - x*r.\nStep 4: Rearrange the equation by collecting terms involving Y and isolate Y on one side, which involves subtracting mpc*Y from both sides.\nStep 5: Divide both sides by (1 - mpc) to solve for Y, yielding an equation where Y is expressed in terms of exogenous autonomous components and a term involving the real interest rate.\nFinal Answer: The resulting equation represents the IS curve, showing that for each real interest rate, there is a corresponding equilibrium output level.\n\n- Topic: Impact of Changes in Government Purchases \nQuestion: Explain how an increase in government purchases affects the IS curve.\nStep-by-step Answer:\nStep 1: Recognize that government purchases (G) are an autonomous component that adds directly to aggregate demand.\nStep 2: Substitute a higher value for G in the IS curve derived from the goods market equilibrium.\nStep 3: Notice that at every given real interest rate, the equilibrium output (Y) increases because of the direct addition to demand.\nStep 4: Conclude that an increase in G shifts the IS curve to the right.\nFinal Answer: Higher government spending leads to a rightward shift in the IS curve, indicating higher equilibrium output at every real interest rate.\n\n"

STEP-BY-STEP ANSWER:

Step 1: Start with the aggregate demand (planned expenditure) equation: Yad = C + I + G + NX.\nStep 2: Substitute the consumption function (C = C\u2080 + mpc * (Y - T)), the investment function (I = I\u2080 - d(r + f)), and the net export function (NX = NX\u2080 - x*r) into the aggregate demand equation.\nStep 3: Set aggregate output (Y) equal to aggregate demand for equilibrium: Y = C\u2080 + mpc*(Y - T) + I\u2080 - d(r + f) + G + NX\u2080 - x*r.\nStep 4: Rearrange the equation by collecting terms involving Y and isolate Y on one side, which involves subtracting mpc*Y from both sides.\nStep 5: Divide both sides by (1 - mpc) to solve for Y, yielding an equation where Y is expressed in terms of exogenous autonomous components and a term involving the real interest rate.\nFinal Answer: The resulting equation represents the IS curve, showing that for each real interest rate, there is a corresponding equilibrium output level.\n\n- Topic: Impact of Changes in Government Purchases \nQuestion: Explain how an increase in government purchases affects the IS curve.\nStep-by-step Answer:\nStep 1: Recognize that government purchases (G) are an autonomous component that adds directly to aggregate demand.\nStep 2: Substitute a higher value for G in the IS curve derived from the goods market equilibrium.\nStep 3: Notice that at every given real interest rate, the equilibrium output (Y) increases because of the direct addition to demand.\nStep 4: Conclude that an increase in G shifts the IS curve to the right.\nFinal Answer: Higher government spending leads to a rightward shift in the IS curve, indicating higher equilibrium output at every real interest rate.\n\n"
Final Answer: The resulting equation represents the IS curve, showing that for each real interest rate, there is a corresponding equilibrium output level.\n\n- Topic: Impact of Changes in Government Purchases \nQuestion: Explain how an increase in government purchases affects the IS curve.\nStep-by-step Answer:\nStep 1: Recognize that government purchases (G) are an autonomous component that adds directly to aggregate demand.\nStep 2: Substitute a higher value for G in the IS curve derived from the goods market equilibrium.\nStep 3: Notice that at every given real interest rate, the equilibrium output (Y) increases because of the direct addition to demand.\nStep 4: Conclude that an increase in G shifts the IS curve to the right.\nFinal Answer: Higher government spending leads to a rightward shift in the IS curve, indicating higher equilibrium output at every real interest rate.\n\n"

"- Topic: Deriving Goods Market Equilibrium and the IS Curve \nQuestion: How do we derive the IS curve from the goods market equilibrium condition given the aggregate demand components?\nStep-by-step Answer:\nStep 1: Start with the aggregate demand (planned expenditure) equation: Yad = C + I + G + NX.\nStep 2: Substitute the consumption function (C = C\u2080 + mpc * (Y - T)), the investment function (I = I\u2080 - d(r + f)), and the net export function (NX = NX\u2080 - x*r) into the aggregate demand equation.\nStep 3: Set aggregate output (Y) equal to aggregate demand for equilibrium: Y = C\u2080 + mpc*(Y - T) + I\u2080 - d(r + f) + G + NX\u2080 - x*r.\nStep 4: Rearrange the equation by collecting terms involving Y and isolate Y on one side, which involves subtracting mpc*Y from both sides.\nStep 5: Divide both sides by (1 - mpc) to solve for Y, yielding an equation where Y is expressed in terms of exogenous autonomous components and a term involving the real interest rate.\nFinal Answer: The resulting equation represents the IS curve, showing that for each real interest rate, there is a corresponding equilibrium output level.\n\n- Topic: Impact of Changes in Government Purchases \nQuestion: Explain how an increase in government purchases affects the IS curve.\nStep-by-step Answer:\nStep 1: Recognize that government purchases (G) are an autonomous component that adds directly to aggregate demand.\nStep 2: Substitute a higher value for G in the IS curve derived from the goods market equilibrium.\nStep 3: Notice that at every given real interest rate, the equilibrium output (Y) increases because of the direct addition to demand.\nStep 4: Conclude that an increase in G shifts the IS curve to the right.\nFinal Answer: Higher government spending leads to a rightward shift in the IS curve, indicating higher equilibrium output at every real interest rate.\n\n"

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