IS-MP Analysis: Interest Rates and Output

Aggregate Expenditure

the total amount of goods and services that people want to buy across the whole economy. It is the sum of four components: consumption, Planned Investments, Government Expenditure, Net Exports

Monetary policy

the process of setting interest rates in an effort to influence economic conditions.

Risk-free real interest rate is set by who?

the Bank of Canada

Risk premuim is determined by what?

Financial Markets

Why is the MP curve horizontal?

Because the central bank chooses interest rates

Overnight rate

the interest rate on a set of overnight loans that are almost certain to be repaid the next day

risk-free interest rate

the interest rate on a loan that involves no risk

risk premium

extra interest that lenders charge to account for risk

Interest rate =

risk free interest rate + risk premium

Fiscal policy

the government’s use of spending and tax policies to influence economic outcomes.

• Causes aggregate expenditure to change.

• Shifts the IS curve

Increased government spending causes the IS curve to shift which direction?

Right

optimistic IS curve

describes spending plans when people are optimistic about their economic futures

Boom

• IS curve shifts rights (strong demand)

• Output is at (or above) potential

• Happy equilibrium

Bust/Recession

• IS shifts left (weak demand)

• Output declines to be less than potential output.

• Unhappy equilibria

John Maynard Keynes theory on the persistence of economic slumps

The economy can be in macroeconomic equilibrium even when output is far below its potential and unemployment is widespread

Multiplier

a measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending.

Financial shocks

any change in borrowing conditions that change the real interest rate at which people can borrow.

• Shifts the MP curve