IS THERE A CORE OF PRACTICAL MACROECONOMICS THAT WE SHOULD ALL BELIEVE ? | |
ECON-8220-001:SEMINAR IN MACRO THEORY|
The IS curve is the functional relationship between real output and real interest rates derived from behavioral determinants of spending such as (endogenous variables) wealth, income, interest rates, government budget and so on. The sensitivity of investment to interest rates is uncertain or questionable in nature. Nonetheless historical observation states that the higher the interest rates, the lower the spending. The downward and negatively sloping IS curve is how the Federal Reserve’s believe monetary policy should work. But it is important to note that there is a paradox; while the interest sensitivity of business investment spending is doubtful, the IS relationship between aggregate demand and interest rates is real. This is the reason and motivation for research in monetary policy. After many years IS curve needs to be refined. LM curve- the upward sloping LM curve (relating real output wit nominal interest rates) that was usually paired the IS curve, has been abandoned due to instabilities in both money supply and money demanded. The LM curve plays no part in policy analysis due to the fact that it is now believed that the central bank control short term nominal interest rates. It should be noted that this point of view should also be altered because while the central bank controls short term interest rates it is real long term interest rates that matters most for spending. When we specify interest rates as a monetary policy instrument the IS curve turns to an Aggregate Demand Curve; and textbooks would usually pair the aggregate supply curve(based on sticky nominal wages) and the short run macroeconomic equilibrium will be the intersection of the two. It is presumed that the price level will adjust quickly to equate Aggregate Demand with Aggregate Supply while wages remain sluggish....