Describe a piece of capital a company might want to purchase by taking out a loan from a bank. Explain how having this new piece of capital would improve profits for the firm. How does the real interest rate impact the firm’s decision to take out the loan? How does the corporate tax rate impact the firm’s decision to take out the loan?
IS-LM-PC Analysis
The IS (Investment Saving), LM (Liquidity Preference- Money Supply), and PC (Philips Curve) is the model that looks at the dynamics of output and inflation. It takes into account the central bank policy decision to adjust the inflation and real interest rate in the economy. It enables the economist to weather to priorities between employment and inflation rate analyzing the model. It is a practice-driven approach adopted by economists worldwide.
IS-LM Analysis
The term IS stands for Investment, Savings, and LM stands for Liquidity Preference, Money Supply. Therefore, the term IS-LM model is known as Investment Savings – Liquidity preference money Supply. This model was introduced by a Keynesian macroeconomic theory which shows the relationship between the economic goods market and loanable funds market or money market. In other words, it shows how the market for real goods interacts with the financial markets to strike a balance between the interest rate and total output in the macroeconomy. This particular model is designed in the form of a graphical representation of the Keynesian economic theory principle. The output and money are the two important factors in an economy.
For this discussion I want you to think of an item (a piece of capital) that a firm could invest in to make profit. The purpose of this discussion is to help understand how the process of commercial banks making loans to firms increases the money supply. In the textbook it seems like the process of banks making loans and firms paying those loans back happens instantaneously. However, in reality that process takes time (several years). Typically, loans are re-paid over 10, 15, or even 30 years. The firms use profits from new business opportunities, opportunities they would not have had without the loan, to repay the bank over time.
- Describe a piece of capital a company might want to purchase by taking out a loan from a bank.
- Explain how having this new piece of capital would improve profits for the firm.
- How does the real interest rate impact the firm’s decision to take out the loan?
- How does the corporate tax rate impact the firm’s decision to take out the loan?
Example: A chef, who currently works for someone else earning 40,000/year, decides that she could make more money if she opened up her own food truck. She can purchase the food truck by taking out a loan from the bank. Assume she can re-sell the food truck for the same price she paid so her only expense would be the interest payments on her bank loan. With the truck she can earn more money because she can drive to the locations where food is in high demand. The truck has everything she needs to prepare high quality food for her customers at any location. Her increase in earnings will be large enough so she can make the monthly payment on her bank loan and still take home more money than she was making at her previous job. If the real interest rate was to increase, this would increase her monthly loan payment. The higher monthly payment means it will be less likely that she could earn more money with the truck than she was making at her other job. This will make her less likely to take out the loan. A higher corporate tax rate would also reduce her monthly earnings with the food truck and make her less likely to take out the loan.
Trending now
This is a popular solution!
Step by step
Solved in 2 steps
