Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 9 The IS Curve

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 9

The IS Curve

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-2

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• To develop the IS curve as the first building block to understand aggregate demand

• To examine factors that cause the IS curve to shift

• To use the IS curve to discuss the economic contraction during the Great Depression and the effects of the fiscal stimulus package of 2009


Planned Expenditure

• Planned expenditure is the total amount of spending on domestically produced goods and services that households, businesses, the government, and foreigners want to make

• Planned expenditure is not the same as actual expenditure, which is the amount actually spent on

• Keynes viewed aggregate demand as planned expenditure


Planned Expenditure (cont’d)

• Total planned expenditure (aggregate demand) is:

where

C = consumption expenditure

I = planned investment spending

G = government purchases

NX = net exports (exports minus imports)

peY C I G NX


The Components of Expenditure

• Consumption expenditure• Planned investment spending• Net exports• Government purchases and taxes


Consumption Expenditure

• Keynes viewed that consumer expenditure is related to disposable income, YD, which is total income minus taxes (Y – T)

• The consumption function

C = (exogenous)

= (the change in

consumption expenditure as a result of an additional

dollar of

mpc

autonomous consumption expenditure

marginal propensity to consume

)DY

( )

where

C C mpc Y T


• Because consumption expenditure is negatively related to the real interest rate, r, the consumption function can be modified as:

( )

where

= responsiveness of to

C C mpc Y T cr

c C r

Consumption Expenditure


• Two types of investment:1. Fixed investment—planned spending by firms

on equipment and structures and planned spending on new residential housing

2. Inventory investment—spending by firms on additional holdings of raw materials, parts, and finished goods in a given time period

• Planned investment spending equals planned fixed investment plus the amount of inventory investment planned by firms

Planned Investment Spending


• In the investment function, planned investment is:– negatively related to the real interest rate– affected by business expectations about the

future (exogenous), as Keynes called “animal spirits”

Planned Investment Spending (cont’d)

where

=

= responsiveness of investment to the real

interest rate

I I dr

I

d

autonomous investment


• In the net export function, net export includes:– the level of net exports that are exogenous– a component negatively related to the real interest

rate: A higher real interest rate raises the demand for dollars and so its exchange rate (the price of the currency), which in turn lowers net exports as exports become more expensive for foreigners

Net Exports

where

=

= responsiveness of net exports to the real

interest rate

NX NX r

NX

autonomous net exports

x

x


• The government affects planned expenditure through:– Government purchases: assumed to be

exogenous at – Taxes: assumed to be exogenous at

Government Purchases and Taxes

G G

T T

GT


• Equilibrium in the economy occurs when the total quantity of output produced equals the total amount of planned expenditure:

Goods Market Equilibrium

peY Y


Solving for Goods Market Equilibrium

Y C I G NX

• The equilibrium condition is:

• Substituting in the consumption, investment and net export functions so that:

• The IS curve is obtained by subtracting mpc×Y from both sides and divide both sides by 1-mpc:

( )

( )

Y C mpc Y T cr I dr G NX xr

C I G NX mpc T mpc Y c d x r

1 [ ]

1 1c d x

Y C I G NX mpc T rmpc mpc


Deriving the IS Curve

• The IS curve shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium

• The IS curve is made up of two terms:1. The first term tells us about shifts in the IS

curve: Since mpc is between zero and one, 1/(1-mpc) >0, so this term tells us that a change in autonomous variables affects output at any given real interest rate.

2. The second term tells us about a movement along the IS curve: A change in the real interest rate affects output.


Understanding the Is Curve

• What the IS curve tell us: Intuition– The IS curve is downward sloping because as

the real interest rate rises, planned expenditure and aggregate output fall due to lower consumption expenditure, planned investment spending and net exports


Understanding the Is Curve (cont’d)

• What the IS curve tell us: Numerical example

• What is the IS curve?

$1.1 trillion, $1.2 trillion, $3.0 trillion

$3.0 trillion, $1.3 trillion

0.6, 0.1, 0.2, 0.1

C I G

T NX

mpc c d x

1 0.1 0.2 0.1 =[1.1 1.2 3.0 1.3 0.6 3.0]

1 0.6 1 0.64.8 0.4

= 120.4 0.4

Y r

r r


Why the Economy Heads Toward the Equilibrium

• What happens if the economy is located at the right of the IS curve?– Actual output is above planned expenditure, so

that firms with unsold inventory will cut production, moving aggregate output toward the equilibrium level


Why the Economy Heads Toward the Equilibrium (cont’d)

• What happens if the economy is located at the left of the IS curve?– Actual output is below planned expenditure, so

that firms with declining inventory will raise production, moving aggregate output toward the equilibrium level


FIGURE 9.1 The IS Curve


Why the IS Curve Has Its Name and Its Relationship With the Saving-Investment Diagram

• The goods market equilibrium of the IS curve is equivalent to the equilibrium at which desired investment, I, equals desired saving, S

• Assume G=0 and NX=0, then the goods market equilibrium occurs when:

• Subtracting C from both sides yields:

• As Y-C equals saving:

Y C I

Y C I

S I


FIGURE 9.2 A Saving-Investment Derivation of the IS Curve


Factors that Shift the IS Curve

• Changes in government purchases– An increase in government purchases that

causes planned expenditure to rise also causes equilibrium output to rise, thereby shifting the IS curve to the right.

– Conversely, a decline in government purchases causes planned expenditure to fall at any given real interest rate and leads to a leftward shift of the IS curve.


FIGURE 9.3 Shift in the IS Curve From an Increase in Government Purchases


Application: Vietnam War Buildup, 1964-1969

• The United States’ involvement in the Vietnam war began in the 1960s

• The resulting increases in military expenditure raised government purchases, which shifts the IS curve to the right

• With the real interest rate constant, the increase in government purchases led to an overheating economy


FIGURE 9.4 Vietnam War Build Up


Factors that Shift the IS Curve (cont’d)

• Changes in Taxes– At any given real interest rate, a rise in taxes

causes planned expenditure and hence equilibrium output to fall, thereby shifting the IS curve to the left.

– Conversely, a cut in taxes at any given real interest rate increases disposable income and causes planned expenditure and equilibrium output to rise, shifting the IS curve to the right.


FIGURE 9.5 Shift in the IS Curve From an Increase in Taxes


Policy and Practice: The Fiscal Stimulus Package of 2009

• By the time the Obama administration took office in January 2009, the U.S. economy was in crisis

• To stimulate the economy, the Obama administration proposed a fiscal stimulus package that included tax cuts and increased federal spending and transfer payments

• This stimulus package was intended to raise planned expenditure, thus shifting the IS curve to the right

• The IS curve did not shift as right as hoped because the effects of the fiscal stimulus was more than offset by declines in consumption and investment


Changes in Autonomous Spending

• Autonomous spending: exogenous spending that is unrelated to variables in the model1. Autonomous consumption2. Autonomous investment spending


Changes in Autonomous Spending (cont’d)

• Autonomous spending: exogenous spending that is unrelated to variables in the model1. Autonomous consumption

– The resulting rise in autonomous consumption would raise planned expenditure and equilibrium output at any given interest rate, shifting the IS curve to the right

– Conversely, a decline in autonomous consumption expenditure causes planned expenditure and equilibrium output to fall, shifting the IS curve to the left

2. Autonomous investment spending


Changes in Autonomous Spending (cont’d)

• Autonomous spending: exogenous spending that is unrelated to variables in the model1. Autonomous consumption2. Autonomous investment spending

– An increase in autonomous spending therefore increases equilibrium output at any given interest rate, shifting the IS curve to the right

– One the other hand, the other hand, a decrease in autonomous investment spending causes planned expenditure and equilibrium output to fall, shifting the IS curve to the left


Changes in Autonomous Net Exports

• An autonomous increase in net exports thus leads to an increase in equilibrium output at any given interest rate and shifts the IS curve to the right

• Conversely, an autonomous fall in net exports causes planned expenditure and equilibrium output to decline, shifting the IS curve to the left


TABLE 9.1 Shifts in the IS Curve From Autonomous Changes in , , , , and C I G T NX

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Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 9 The IS Curve