1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-1 CHAPTER 10 Investment, Net Exports, and Interest Rates

2. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-2 Questions How are the determinants of investment different in a sticky-price than in a flexible-price model? How are the determinants of net exports different in a sticky-price than in a flexible-price model? How do changes in interest rates affect the equilibrium level of production and income in a sticky- price model?

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-3 Questions What is the “IS Curve”? –What use is it? What determines the equilibrium level of real GDP when the central bank’s policy is to keep the real interest rate constant?

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-4 The Importance of Investment Changes in investment are the driving force behind the business cycle –reductions in investment have played a powerful role in every recession and depression –increases in investment have spurred every boom

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-5 The Importance of Investment Understanding the causes and consequences of changes in investment will help us to understand business cycles

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-6 Figure 10.1 - Investment as a Share of Real GDP, 1970-2000

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-7 The Role of Investment In the flexible-price model, the real interest rate is a market-clearing price –it is pushed up or down by supply and demand to equate the flow of savings to the flow of investment

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-8 The Role of Investment In the sticky-price model, the interest rate is not set in the loanable funds market –it is set directly by the central bank or indirectly by the combination of the stock of money and the liquidity preferences of households and businesses –businesses match the quantity they produce to aggregate demand automatically creates balance in the financial market

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-9 Fluctuations in Investment Fluctuations in investment have two sources –changes in the real interest rate –shifts in investors’ expectations about future growth, profits, and risk

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-10 Investment and the Interest Rate The opportunity cost of an investment project is the real interest rate –the higher the interest rate, the lower the number and value of investment projects that will return more than their current cost and the lower the level of investment spending

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-11 Investment and the Interest Rate The interest rate that is relevant for determining investment spending is a long-term interest rate –when considering an investment project, a manager must compare the potential profits of the project to the opportunity to make money from a long-term commitment of the funds elsewhere

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-12 Investment and the Interest Rate Long-term and short-term interest rates are different and do not always move in step –long-term interest rates are usually higher than short-term interest rates –the term premium is the premium in the interest rate that the market charges on long-term loans vis-à-vis short term loans

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-13 Figure 10.2 - Bond Yield Curves

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-14 Investment and the Interest Rate The interest rate that is relevant for investment spending decisions is the real interest rate

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-15 Figure 10.3 - Gaps between Real and Nominal Interest Rates

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-16 Investment and the Interest Rate The interest rate that a firm faces is the interest rate charged to risky borrowers –the premium that lenders charge for loans to companies rather than to safe government borrowers is called the risk premium

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-17 Figure 10.4 - The Risk Premium: Safe and Risky Interest Rates

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-18 Investment and the Interest Rate In the investment function the relevant interest rate (r) is the long- term, real, risky interest rate As r rises, the level of investment spending will decline

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-19 Figure 10.5 - Investment as a Decreasing Function of the Long-Term, Real, Risky Interest Rate

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-20 Exports and Autonomous Spending Gross exports depend on –foreign total incomes (Y f ) –the real exchange rate () the real exchange rate depends on the domestic real interest rate (r) Like investment, gross exports are affected by changes in the real interest rate

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-21 Exports and Autonomous Spending A higher interest rate reduces autonomous spending (A) by reducing exports (X   r  r) as well as by reducing investment (I r  r)

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-22 Exports and the Interest Rate A higher real interest rate reduces gross exports –investing in the home country is more attractive foreign exchange speculators shift their portfolio holdings to include more home currency-denominated assets –the exchange rate falls exports are more expensive to foreigners

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-23 Figure 10.6 - From the Real Interest Rate to the Change in Exports

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-24 Autonomous Spending and the Real Interest Rate A one-percentage-point increase in the real interest rate (r) reduces autonomous spending by (I r + X   r )

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-25 Figure 10.7 - Autonomous Spending as a Function of the Real Interest Rate

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-26 The Investment-Saving (IS) Curve Because a change in the real interest rate changes autonomous spending, it will change the equilibrium level of real GDP –the effect will be equal to the interest sensitivity of autonomous spending (I r + X   r ) times the multiplier

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-27 The Investment-Saving (IS) Curve The relationship between the level of the real interest rate and the equilibrium level of real GDP is the IS curve –IS stands for “Investment-Saving”

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-28 The Investment-Saving (IS) Curve To find a point on the IS curve: –pick a value for the real interest rate and determine the level of autonomous spending at that interest rate –use the income-expenditure diagram to determine the equilibrium level of real GDP Repeat this procedure to find other points on the IS curve

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-29 Figure 10.8 - The IS Curve

30. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-30 The IS Curve Define baseline autonomous spending (A 0 ) to include the determinants of autonomous spending that do not depend on the real interest rate

31. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-31 The IS Curve Recall that real GDP is equal to autonomous spending (A) divided by (1-MPE) Substituting, we get

32. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-32 The IS Curve The term on the left is the horizontal intercept of the IS curve –the value of equilibrium real GDP if the real interest rate was equal to zero The term on the right is the slope of the IS curve –the responsiveness of real GDP to changes in the interest rate

33. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-33 Figure 10.9 - The IS Curve

34. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-34 The Slope of the IS Curve The first term is the multiplier (1/1-MPE) The second term shows how large a change in investment or exports is generated by a change in the real interest rate

35. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-35 The Position of the IS Curve The position of the IS curve depends on the baseline level of autonomous spending times the multiplier Changes in any of these determinants will shift the position of the IS curve

36. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-36 Figure 10.10 - A Change in Fiscal Policy and the Position of the IS Curve

37. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-37 Changes in the Interest Rate To calculate how much a change in the interest rate will shift the equilibrium level of real GDP, you need to know four things: –the marginal propensity to spend (MPE) –the interest sensitivity of investment (I r ) –the interest sensitivity of the exchange rate ( r ) –the exchange rate sensitivity of exports (X  )

38. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-38 Moving to the IS Curve If the economy is above the IS curve: –real GDP > planned expenditure inventories rise firms cut production employment, real GDP, and national income fall If the economy is below the IS curve: –planned expenditure > real GDP inventories fall firms expand production employment, real GDP, and national income rise

39. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-39 Figure 10.11 - Off of the IS Curve

40. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-40 Shifting the IS Curve Two kinds of government policies directly affect the position of the IS curve –a shift in tax rates changes both the position and the slope of the IS curve –a change in the level of government purchases changes the position of the IS curve

41. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-41 Shifting the IS Curve Example - an increase in government spending –G = $200 billion –MPE = 0.5 –I r = $0.11 –X   r = $0.015 –r = 4%

42. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-42 Moving along the IS Curve Changes in the real interest rate will move the economy along the IS curve –a higher real interest rate will produce a lower level of aggregate demand and equilibrium real GDP –a lower real interest rate will produce a higher level of aggregate demand and equilibrium real GDP

43. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-43 Moving along the IS Curve Example - cutting interest rates to boost equilibrium real GDP by $500 billion –MPE = 0.5 –I r = $0.11 –X  = 5% – r = $0.003 To boost real GDP by $500 billion, the real interest rate must fall by 2 percentage points

44. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-44 Figure 10.12 - Cutting Target Interest Rates and Raising Real GDP

45. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-45 Changing Interest Rates The Federal Reserve controls interest rates through open market operations –buying and selling short-term government bonds for cash

46. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-46 Open Market Operations When the Federal Reserve buys government bonds –the total cash in the hands of the public and bank reserves increases –households, businesses, and banks find that they are holding more money than they would like use the money to buy assets (such as bonds) –bond prices rise and interest rates fall

47. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-47 Open Market Operations When the Federal Reserve sells government bonds –the total cash in the hands of the public and bank reserves decreases –households, businesses, and banks find that they are holding less money than they would like try to get money by selling assets (such as bonds) –bond prices fall and interest rates rise

48. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-48 Figure 10.13 - Open Market Operations

49. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-49 Difficulties Our knowledge of the structure of the economy is imperfect Even when policies have their expected effects, these effects do not necessarily arrive on schedule The interest rates the Federal Reserve can control are short-term, nominal, safe interest rates

50. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-50 The IS Curve of the 1960s In the 1960s, there was a rightward shift in the IS curve –increased optimism on the part of businesses –a cut in income taxes –extra government expenditures (Vietnam War)

51. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-51 Figure 10.14 - Real GDP and the Interest Rate, 1960-1999

52. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-52 The IS Curve of the 1960s In the late 1960s, there was a movement down along the IS curve as real interest rates declined –the drop in real interest rates was caused (in part) by an increase in inflation

53. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-53 Figure 10.15 - Shifting Out and Moving along the IS Curve, 1960s

54. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-54 The IS Curve of the Late 1970s From 1977 to 1979, the U.S. economy moved down and to the right of the IS curve –the expansion toward potential output was accompanied by high and rising inflation In 1979, the Federal Reserve began fighting inflation –raised real interest rates from 1979 to 1982

55. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-55 Figure 10.16 - Moving along the IS Curve, Late 1970s

56. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-56 The IS Curve of the 1980s The 1980s began with a large outward shift in the IS curve –an increase in military spending –a cut in income taxes –an increase in investor optimism The Federal Reserve responded to this shift by raising real interest rates

57. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-57 Figure 10.17 - Shifting the IS Curve Out, Early 1980s

58. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-58 The IS Curve of the 1980s As inflation remained low through the mid- and late- 1980s, Federal Reserve policymakers gained confidence –began reducing real interest rates causing a movement along the IS curve

59. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-59 Figure 10.18 - Moving along the IS Curve, Late 1980s

60. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-60 The IS Curve of the 1990s In the second half of 1990, there was a leftward shift of the IS curve –a drop in investment as firms worried about the price of oil after the Iraqi invasion of Kuwait The Federal Reserve took no steps to reduce real interest rates to offset the recession

61. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-61 The IS Curve of the 1990s In 1993, the Federal Reserve began a policy of maintaining lower interest rates in response to the reduction in the federal budget deficit –the goal of the policy was to increase investment During the last half of the 1990s, interest rates remained low Inflation remained low as well

62. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-62 Figure 10.19 - The Recession of 1990-1992

63. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-63 Chapter Summary In the sticky-price model, the investment function is the same as in the flexible-price model –in the flexible price model, the level of savings determined investment and the investment function determined the real interest rate –in the sticky-price model, the real interest rate is determined outside the IS framework, and the level of investment powerfully affects the level of real GDP

64. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-64 Chapter Summary The international sector of the sticky- price model is essentially the same as the international sector of the flexible- price model

65. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-65 Chapter Summary The income-expenditure diagram takes autonomous spending as given, and then determines the equilibrium levels of real GDP, aggregate demand, and national income as functions of autonomous spending and the marginal propensity to spend

66. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-66 Chapter Summary The IS curve incorporates the effect of changing interest rates on autonomous spending and adds this effect of changing interest rates on autonomous spending to the income- expenditure diagram

67. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-67 Chapter Summary The IS curve slopes downward because a higher interest rate lowers both investment and exports and these reductions in autonomous spending in turn lower aggregate demand and equilibrium real GDP

68. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 10-68 Chapter Summary When the central bank’s policy involves targeting the real interest rate, the position of the IS curve and the central bank’s interest rate target together determine the equilibrium level of aggregate demand and real GDP