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

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-3 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-4 Planned Expenditure (cont’d) Total planned expenditure (aggregate demand) is:

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-5 The Components of Expenditure Consumption expenditure Planned investment spending Net exports Government purchases and taxes

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-6 Consumption Expenditure Keynes viewed that consumer expenditure is related to disposable income, Y D, which is total income minus taxes (Y – T) The consumption function

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-7 Because consumption expenditure is negatively related to the real interest rate, r, the consumption function can be modified as: Consumption Expenditure

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-8 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

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The government affects planned expenditure through: –Government purchases: assumed to be exogenous at –Taxes: assumed to be exogenous at Government Purchases and Taxes

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Equilibrium in the economy occurs when the total quantity of output produced equals the total amount of planned expenditure: Goods Market Equilibrium

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Solving for Goods Market Equilibrium 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:

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Understanding the Is Curve (cont’d) What the IS curve tell us: Numerical example What is the IS curve?

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved FIGURE 9.1 The IS Curve

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved FIGURE 9.2 A Saving-Investment Derivation of the IS Curve

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved FIGURE 9.3 Shift in the IS Curve From an Increase in Government Purchases

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Application: Vietnam War Buildup, 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved FIGURE 9.4 Vietnam War Build Up

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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved FIGURE 9.5 Shift in the IS Curve From an Increase in Taxes

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Changes in Autonomous Spending Autonomous spending: exogenous spending that is unrelated to variables in the model 1.Autonomous consumption 2.Autonomous investment spending

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Changes in Autonomous Spending (cont’d) Autonomous spending: exogenous spending that is unrelated to variables in the model 1.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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Changes in Autonomous Spending (cont’d) Autonomous spending: exogenous spending that is unrelated to variables in the model 1.Autonomous consumption 2.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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved TABLE 9.1 Shifts in the IS Curve From Autonomous Changes in