1. Chapter 9
The IS Curve

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 2

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 3

4. Planned Expenditure (cont’d)
Total planned expenditure (aggregate demand) is: 4

5. The Components of Expenditure
Consumption expenditure
Planned investment spending
Net exports
Government purchases and taxes 5

6. Consumption Expenditure
Keynes viewed that consumer expenditure is related to disposable income, YD, which is total income minus taxes (Y – T)
The consumption function 6

7. Consumption Expenditure
Because consumption expenditure is negatively related to the real interest rate, r, the consumption function can be modified as: 7

8. Planned Investment Spending
Two types of investment:
Fixed investment—planned spending by firms on equipment and structures and planned spending on new residential housing
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 8

9. Planned Investment Spending (cont’d)
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” 9

10. In the net export function, net export includes:
Net Exports
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 10

11. Government Purchases and Taxes
The government affects planned expenditure through:
Government purchases: assumed to be exogenous at
Taxes: assumed to be exogenous at 11

12. Goods Market Equilibrium
Equilibrium in the economy occurs when the total quantity of output produced equals the total amount of planned expenditure: 12

13. 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: 13

14. The IS curve is made up of two terms:
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:
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.
The second term tells us about a movement along the IS curve: A change in the real interest rate affects output. 14

15. Understanding the Is Curve
What the IS curve tells 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 15

16. Understanding the Is Curve (cont’d)
What the IS curve tell us: Numerical example
What is the IS curve? 16

17. 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 17

18. 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 18

19. FIGURE 9.1 The IS Curve 19

20. Assume G=0 and NX=0, then the goods market equilibrium occurs when:
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: 20

21. FIGURE 9.2 A Saving-Investment Derivation of the IS Curve21

22. 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. 22

23. FIGURE 9.3 Shift in the IS Curve from an Increase in Government Purchases23

24. 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 24

25. FIGURE 9.4 Vietnam War Build Up25

26. 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. 26

27. FIGURE 9.5 Shift in the IS Curve from an Increase in Taxes27

28. 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 28

29. Changes in Autonomous Spending
Autonomous spending: exogenous spending that is unrelated to variables in the model
Autonomous consumption
Autonomous investment spending 29 29

30. Changes in Autonomous Spending (cont’d)
Autonomous spending: exogenous spending that is unrelated to variables in the model
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
Autonomous investment spending 30

31. Changes in Autonomous Spending (cont’d)
Autonomous spending: exogenous spending that is unrelated to variables in the model
Autonomous consumption
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 31 31

32. 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 32

33. TABLE 9.1   33