The IS Curve CHAPTER 22 LEARNING OBJECTIVES PREVIEW. rates and aggregate output, the IS curve

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1 CHAPTER 22 The IS Curve LEARNING OBJECTIVES After studying this chapter you should be able to 1. understand the equilibrium relationship between real interest rates and aggregate output, the IS curve 2. understand why fluctuations in the level of economic activity occur and how fiscal stimulus packages, like those instituted by most governments around the world during the global financial crisis, affected the economy PREVIEW During the Great Depression of the 1930s, aggregate output fell precipitously, with unemployment rising to 30%. Although the recession of was not as severe, the contraction in economic activity led to unemployment rising to over 8.7%. To understand why these contractions in economic activity occur, economists make use of the concept aggregate demand, the total amount of output demanded in the economy. This concept was developed by John Maynard Keynes in his revolutionary book, The General Theory of Employment, Interest, and Money, published in 1936, in which he argued that short-run changes in aggregate output, such as the decline during the Great Depression, were determined by changes in aggregate demand. The concept of aggregate demand is a central element in the aggregate demand aggregate supply (AD/AS) model, the basic macroeconomic model for explaining short-run fluctuations in aggregate output. In this chapter, we develop the first building block to understand aggregate demand, the IS curve, which describes the relationship between real interest rates and aggregate output when the market for goods and services (more simply referred to as the goods market ) is in equilibrium. We begin by deriving the IS curve and then go on to explain what factors cause the IS curve to shift. With our understanding of the IS curve, we can examine why fluctuations in economic activity occur and how the U.S. fiscal stimulus package of 2009 affected the American economy. Then in later chapters, we make use of the IS curve to understand the role of monetary policy in economic fluctuations. 1

2 2 PART VI Monetary Theory Planned Expenditure and Aggregate Demand We start our analysis by discussing the concept of planned expenditure, the total amount of spending on domestically produced goods and services that households, businesses, the government, and foreigners want to make. In contrast, actual expenditure is the amount that they actually do spend, which equals the total amount of output produced in the economy. Note that all the analysis in this chapter is for expenditure in real terms, that is, in terms of actual physical amounts of goods and services. Keynes viewed aggregate demand, the total amount of output demanded in the economy, as being the same as planned expenditure. As we shall see shortly, planned expenditure and hence aggregate demand explains the level of aggregate output when the goods market is in equilibrium; that is, when aggregate demand for goods and services is equal to the actual amount of goods and services produced. The total amount of aggregate demand (planned expenditure) is the sum of four types of spending: 1. Consumption expenditure ( C ), the total demand for consumer goods and services (e.g., hamburgers, ipods, rock concerts, visits to the doctor, etc.) 2. Planned investment spending ( I ), the total planned spending by businesses on new physical capital (e.g., machines, computers, factories) plus planned spending on new homes 3. Government purchases ( G ), the spending by all levels of government on goods and services (e.g., aircraft carriers, government workers, red tape), not including transfer payments 4. Net exports ( NX ), the net foreign spending on domestic goods and services, equal to exports minus imports We represent the total aggregate demand ( Y ad ) with the following equation: The Components of Aggregate Demand Y ad = C + I + G + NX (1) To understand what determines aggregate demand (total planned expenditure) in the economy, let s look at each of its components in detail. Consumption Expenditure What determines how much you spend on consumer goods and services? Your income is likely the most important factor; if your income rises, you will be willing to spend more. Keynes reasoned similarly that consumption expenditure is related to disposable income (denoted by Y D ), the total income available for spending, equal to aggregate output ( Y ) minus taxes T, ( Y - T ). 1 CONSUMPTION FUNCTION Keynes called the relationship between disposable income Y D and consumption expenditure C the consumption function and expressed it as follows: Or alternately, C = C + mpc * Y D (2) C = C + mpc * (Y - T ) (3) 1 More precisely, taxes T refers to taxes minus net transfers (government payments to households and businesses that are in effect negative taxes). Examples of government transfers are Canada Pension Plan payments or employment insurance payments.

3 CHAPTER 22 The IS Curve 3 The term C stands for autonomous consumption expenditure, the amount of consumption expenditure that is exogenous (independent of variables in the model, such as disposable income). Autonomous consumption is related to consumers optimism about their future income and household wealth, which induce consumers to increase spending. The term mpc, the marginal propensity to consume, reflects the change in consumption expenditure that results from an additional dollar of disposable income. Keynes assumed that mpc was a constant between the values of 0 and 1. If, for example, a $1.00 increase in disposable income leads to an increase in consumption expenditure of $0.60, then mpc = Planned Investment Spending Investment spending is another key component of total expenditure. There are two types of investment: fixed and inventory. (Note that economist s use of the word investment differs from everyday use of the term, as is explained in the FYI box.) FIXED INVESTMENT Fixed investment is planned spending by firms on equipment (machines, computers, airplanes) and structures (factories, office buildings, shopping centres) and planned spending on new residential housing. INVENTORY INVESTMENT Inventory investment is spending by firms on additional holdings of raw materials, parts, and finished goods, calculated as the change in holdings of these items in a given time period say, a year. Inventory investment is a much smaller component of investment than fixed investment. We discuss it in detail at this juncture because it plays an important role in the determination of aggregate output. To illustrate, consider the following scenarios: 1. Suppose that Ford Motor Company has cars sitting in its factory lots on December 31, 2013, ready to be shipped to dealers. If each car has a wholesale price of $20 000, Ford has an inventory worth $2 billion. If by December 31, 2014, its inventory of cars has risen to , with a value of $3 billion, its inventory investment in 2014 is $1 billion, the change in the level of its inventory over the course of the year ($3 billion minus $2 billion). 2. Now suppose that by December 31, 2014, Ford s inventory of cars has dropped to with a value of $1 billion. Its inventory investment in 2014 is now $1 billion, the change in the level of its inventory over the course of the year ($1 billion - $2 billion). 3. Ford may also have additional inventory investment if the level of raw materials and parts that it is holding to produce these cars increases over the course of the year. If on December 31, 2013, it holds $50 million of steel used to produce its cars and on December 31, 2014, it holds $100 million, it has an additional $50 million of inventory investment in FYI Meaning of the Word Investment Economists use the word investment somewhat differently than other people do. When noneconomists say that they are making an investment, they are normally referring to the purchase of common stocks or bonds, purchases that do not necessarily involve newly produced goods and services. But when economists speak of investment spending, they are referring to the purchase of new physical assets, such as new machines or new houses purchases that add to aggregate demand.

4 4 PART VI Monetary Theory An important feature of inventory investment is that some inventory investment can be unplanned (in contrast, fixed investment is always planned). Suppose the reason Ford finds itself with an additional $1 billion of cars on December 31, 2014, is that $1 billion fewer of its cars were sold in 2014 than expected. This $1 billion of inventory investment in 2014 was unplanned. In this situation, Ford is producing more cars than it can sell, and it will cut production in order to keep from accumulating unsold goods. Adjusting production to eliminate unplanned inventory investment plays a key role in the determination of aggregate output, as we shall see. PLANNED INVESTMENT SPENDING AND REAL INTEREST RATES Planned investment spending, a component of aggregate demand, Y ad, is equal to planned fixed investment plus the amount of inventory investment planned by firms. Keynes considered the level of the real cost of borrowing to be a key determinant of planned investment spending. To understand Keynes s reasoning, we need to recognize that businesses make investments in physical capital (machines and factories) as long as they expect to earn more from the physical capital than the interest cost of a loan to finance the investment. When the real interest rate on borrowing is high, say, at 10%, fewer investments in physical capital will earn more than the 10% cost of borrowed funds, so planned investment spending will be low. When the real interest rate on loans is low, say, 1%, many investments in physical capital will earn more than the 1% interest cost of borrowed funds. Therefore, when the real interest rate on loans and hence the cost of borrowing are low, business firms are more likely to undertake an investment in physical capital, and planned investment spending will increase. Even if a company has surplus funds and does not need to borrow to undertake an investment in physical capital, its planned investment spending still will be affected by the real interest rate on debt instruments. Instead of investing in physical capital, it could purchase a security, such as a bond. If the real interest rate on this security is high, say, 10%, the opportunity cost (forgone interest earnings) of an investment is high. Planned investment spending will then be low, because the firm would probably prefer to purchase the security and earn the high 10% return than to invest in physical capital. As the real interest rate and the opportunity cost of investing fall, say, to 1%, planned investment spending will increase because investments in physical capital are likely to earn greater income for the firm than the measly 1% the security earns. PLANNED INVESTMENT AND BUSINESS EXPECTATIONS Keynes also believed that planned investment spending is heavily influenced by business expectations about the future. Businesses that are optimistic about future profit opportunities are willing to spend more, whereas pessimistic businesses cut back their spending. Thus Keynes posited a component of planned investment spending he called autonomous investment, I, that is completely exogenous and so is unexplained by variables in his model, such as output or interest rates. Keynes believed that changes in autonomous spending are dominated by these unstable exogenous fluctuations in planned investment spending, which are influenced by emotional waves of optimism and pessimism factors he labelled animal spirits. His view was coloured by the collapse in investment spending during the Great Depression, which he saw as the primary reason for the economic contraction. INVESTMENT FUNCTION Combining Keynes two factors that drive investment leads to an investment function, which describes how planned investment spending

5 CHAPTER 22 The IS Curve 5 is related to autonomous investment and the real interest cost of borrowing. We write it as follows: I = I - dr c (4) where d is a parameter reflecting how responsive investment is to the real cost of borrowing, which is denoted by r c. However, as we learned in Chapter 9, the real cost of borrowing reflects not only the real interest rate on default-free debt instruments, r, but also financial frictions, denoted by f, which are additions to the real cost of borrowing because of asymmetric information problems in financial markets. In other words, the real cost of borrowing can be written as follows: r c = r + f (5) Substituting in Equation 4 the real cost of borrowing from Equation 5 yields: I = I - d (r + f ) (6) Equation 6 says that investment is positively related to business optimism, as represented by autonomous investment, and is negatively related to the real interest rate and financial frictions. Net Exports As with planned investment spending, we can think of net exports as being made up of two components, autonomous net exports and the part of net exports that is affected by changes in real interest rates. REAL INTEREST RATES AND NET EXPORTS Real interest rates influence the amount of net exports through the exchange rate, the price of one currency, say, the dollar, in terms of other currencies, say, the euro. 2 We examined a model that explains the link between the exchange rate and real interest rates in Chapter 19, but here we will only outline the intuition. When Canadian real interest rates rise, Canadian dollar assets earn higher returns relative to foreign assets. People then want to hold more dollars, so they bid up the value of dollars and thereby increase its value relative to other currencies. Thus a rise in Canadian real interest rates leads to a higher value of the dollar. A rise in the value of the dollar makes Canadian exports more expensive in foreign currencies so foreigners will buy less of them, thereby driving down net exports. It also makes foreign goods less expensive in terms of dollars, so Canadian imports will rise, also causing a decline in net exports. We therefore see that a rise in the real interest rate, which leads to an increase in the value of the dollar, in turn leads to a decline in net exports. AUTONOMOUS NET EXPORTS The amount of exports is also affected by the demand by foreigners for domestic goods, while the amount of imports is affected by the demand by domestic residents for foreign goods. For example, if the Chinese have a poor harvest and want to buy more Canadian wheat, Canadian exports will rise. If Canadian consumers discover how good Chilean wine is and want to buy more, then Canadian imports will rise. Thus we can think of net exports as being 2 If the government pegs the exchange rate to another currency so it is fixed, in what is called a fixed exchange rate regime (see Chapter 20 ), then real interest rates do not directly affect net exports as in Equation 5 and NX = NX. Note also that a rise in income in the domestic economy leads to a rise in spending on imports and thus causes net exports to decline. Adding a response of net exports to domestic income, Y, or taking out the response of net exports to the real interest rates does not change the basic analysis in the chapter but does lead to a slightly different Equation 12 later in the chapter.

6 6 PART VI Monetary Theory determined by real interest rates as well as by a component, autonomous net exports, NX, which is the level of net exports that is treated as exogenous (outside the model). NET EXPORT FUNCTION Putting these two components of net exports together leads to a net export function: NX = NX - xr ( 7 ) where x is a parameter that indicates how net exports respond to the real interest rate. This equation tells us that net exports are positively related to autonomous net exports and are negatively related to the level of real interest rates. Government Purchases and Taxes Now we bring the government into the picture. The government affects aggregate demand in two ways: through its purchases and taxes. GOVERNMENT PURCHASES As we saw in the aggregate demand Equation 1, government purchases add directly to aggregate demand. Here we assume that government purchases are also exogenous and write government purchases as follows: G = G (8) which says that government purchases are set at a fixed amount G. TAXES The government affects spending through taxes because, as we discussed earlier, disposable income is equal to income minus taxes, Y - T, and disposable income affects consumption expenditure. Higher taxes T reduce disposable income for a given level of income and hence cause consumption expenditure to fall. The tax laws in a country like Canada are very complicated, so to keep the model simple, we assume that government taxes are exogenous and are a fixed amount T : 3 T = T (9) Goods Market Equilibrium Keynes recognized that equilibrium would occur in the economy when the total quantity of output equals the total amount of aggregate demand (planned expenditure). That is, Y = Y ad (10) When this equilibrium condition is satisfied, planned spending for goods and services is equal to the amount that is produced. Producers are able to sell all their output and have no reason to change their production because there is no unplanned inventory investment. This analysis explains why aggregate output goes to a certain level by examining the factors that affect each component of planned spending. 3 For simplicity, we assume here that taxes are unrelated to income. However, because taxes increase with income, we can describe taxes with the following more realistic tax function: T = T + ty Using this equation instead of Equation 9 in the derivation of Equation 12 later in the chapter would lead to mpc being replaced by mpc (1 - t ) in Equation 12.

7 CHAPTER 22 The IS Curve 7 Solving for Goods Market Equilibrium Deriving the IS Curve With our understanding of what drives the components of aggregate demand, we can see how aggregate output is determined by using the aggregate demand Equation 1 to rewrite the equilibrium condition in Equation 10 as follows: Y = C + I + G + NX (11) Aggregate Output = Consumption Expenditure + Planned Investment Spending + Government Purchases + Net Exports Now we can use our consumption, investment, and net export functions in Equation 3, Equation 6, and Equation 7, along with Equation 8 and Equation 9, to determine aggregate output. Substituting all these equations into the equilibrium condition Equation 11 yields the following: Y = C + mpc * (Y - T ) + I - d (r + f ) + G + NX - xr Collecting terms, we can rewrite this equation as follows: Y = C + I - d f + G + NX + mpc * Y - mpc * T - (d + x )r Subtracting mpc * Y from both sides of the equation, Y - mpc * Y = Y(1 - mpc) = C + I - d f + G + NX - mpc * T - (d + x )r Then, dividing both sides of the equation by 1 - mpc, we obtain an equation explaining how to determine aggregate output when the goods market is in equilibrium 4 : 1 Y = [C + I - df + G + NX - mpc * T ] * 1 - mpc - d + x 1 - mpc * r (12) We refer to Equation 12 as the IS curve, and it shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium. Equation 12 is made up of two terms. Since mpc is between zero and one, 1/(1 mpc ) is positive, so the first term tells us that increases in autonomous consumption, investment, government purchases, or net exports, or a decrease in taxes or financial frictions, leads to an increase in output at any given real interest rate. In other words, the first term tells us about shifts in the IS curve. The second term tells us that an increase in real interest rates results in a decline in output, which is a movement along the IS curve. Understanding the IS Curve To gain a deeper understanding of the IS curve, we will proceed in several steps. In this section we begin by looking at the intuition behind the IS curve and then discuss a numerical example. Then in the following section, we will outline the factors that shift the IS curve. What the IS Curve Tells Us: Intuition The IS curve traces out the points at which the goods market is in equilibrium. For each given level of the real interest rate, the IS curve tells us what the aggregate output must be for the goods market to be in equilibrium. As the real interest rate rises, planned investment spending and net exports fall, which in turn lowers aggregate demand; aggregate output must be lower for it to equal aggregate demand and satisfy goods market equilibrium. Hence the IS curve is downward-sloping. 4 Note that the term 1/(1 mpc ) that multiplies G is known as the expenditure multiplier, while the term mpc/ (1 mpc ) that multiplies T is called the tax multiplier and it is smaller in absolute value than the expenditure multiplier because mpc < 1.

8 8 PART VI Monetary Theory What the IS Curve Tells Us: Numerical Example We can also see what the IS curve tells us with the following numerical example, with specific values for the exogenous variables and for the parameters in Equation 12. C = $1.4 trillion I = $1.2 trillion G = $3.0 trillion T = $3.0 trillion NX = -$1.3 trillion f = 1 mpc = 0.6 d = 0.3 x = 0.1 With these values, we can rewrite Equation 12 as follows: 1 Y = [ * 3.0 ] * Plugging these values into Equation 12 yields the IS curve in Figure 22-1 : Y = * r * r = 12 - r (13) At a real interest rate r = 3%, equilibrium output Y =12 3 = $9 trillion. We plot this combination of the real interest rate at equilibrium output as point A in Figure At a real interest rate of r = 1%, equilibrium output Y =12 1 = $11 trillion, FIGURE 22-1 The IS Curve The downward-sloping IS curve represents points at which the goods market is in equilibrium for example, points A and B. Notice that output changes as necessary to return to equilibrium. For example, at point G an excess supply of goods exists and firms will cut production, decreasing aggregate output to the equilibrium level at point A. At point H an excess demand for goods exists, so firms will increase production and aggregate output will increase toward the equilibrium level at point B. Real Interest Rate, r (%) 7% 6% IS Region of Excess Supply of Goods 5% 4% When there is an excess supply of goods, output falls. 3% 2% 1% Region of Excess Demand for Goods A H G B 0% When there is excess demand for goods, output rises. Aggregate Output, Y ($ trillions)

9 CHAPTER 22 The IS Curve 9 which we plot as point B. The line connecting these points is the IS curve and, as you can see, it is downward-sloping. Why the Economy Heads Toward the Equilibrium The concept of equilibrium is useful only if there is a tendency for the economy to settle there. Let s first consider what happens if the economy is located to the right of the IS curve, where an excess supply of goods exists. In Figure 22-1 at point G, actual output is above aggregate demand, and firms are saddled with unsold inventory. To keep from accumulating unsold goods, firms will continue cutting production. As long as production is above the equilibrium level, output will exceed aggregate demand and firms will continue cutting production, sending aggregate output toward the equilibrium level, as is indicated by the leftward arrow from point G to point A. Only when the economy moves to point A on the IS curve will there be no further tendency for output to change. What happens if aggregate output is below the equilibrium level of output (the area to the left of the IS curve), where an excess demand for goods exists? At point H in Figure 22-1, actual output is below aggregate demand, so firms will want to increase production because inventories are declining more than they desire, and aggregate output will increase, as shown by the rightward arrow. When the economy has moved to point B on the IS curve, there will again be no further tendency for output to change. Factors That Shift the IS Curve You have now learned that the IS curve describes equilibrium in the goods market the combinations of the real interest rate and equilibrium output. The IS curve shifts whenever change occurs in autonomous factors (factors independent of aggregate output and the real interest rate). Note that a change in the real interest rate that affects equilibrium aggregate output causes only a movement along the IS curve. A shift in the IS curve, by contrast, occurs when equilibrium output changes at each given real interest rate. In Equation 12, we identified six candidates as autonomous factors that can shift aggregate demand and hence affect the level of equilibrium output. Although Equation 12 directly tells us how these factors shift the IS curve, we will develop some intuition as to how each autonomous factor does so. Changes in Government Purchases Let s look at what happens if government purchases rise from $3 trillion to $4 trillion in Figure IS 1 represents the same IS curve that we developed in Figure We determine the equation for IS 2 by inputting the $4 trillion value into Equation 12 : 1 Y = [ * 3.0] * r = r = r On the basis of these results, at a real interest rate of r = 3%, equilibrium output Y = = $11.5 trillion, which we mark as point C on Figure At a real interest rate r = 1%, equilibrium output has increased to Y = = $13.5 trillion, which we mark as point D. The increase in government purchases therefore shifts the IS curve to the right from IS 1 to IS 2. An intuitive way to see why an increase in government purchases leads to a rightward shift of the IS curve is to recognize that an increase in government purchases causes aggregate demand to increase at any given real interest rate. Since aggregate output equals aggregate demand when the goods market is in equilibrium, an increase in government purchases that causes aggregate demand to rise also causes equilibrium output to rise, thereby shifting the IS curve to the right. Conversely, a decline in government purchases causes aggregate demand to fall at any given real interest rate and leads to a leftward shift of the IS curve.

10 10 PART VI Monetary Theory FIGURE 22-2 Shift in the IS Curve from an Increase in Government Purchases IS 1 represents the IS curve we derived in Figure IS 2 reflects a $1.0 trillion increase in government purchases. The increase in government purchases causes aggregate output to rise, shifting the IS curve to the right by $2.5 trillion from IS 1 to IS 2. Real Interest Rate, r (%) 7% Step 1. A rise in government purchases increases equilibrium output at each real interest rate... 6% IS 1 IS 2 5% 4% 3% 2% 1% 0% 5 A B Step 2. causing a rightward shift in the IS curve. C D Aggregate Output, Y ($ trillions) APPLICATION The Vietnam War Buildup, The United States involvement in Vietnam began to escalate in the early 1960s. After 1964, the United States was fighting a full-scale war. Beginning in 1965, the resulting increases in military expenditure raised government purchases. Usually during a period when government purchases are rising rapidly, central banks raise real interest rates to keep the economy from overheating. The Vietnam War period, however, is unusual because the Federal Reserve decided to keep real interest rates constant. Hence, this period provides an excellent example of how policymakers could make use of the IS curve analysis to inform policy. The rise in government purchases would shift the IS curve to the right, from IS 1964 to IS 1969 in Figure Because the Federal Reserve decided to keep real interest rates constant during this period, at 2%, equilibrium output rose from $3.0 trillion (in 2000 dollars) in 1964 to $3.8 trillion by 1969, with the unemployment rate falling steadily from 5% in 1964 to 3.4% in However, all was not well for the economy: The increase in government purchases with the real interest rate constant led to an overheating of the economy that eventually resulted in high inflation. (We will discuss the link between an overheating economy and inflation in the coming chapters.)

11 CHAPTER 22 The IS Curve 11 FIGURE 22-3 Vietnam War Buildup Beginning in 1965, increases in military spending caused the IS curve to shift from IS 1964 to IS Because the Federal Reserve decided to keep real interest rates constant during this period, at 2%, equilibrium output rose from $3.0 trillion (in 2000 dollars) in 1964 to $3.8 trillion in 1969, setting the stage for an increase in inflation. Real Interest Rate, r (%) IS 1964 IS 1969 Step 1. Increasing military spending shifted the IS curve rightward... 2% Step 2. while Federal Reserve actions kept the interest rate constant Step 3. raising aggregate output Aggregate Output, Y ($ trillions, 2000 dollars) Changes in Taxes Now let s look at Figure 22-4 to see what happens if the government raises taxes from $3 trillion to $4 trillion. IS 1 represents the same IS curve that we developed in Figure We determine the equation for IS 2 by inputting the $4 trillion value in Equation 12 : Y = [ * 4.0 ] * = r r = r At a real interest rate of r = 3%, equilibrium output Y = = $7.5 trillion, which we mark as point E in Figure At this real interest rate, equilibrium output has decreased from point A to point E, as shown by the leftward arrow. Similarly, at a real interest rate r = 1%, equilibrium output has decreased to Y = = $9.5 trillion, causing a leftward shift from point B to point F. The IS curve shifts to the left, from IS 1 to IS 2, as a result of the increase in taxes. We then have the following result: At any given real interest rate, a rise in taxes causes aggregate demand 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 aggregate demand and equilibrium output to rise, shifting the IS curve to the right. Policymakers use both tax and government purchases policies to stimulate the economy when it enters recessions, as the Application on the next page illustrates.

12 12 PART VI Monetary Theory FIGURE 22-4 Shift in the IS Curve from an Increase in Taxes IS 1 represents the IS curve we derived in Figure IS 2 reflects a $1.0 trillion increase in government tax revenue. The increase in taxes decreases aggregate output levels by $1.5 trillion, shifting the IS curve to the left from IS 1 to IS 2. Real Interest Rate, r (%) 7% 6% IS 2 IS 1 5% 4% 3% 2% 1% 0% 4 Step 2. causing a leftward shift in the IS curve. E A F Step 1. An increase in taxes causes equilibrium output to fall at each real interest rate... B Aggregate Output, Y ($ trillions) APPLICATION The Fiscal Stimulus Package of 2009 In the fall of 2008, the U.S. economy was in crisis. By the time the new Obama administration had taken office, the unemployment rate had risen from 4.7% just before the recession began in December 2007 to 7.6% in January To stimulate the economy, the Obama administration proposed a fiscal stimulus package that, when passed by Congress, included $288 billion in tax cuts for households and businesses and $499 billion in increased federal spending, including transfer payments. What does our IS curve analysis suggest should have happened to the economy? As the analysis in Figure 22-2 and Figure 22-4 indicates, these tax cuts and spending increases would increase aggregate demand, thereby raising the equilibrium level of aggregate output at any given real interest rate and so shifting the IS curve to the right. Unfortunately, things didn t work out quite as the Obama administration planned. Most of the government purchases did not kick in until after 2010, while the decline in autonomous consumption and investment were much larger than anticipated. The fiscal stimulus was more than offset by weak consumption and investment, with the result that the aggregate demand ended up contracting rather than rising, and the IS curve did not shift to the right, as hoped. Despite the good intentions of the fiscal stimulus package, the unemployment rate ended up rising to over 10% in Without the fiscal stimulus, however, the IS curve would likely have shifted further to the left, resulting in even more unemployment.

13 CHAPTER 22 The IS Curve 13 Changes in Autonomous Spending As you can see in Equation 12, autonomous consumption, investment, and net exports, C, I, and NX, respectively, all are multiplied by the term 1/(1 - mpc ) in the same way the G term is. Thus an increase in any of these variables has the same impact on the IS curve as an increase in government purchases. For this reason, we can lump these variables together as autonomous spending, exogenous spending that is unrelated to variables in the model such as output or real interest rates. We look intuitively at how changes in each of these variables affects the IS curve in turn. AUTONOMOUS CONSUMPTION Suppose that consumers find their wealth has increased when the stock market has boomed or they have become increasingly optimistic about their future income prospects because a positive productivity shock to the economy has occurred. Both of these events are autonomous; that is, they are not affected by the level of the real interest rate. The resulting rise in autonomous consumption would raise aggregate demand and equilibrium output at any given interest rate, shifting the IS curve to the right. Conversely, a decline in autonomous consumption expenditure causes aggregate demand and equilibrium output to fall, shifting the IS curve to the left. AUTONOMOUS INVESTMENT SPENDING Earlier in the chapter, we learned that changes in the real interest rate affect planned investment spending and hence the equilibrium level of output. This change in investment spending merely causes a movement along the IS curve and not a shift. An autonomous rise in planned investment spending unrelated to the real interest rate say, because companies become more confident about investment profitability after the stock market rises increases aggregate demand. An increase in autonomous investment spending therefore increases equilibrium output at any given interest rate, shifting the IS curve to the right. On the other hand, a decrease in autonomous investment spending causes aggregate demand and equilibrium output to fall, shifting the IS curve to the left. AUTONOMOUS NET EXPORTS An autonomous rise in net exports unrelated to the real interest rate say, because Canadian-made handbags become more chic than French-made handbags, or because foreign countries have a boom and thus buy more Canadian goods causes aggregate demand to rise. 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 aggregate demand and equilibrium output to decline, shifting the IS curve to the left. Changes in Financial Frictions Summary of Factors That Shift the IS Curve An increase in financial frictions, as occurred during the financial crisis of , raises the real cost of borrowing to firms and hence causes investment spending and aggregate demand to fall. An increase in financial frictions leads to a decline in equilibrium output at any given real interest rate and shifts the IS curve to the left. Conversely, a decline in financial frictions causes aggregate demand and equilibrium output to rise, shifting the IS curve to the right. As a study aid, Summary Table 22-1 shows how each factor shifts the IS curve and the reason the shift occurs. Now that we have a full understanding of the IS curve, we can use this building block to examine the relationship between monetary policy and the aggregate demand curve in the following chapter.

14 14 PART VI Monetary Theory TABLE 22.1 Shifts in the Is Curve From Autonomous Changes in C, I, G, T, NX, and f Variable Change in Variable Shift in IS Curve Reason Autonomous consumption expenditure, C c r C c Y c r IS 1 IS 2 Autonomous investment, I c I c Y c Y r IS 1 IS 2 Government spending, G c G c Y c Y IS 1 IS 2 Y Taxes, T c T c 1 C T Y T r r IS 2 IS 1 Autonomous net exports, NX c NX c Y c Y IS 1 IS 2 Y Financial frictions, r f c I T YT IS 2 IS 1 Y Note : Only increases (c) in the variables are shown; the effects of decreases in the variables on aggregate output would be the opposite of those indicated in the last two columns. MyEconLab MyEconLab is an online homework and tutorial system that puts you in control of your own learning with study and practice tools directly correlated to this chapter s content. Visit MyEconLab to explore the following resources: All of the Applied Problems marked in green are available in the Study Plan on MyEconLab for further practice. You will also find the answers to the questions marked with an asterisk in the Student Resources section of your MyEconLab. MyEconLab also features Additional Readings, videos, Glossary Flashcards, Audio Chapter Summaries, Economics News Feeds, Animations, and many additional tools to help you master key concepts from the text.

15 CHAPTER 22 The IS Curve 15 SUMMARY 1. Planned expenditure, the total amount of goods demanded in the economy, is the same as aggregate demand, which is the sum of four types of spending: consumption expenditure, planned investment spending, government purchases, and net exports. We represent the total aggregate demand ( Y ad ) with Equation 1 : Y ad = C + I + G + NX. 2. Consumption expenditure is described by the consumption function, which indicates that consumption expenditure will rise as disposable income increases. Planned expenditure and hence aggregate demand is negatively related to the real interest rate because a rise in the real interest rate reduces both planned investment spending and net exports. An increase in financial frictions raises the real cost of borrowing and hence lowers investment spending and aggregate demand. The government also affects planned expenditure by increased spending, which directly raises aggregate demand, or by taxes, which indirectly affect aggregate demand by influencing disposable income and hence consumption expenditure. 3. The level of aggregate output when the goods market is in equilibrium is determined by the condition that aggregate output equals aggregate demand. 4. The IS curve traces out the combinations of the real interest rate and aggregate output for which the goods market is in equilibrium. The IS curve slopes downward because higher real interest rates lower planned investment spending and net exports and so lower equilibrium output. 5. The IS curve shifts to the right when there is a rise in autonomous consumption, a rise in autonomous investment, a rise in government purchases, a rise in autonomous net exports, a fall in taxes, or a fall in financial frictions. Movements of these six factors in the opposite direction will shift the IS curve to the left. KEY TERMS aggregate demand, p. xx animal spirits, p. xx autonomous consumption expenditure, p. xx autonomous investment, p. xx autonomous net exports, p. xx autonomous spending, p. xx consumption expenditure, p. xx consumption function, p. xx disposable income, p. xx exchange rate, p. xx exogenous, p. xx fixed investment, p. xx government purchases, p. xx inventory investment, p. xx IS curve, p. xx marginal propensity to consume, p. xx net exports, p. xx planned expenditure, p. xx planned investment spending, p. xx QUESTIONS 1. When the stock market rises, investment is increasing. Is this statement true, false, or uncertain? Explain your answer. 2. Why is inventory investment counted toward aggregate spending if it isn t actually sold to the final end user? 3. Since inventories can be costly to hold, firms planned inventory investment should be zero, and firms should acquire inventory only through unplanned inventory accumulation. Is this statement true, false, or uncertain? Explain your answer. 4. During and in the aftermath of the financial crisis of , planned investment fell substantially, despite significant decreases in the real interest rate. What factors related to the planned investment function could explain this? 5. If households and firms believe the economy will be in a recession in the future, will this necessarily cause a recession, or have any impact on output at all? 6. Why do increases in the real interest rate lead to decreases in net exports, and vice versa? 7. Why does equilibrium output increase as the marginal propensity to consume increases? 8. If firms suddenly become more optimistic about the profitability of investment and planned investment spending rises by $100 billion, while consumers become more pessimistic and autonomous consumer spending falls by $100 billion, what happens to aggregate output? 9. In each of the cases below, what happens to equilibrium output? Briefly explain how it affects the relevant component(s) of planned spending. a. The real interest rate rises. b. The marginal propensity to consume declines. c. Financial frictions increase. d. Autonomous consumption decreases.

16 16 PART VI Monetary Theory e. Both taxes and government spending decrease by the same amount. f. The sensitivity of net exports to changes in the real interest rate decreases. g. The government provides tax incentives for research and development programs for firms. 10. Will aggregate output rise or fall if an increase in autonomous consumer expenditure is matched by an equal increase in taxes? 11. If a change in the interest rate has no effect on planned investment spending or net exports, then what does this imply about the slope of the IS curve? 12. Why do companies cut production when they find that their unplanned inventory investment is greater than zero? If they didn t cut production, what effect would this have on their profits? Why? 13. Firms will increase production when planned investment is less than (actual) total investment. Is this statement true, false, or uncertain? Explain your answer. 14. In each of the cases below, explain whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift. a. The real interest rate rises. b. The marginal propensity to consume declines. c. Financial frictions increase. d. Autonomous consumption decreases. e. Both taxes and government spending decrease by the same amount. f. The sensitivity of net exports to changes in the real interest rate decreases. g. The government provides tax incentives for research and development programs for firms. 15. The fiscal stimulus package of 2009 caused the IS curve to shift to the left, since output decreased and unemployment increased after the policies were implemented. Is this statement true, false, or uncertain? Explain your answer. 16. When the central bank reduces its policy interest rate, how, if at all, is the IS curve affected? Briefly explain. 17. In its February 18, 2010, edition, The Wall Street Journal stated, The dollar strengthened [...] and stocks [...] followed suit. The Dow industrials rose points, or 0.4%. a. What effect does the strengthened dollar have on the IS curve? b. What effect does the increase in stock prices have on the IS curve? c. What is the combined effect of these two events on the IS curve? APPLIED PROBLEMS 18. Calculate the value of the consumption function at each level of income in the table below if autonomous consumption =300, taxes =200, and mpc =0.9. Income Y Disposable Income Y D Consumption C 19. Assume that autonomous consumption is $1 625 billion and disposable income is $ billion. Calculate consumption expenditure if an increase of $1 000 in disposable income leads to an increase of $750 in consumption expenditure. 20. Suppose that Dell Corporation has computers in its warehouses on December 31, 2012, ready to be shipped to merchants (each computer is valued at $500). By December 31, 2013, Dell Corporation has computers ready to be shipped, each valued at $450. a. Calculate Dell s inventory on December 31, b. Calculate Dell s inventory investment in c. What happens to inventory spending during the early stages of an economic recession? 21. If the consumption function is C = Y D, I = 200, government spending is 200, and net exports are zero, what will be the equilibrium level of output? What happens to aggregate output if government spending rises by 100? 22. If the marginal propensity to consume is 0.75, how much would government spending have to rise to increase output by $1000 billion? How much will taxes need to decrease to increase output by $1000 billion?

17 CHAPTER 22 The IS Curve Assuming both taxes and government spending increase by the same amount, calculate an expression for the effect on equilibrium output. 24. Consider an economy described by the following: C = $3.25 trillion I = $1.3 trillion G = $3.5 trillion T = $3.0 trillion NX = -$1.0 trillion f = 1 mpc = 0.75 d = 0.3 x = 0.1 a. Calculate simplified expressions for the consumption function, investment function, and net export function. b. Calculate an expression for the IS curve. c. If the real interest rate is r = 2, then what is equilibrium output? If r = 5, then what is equilibrium output? d. Draw a graph of the IS curve, showing the answers from part (c) above. e. If government purchases increases to $4.2 trillion, what will happen to equilibrium output at r =2? What happens to equilibrium output at r =5? Show the effect of the increase in government purchases in your graph from part (d). 25. Consider an economy described by the following: C = $4 trillion I = $1.5 trillion G = $3.0 trillion T = $3.0 trillion NX = $1.0 trillion f = 0 mpc = 0.8 d = 0.35 x = 0.15 a. Calculate an expression for the IS curve. b. Assume that the central bank controls the interest rate and sets the interest rate at r = 4. What is the equilibrium level of output? c. Suppose that a financial crisis begins, and f increases to f = 3 What will happen to equilibrium output? If the central bank can set the interest rate, then what should the interest rate be set at to keep output from changing? d. Suppose that as a result of the financial crisis, in addition to f increasing as in part (c), planned autonomous investment decreases to I = $1.1 trillion. Will the change in the interest rate by the central bank from part (c) be effective at stabilizing output? If not, what additional monetary or fiscal policy changes could be implemented to stabilize output at the original equilibrium output level in part ( b)? WEB EXERCISES 1. Go to Set the policy instruments to be G =80, t =0.20, c =0.75, b = 40. Now increase government spending, G, from 80 to 160. How much does the IS curve shift horizontally to the right? Why is this amount greater than the increase in G? Now increase the marginal propensity to consume, c, from 0.75 to Which direction does the IS curve shift and why? How much does it shift? Now increase the tax rate, t, from 0.20 to Which direction does the IS curve shift and why? How much does it shift? 2. Go to Set the policy instruments to be G =80, t =0.20, c =0.75, b = 40. Now increase the sensitivity of investment to the interest rate, b, from 40 to 80. What happens to the slope of the IS curve? Why?