1/24/2013
Chapter 11
The IS Curve
• The Federal Reserve exerts a
substantial influence on the level of
economic activity in the short run.
– Sets the rate at which people borrow and
lend in financial markets
By Charles I. Jones
• The basic story is this:
Media Slides Created By
Dave Brown
Penn State University
11.1 Introduction
• In this chapter, we learn
– The first building block of our short-run
model: the IS curve
• describes the effect of changes in the real
interest rate on output in the short run.
– How shocks to consumption, investment,
government purchases, or net exports—
“aggregate demand shocks”—can shift the
IS curve.
• The IS curve
– The IS curve captures the relationship
between interest rates and output in the short
run.
– There is a negative relationship between the
interest rate and short-run output.
– An increase in the interest rate will decrease
investment, which will decrease output.
– A theory of consumption called the lifecycle/permanent-income hypothesis.
– That investment is the key channel through
which changes in real interest rates affect
GDP in the short run.
1
1/24/2013
11.2 Setting Up the Economy
• The national income accounting identity
– Implies that the total resources available to
the economy equal total uses
– One equation with six unknowns
Investment
Consumption
Production
Government
purchases
Exports
Imports
• We need five additional equations to solve
the model:
• Potential output is smoother than actual
GDP.
– A shock to actual GDP will leave potential
output unchanged
• The equation depends on potential output.
– Shocks to income are “smoothed” to keep
consumption steady.
Consumption and Friends
• Level of potential output is
given exogenously.
– Consumption C,
government purchases G,
exports EX, and imports IM
depend on the economy’s
potential output.
– Each of these components
of GDP is a constant
fraction of potential output.
• the fraction is a parameter
The Investment Equation
A term weighting the
difference between
the real interest rate
and the MPK
The share of
potential output that
goes to investment
Marginal
Product of
Capital
(MPK)
Real
interest
rate
2
1/24/2013
11.3 Deriving the IS Curve
• The MPK
– Is an exogenous parameter
– Is time invariant
• If the MPK is low relative to the real
interest rate
– Firms should save money and not invest in
capital
1. Divide the national income accounting
identity by potential output.
2. Substitute the five equations into this
equation.
3. Recall the definition of short-run output.
Simplifies the equation for the IS curve:
• If the MPK is high relative to the real
interest rate
– Firms should borrow and invest in capital
• In the short run, the MPK and the real
interest rate can be different.
– Installing capital to equate the two takes time.
• The gap between the real interest rate and
the MPK is what matters for output
fluctuations.
– Firms can always earn the MPK on new
investments.
• The parameter
– Is
– Is called the aggregate demand shock
– Will equal zero when potential output is equal
to actual output
3
1/24/2013
Case Study: Why is it called the “IS Curve”?
• IS stands for “investment = savings”
• See this again in Chapters 17 and 18.
11.4 Using the IS Curve
The Basic IS Curve
• When the demand shock parameter
equals zero, the IS curve has a shortrun output of 0 where the real interest
rate is equal to the long-run value of the
MPK.
The Effect of a Change in
the Interest Rate
• When the real interest rate changes, the
economy will move along the IS curve.
– An increase in the interest rate
• causes the economy to move up the IS
curve
• Causes short-run output to decline
• When the real interest rate changes, the
economy will move along the IS curve:
– The higher interest rate
• raises borrowing costs
• reduces demand for investment
• reduces output below potential
4
1/24/2013
Case Study: Move Along or Shift?
A Guide to the IS Curve
• If the sensitivity to the interest rate were
higher
– The IS curve would be flatter
– Any change in the interest rate would be
associated with larger changes in output
An Aggregate Demand Shock
• Suppose that information technology
improvements create an investment
boom.
– The aggregate demand shock parameter will
increase.
– Output is higher at every interest rate and the
IS curve shifts right.
– For any given real interest rate Rt, output is
Demand shock
higher when
parameter
• A change in R shows up as a
movement along the IS curve.
– The IS curve is a graph of R versus
short-run output.
• Any other change in the parameters
of the short-run model causes the IS
curve to shift.
A Shock to Potential Output
• Shocks to potential output
– Change actual output by the same amount in
our setup
– Do not change short-run output
• Some shocks to potential output may change
other parameters. Earthquake, for example:
– Reduces actual and potential output by the
same amount
– Leads to an increase in short-run output
because it also increases the MPK
Other Experiments
• Imagine that Japan enters into a
recession.
– The aggregate demand parameter for
exports declines.
• the IS curve shifts to the left
– thus the Japanese recession has an
international effect.
– We could shock any of the other aggregate
demand parameters.
5
1/24/2013
11.5 Microfoundations of the
IS Curve
• Microfoundations
– The underlying microeconomic behavior
that establishes the demands for C, I, G,
EX, and IM.
Consumption
• People prefer a smooth path for
consumption compared to a path that
involves large movements.
• The life-cycle model of consumption:
– Young people borrow to consume more
than their income.
– As income rises over a person’s life
• consumption rises more slowly
• individuals save more
– During retirement, individuals live off
their accumulated savings.
• The life-cycle/permanent-income (LC/PI)
hypothesis
– Implies that people smooth their consumption
relative to their income
– This is why we set consumption proportional
to potential output rather than actual output.
• The permanent-income hypothesis
– People will base their consumption on an
average of their income over time rather than
on their current income.
• The life-cycle model of consumption
– Suggests that consumption is based on
average lifetime income rather than on
income at any given age.
6
1/24/2013
• Alaska:
– Residents receive a refund based on
state oil revenues.
– A separate refund from federal tax
revenues
– A study shows that:
• Solving for the IS curve
– Will yield a similar result
– Now includes a multiplier on the aggregate
demand shock and interest rate terms:
• the multiplier is larger than one
• consumption does not change when
residents receive the oil revenue refund.
• the same individuals increase consumption
when federal tax refunds are received.
Case Study: Permanent Income and
Present Discounted Value
• Permanent Income
– Constant stream of income that has the
same present discounted value of the
actual income stream.
• Consumption
– Likely depends on permanent income
– Likely depends on the stage in the life
cycle
– May respond to temporary changes in
income
Multiplier Effects
• We can modify the consumption
equation to include a term that is
proportional to short-run output.
• With a multiplier:
– Aggregate demand shocks will increase
short-run output by more than one-for-one.
– A shock will “multiply” through the economy
and will result in a larger effect.
• If short-run output falls with a multiplier
– Consumption falls
– Which leads to short-run output falling
– Consumption falls again
– “Virtuous circle” or “vicious circle”
Investment
• At the firm level, investment is
determined by the gap between the real
interest rate and MPK.
• In a simple model
– The return on capital is the MPK minus
depreciation.
• The richer framework includes:
– Corporate income taxes
– Investment tax credits
– Depreciation allowances
7
1/24/2013
• A second determinant of investment
– The firm’s cash flow
• the amount of internal resources the
company has on hand after paying its
expenses
• Agency problems
– When one party in a transaction has more
information than the other party
– It is more expensive to borrow to finance
investment because of this.
• Adverse selection
– If a firm knows it is particularly vulnerable
• it will want to borrow because if the firm
does well it can pay back the loans.
• if it fails, the firm cannot pay back the
loan but will instead declare bankruptcy.
• Moral hazard
– A firm that borrows a large sum of money
may undertake riskier investments
• if it does well, it can repay.
• if it fails, it can declare bankruptcy.
• The potential output term in the
investment equation incorporates cash
flows.
• Captures cash flow.
• If we wish to add short-run output, it
would provide additional justification for
a multiplier.
Government Purchases
• Government purchases can be
– A source of short-run fluctuation
– An instrument to reduce fluctuations
• Discretionary fiscal policy
– Includes purchases of additional goods in
addition to the use of tax rates
– For example, the government can use the
investment tax credit to encourage
investment
• Transfer spending often increases when
an economy enters into a recession.
• Automatic stabilizers
– Programs where additional spending
occurs automatically to help stabilize the
economy
– Welfare programs and Medicaid are two
such stabilizer programs.
• receive additional funding when the
economy weakens
• Fiscal policy’s impact depends on two
things:
1. The problem of timing
• discretionary changes are often put into
place with significant delay.
2. The no-free-lunch principle
• implies that higher spending today must
be paid for today or some point in the
future.
• such taxes may offset the impact of the
discretionary spending adjustment.
8
1/24/2013
• What matters for consumption today?
• The permanent-income hypothesis
says:
– wwhat matters is the present discounted
value of your lifetime income, after taxes.
• Ricardian equivalence says:
– What matters is the present value of what
the government takes from the consumers
rather than the specific timing of the taxes.
• An increase in government purchases
financed by taxes today
– Will have a modest positive impact on the
IS curve
– Will raise output by a small amount in the
short run
• An increase in spending today financed
by taxes in the future
– Will shift the IS curve out by a moderate
amount
– Perhaps by 75 cents to $1 for each dollar
Case Study: The Macroeconomic
Effects of the American Recovery
and Reinvestment Act of 2009
• Economists had a wide range of opinions
about the effectiveness and costs of the
stimulus.
• Congressional Budget Office (CBO) gave
estimates of unemployment with and
without a stimulus.
– Estimated 9 percent peak without a stimulus
– Actual unemployment rate with stimulus was
above this.
Case Study: Fiscal Policy
and Depressions
• The most famous example of U.S.
discretionary fiscal policy is the New Deal
during the Great Depression.
– Between 1929 and 1934
– Share of government purchases in the
economy expanded from 9 to 16 percent.
– Followed by an enormous expansion in
military expenditures during World War II,
• raised the share of government
purchases to 48 percent
• Japan in the last two decades
– Performance screeched to a halt in 1990.
– One response by the Japanese government
was a large fiscal expansion.
• the expansion was financed primarily by
increased borrowing.
– This policy does not appear to have been
successful at pulling the Japanese economy
out of its slump.
• perhaps in part because of the perceived
future tax burden associated with the fiscal
expansion.
9
1/24/2013
Net Exports
• If the trade balance is a deficit
– The economy imports more than it exports
• If the trade balance is a deficit
– The economy imports more than it exports
Net Exports
• If Americans demand more imports
– The IS curve shifts left and reduces shortrun output
• If foreigners demand more American
exports
– The IS curve shifts right
11.6 Conclusion
• Higher interest rates
– Raise the cost of borrowing to firms and
households
– Reduce the demand for investment
spending
– Decrease short-run output
Summary
• The IS curve
– Describes how output in the short run
depends on the real interest rate and on
shocks to the aggregate economy
– Shows a negative relationship between
output and the real interest rate
• When the real interest rate rises, the cost of
borrowing increases, leading to delayed
purchases of capital.
• These delays reduce the level of investment,
which in turn lowers output below potential.
• Shocks to aggregate demand can shift
the IS curve. These shocks include:
– Changes in consumption relative to
potential output
– Technological improvements that stimulate
investment demand given the current
interest rate
– Changes in government purchases relative
to potential output
– Interactions between the domestic and
foreign economies that affect exports and
imports
• The life-cycle/permanent-income
hypothesis
– Individual consumption depends on average
income over time rather than current income
– Serves as the underlying justification for why
we assume consumption depends on
potential output
10
1/24/2013
• The permanent-income theory
– Does not seem to hold exactly
– Consumption responds to temporary
movements in income as well.
• When we include this effect in our IS
curve, a multiplier term appears.
– That is, a shock that reduces the aggregate
demand parameter may have an even larger
effect on short-run output.
• A consideration of the microfoundations
of the equations that underlie the IS
curve reveals important subtleties.
• The most important are associated with
the no-free-lunch principle imposed by
the government’s budget constraint.
• Depending on how government
purchases are financed, they can also
affect consumption and investment.
– partially mitigating the effects of fiscal policy
on short-run output
Additional Figures for
Worked Exercises
11
1/24/2013
This concludes the Lecture
Slide Set for Chapter 11
Macroeconomics
Second Edition
by
Charles I. Jones
W. W. Norton & Company
Independent Publishers Since 1923
12