What determines consumption and investment and how do these variables drive the position of the
IS curve? Distinguish carefully between the effect of current conditions and expectations about the
future.
Investment and consumption are determined by numerous variables, which all drive the position of
the IS curve in different ways. This essay will begin by setting up the IS curve, it will then look at the
determinants of investment, including interest rates, optimism about future profits and changes in
government spending, imports and exports, and finally we will look slightly more at consumption,
dismissing the permanent-income hypothesis and instead finding the presence of a multiplier.
The IS curve, investment-savings curve, is a key building block for the wider short-run model. The
curve essentially captures the negative short-run relationship between interest rates and output. We
can derive the IS curve from the national income account identity by putting consumption,
investment, government expenditure, exports and imports in terms of output. By doing this we can
eventually reach the equation of the IS curve:
In this equation Y is the deviation of output from the long-run level, a and b are parameters, R is the
real interest rate and r is the marginal product of labour. The IS curve is shown in the diagram below:
The first determinant of investment we will look at, and perhaps the one best explained by the IS
curve, is the level of interest rates. The interest rate is essentially the price of borrowing base
money. As interest rates are set by the government this determinant is a “current condition” rather
than anything grounded in expectation for the future. The impact of interest rates can be
demonstrated intuitively; as the interest rate falls, borrowing money leads to a lower cost of
borrowing and a lower opportunity cost of investing. This is demonstrated in the following bar chart
where a fall in interest rate increases the number of viable investments:
The impact of interest rates on investment can also be illustrated by the following equation, which is
to be found in one of the steps of deriving the IS curve:
This equation shows that the investment rate depends on the gap between interest rate and the
marginal product of capital. When interest rate rises, given that the equation assumes MPK is
exogenous (although in the real world it can and does change), the investment and output will fall.
This is shown on the graph below where an interest rate shifts us up the IS curve.
The second part of the IS curve that determines investment is the parameter a, which can be
changed by numerous events, including but not limited to, optimism about the future, government
investment, changes in foreign prices and changes in foreign demand. An event that causes
increased optimism about the future is called an aggregate demand shock and it leads businesses to
invest more at every interest rate. For example, significant improvements in technology will make
businesses optimistic that they can increase their profits if they invest in said technology. It is
important to acknowledge that this determinant is not about current conditions but rather “rather
expectations about future”. Keynes emphasis the importance of expectations, or animal spirits as he
called them, and he said “in estimating the prospects of investment we must have regard therefore,
to the nerves and hysteria and even the digestions and reactions to the weather”. As this optimism
leads to an increase of investment at every interest level it is represented by an outward shift of the
IS cure; we can see this below:
It is important to acknowledge that optimism about the future is not the only thing that can change
the value of the parameter a. The parameter is made up of the parameter that represent proportion
of output coming from government, exports and imports. Therefore, an increase in government
spending, an increase in foreign demand and a fall in foreign prices will all increase the size of the
parameter a. This will have the same impact as an aggregate demand shock and will lead to an
increase in output at all interest rates. Unlike optimism these are “current conditions” rather than
expectations for the future.
Having looked in depth at what determines investment it is necessary to have a look at what
determines consumption and how this fits into the IS model. Milton Friedman believed that
consumption was fairly constant and determined solely by average expected lifetime income. As we
cannot know our future income this determinant is an example of expectation for the future rather
than current condtions This permanent income-hypothesis was expanded in the life-cycle model of
consumption, shown below, which held that income was far more volatile then consumption:
This assumption explains why the IS curve assumes consumption is exogenous and is a function of
potential output, which is relatively stable. There is some evidence that people do act in this way
and Chang-Tai Hseih found that residents of Alaska consumed on the basis of what they knew their
pay out from the Alaska fund would be next year. This being said there is also evidence that people’s
short-term consumption is changed by reductions in income, which is why it is necessary to
introduce a multiplier. It important to note that the multiplier is meant to model current conditions
rather than expectation fot future. The multiplier means that consumption is not just a function of
potential output but also of actual output. This multiplier means that changes to the IS equation
have greater effects on short-run output then we previously believed. This is intuitive because a
reduction in investment will lead to more unemployment, which will lead to less consumption, which
will lead to more unemployment and this will lead to less consumption. We can incorporate the
multiplier into the normal IS equation by changing the parameters accordingly. Changing a will lead
to the IS curve shifting inwards or outwards but perhaps more interestingly changing b will change
the gradient of the IS curve because the gradient of the IS curve is -1/b. The effect of increasing b
makes output less responsive to changes in interest rate as shown below:
In conclusion, there are two main determinants of investment. The first, and the one upon which
the IS model is based, is interest rates and the second is optimism/pessimism regarding future
profits. Consumption also has two main determinants, contrary to the view of the permanentincome hypothesis, which are expected average lifetime income and short-term temporary shifts in
income. The impacts of these determinants are well represented on the IS curve as shown by the
essay.