Chapter 21
The IS Curve
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Preview
This chapter develops the IS schedule,
which describes the relationship between
real interest rates and aggregate output
when the market for real goods and services
is in equilibrium.
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Learning Objectives
List the four components of aggregate demand
(or planned expenditure).
List and describe the factors that determine the
four components of aggregate demand (or
planned expenditure).
Solve for the goods market equilibrium.
Describe why the IS curve slopes downward and
why the economy heads to a goods market
equilibrium.
List the factors that shift the IS curve and
describe how they shift the IS curve.
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Planned Expenditure and Aggregate
Demand
Planned expenditure is the total amount
of spending on domestically produced goods
and services that households, businesses,
the government, and foreigners want to
make.
Aggregate demand is the total amount of
output demanded in the economy.
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Planned Expenditure and Aggregate
Demand
The total quantity demanded of an
economys output is the sum of 4 types of
spending:
-Consumption expenditure (C)
-Planned investment spending (I )
-Government purchases (G )
-Net exports (NX )
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The Components of Aggregate
Demand
Consumption expenditure and the consumption function:
Income is the most important factor determining consumption spending
Disposable income (YD ) is total income less taxes (Y - T)
The marginal propensity to consume (mpc) is the slope of
the consumption function (DC / DYD ), the change in consumer
expenditure that results from an additional dollar of disposable income
a is automonous consumer expenditure, the amount of consumer
expenditure that is independent of disposable income (how much
will be spent when disposable income is 0)
C = a+ mpc(YD )
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Planned Investment Spending
Fixed investment are always planned.
Inventory investment can be unplanned.
Planned investment spending
Interest rates
Expectations
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Net Exports
Made up of two components: autonomous
net exports and the part of net exports that
is affected by changes in real interest rates
Net export function:
NX = N X - xr
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Government Purchases and Taxes
The government affects aggregate demand
in two ways: through its purchases and
taxes
Government purchases:
G=G
Government taxes:
T =T
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Goods Market Equilibrium
Keynes recognized that equilibrium would
occur in the economy when the total
quantity of output produced in the economy
equals the total amount of aggregate
demand (planned expenditure).
Solving for goods market equilibrium:
Aggregate Output = Consumption Expenditure +
Planned Investment Spending + Government
Purchases + Net Exports
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Understanding the IS Curve
What the IS curve tells us: traces out the
points at which the goods market is in
equilibrium
Examines an equilibrium where aggregate
output equals aggregate demand
Assumes fixed price level where nominal and
real quantities are the same
IS curve is the relationship between
equilibrium aggregate output and the interest
rate.
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Figure 1 The IS Curve
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Why the Economy Heads Toward the
Equilibrium
Interest rates and planned investment spending
Negative relationship
Interest rates and net exports
Negative relationship
IS curve: the points at which the total quantity of
goods produced equals the total quantity of goods
demanded
Output tends to move toward points on the curve
that satisfies the goods market equilibrium.
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Factors that Shift the IS Curve
The IS curve shifts whenever there is a
change in autonomous factors (factors
independent of aggregate output and the
real interest rate).
One example is changes in government
purchases, as in Figure 2.
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Figure 2 Shift in the IS Curve from an
Increase in Government Purchases
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Application: The Vietnam War
Buildup, 19641969
The United States involvement in Vietnam began
to escalate in the early 1960s.
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.
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Figure 3 Vietnam War Build Up
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Changes in Taxes
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.
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Figure 4 Shift in the IS Curve from
an Increase in Taxes
Another example of what shifts the IS curve is changes in
taxes, as in Figure 4
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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 2009.
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.
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Application: The Fiscal Stimulus
Package of 2009
These tax cuts and spending increases were predicted
to 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, 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.
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Factors that Shift the IS Curve
Changes in autonomous spending also affect
the IS curve:
Autonomous consumption
Autonomous investment spending
Autonomous net exports
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Autonomous Consumption
A 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.
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Autonomous Investment Spending
An increase in autonomous investment
spending 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.
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Autonomous Net Exports
An autonomous increase in net exports
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.
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Factors that Shift the IS Curve
Another factor that shifts the IS curve is
changes in financial frictions
An increase in financial frictions, as occurred
during the financial crisis of 2007-2009, raises
the real cost of borrowing to firms and hence
causes investment spending and aggregate
demand to fall
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Summary Table 1
Shifts in the IS
Curve from
Autonomous
Changes in , , ,
, C I G T
NX and f
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