Chapter 11

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 shockscan shift the IS curve.

 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.

 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

The basic story is this:

 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.

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 Government purchases Exports

Production

Imports

 We need five additional equations to solve the model:

Consumption and Friends

Level of potential output is given exogenously. Consumption C, government purchases G, exports EX, and imports IM depend on the economys potential output. Each of these components of GDP is a constant fraction of potential output.
the fraction is a parameter

 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.

The Investment Equation

A term weighting the difference between the real interest rate and the MPK Marginal Product of Capital (MPK)

The share of potential output that goes to investment

Real interest rate

 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

Understanding investments
If the marginal product of capital is low relative to the real interest rate, then firms are better off saving their retained earnings in the financial market (for example, by buying U.S. government bonds). Alternatively, if the marginal product of capital is high relative to the real interest rate, then firms would find it profitable to borrow at the real interest rate and invest the proceeds in capital, leading to a rise in investment. To be more concrete, suppose Rt =10% and r =15%. Now suppose a firm borrows 100 units of output at this 10 percent rate, invests it as capital, and produces. The extra 100 units of capital produce 15 units of output, since the marginal product of capital is 15 percent. The firm can pay back the 10 units it owes in interest and keep a profit of 5 units. In this scenario, one would expect firms to invest a relatively large amount. This discussion also helps us understand the b bar parameter, which tells us how sensitive investment is to changes in the interest rate.

 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.

11.3 Deriving the IS Curve

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:

 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

 This parameter, called the AGGREGATE DEMAND SHOCK will equal zero when potential output is equal to actual output To understand this equation, consider the case where the economy has settled down at its long-run values, so output is at potential and Yt tilde = 0. In the long run, as weve seen, the real interest rate prevailing in financial markets is equal to the marginal product of capital, so that Rt = r. In this case, the IS equation reduces to a simple statement that 0 = a bar. Our baseline IS curve will respect this long-run value. We will think of a bar = 0 as the default case. However, shocks to the economy can push a bar away.

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

 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

Case Study: Move Along or Shift? A Guide to the IS Curve 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.

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 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.

 The life-cycle model of consumption: Young people borrow to consume more than their income. As income rises over a persons 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.

 Alaska: Residents receive a refund based on state oil revenues. A separate refund from federal tax revenues A study shows that:
consumption does not change when residents receive the oil revenue refund. the same individuals increase consumption when federal tax refunds are received.

LC/PI hypotheses: Evidence

Two shocks: the annual payment from the State of Alaskas Permanent Fund and the annual payment of federal tax refunds. The Permanent Fund pays out a large sum of money each year to every resident of Alaska based on oil revenues; the general size of the payment is known through experience, and the exact size is announced six months before its actually made. The LC/PI hypothesis predicts that consumption should not change when the Permanent Fund check is received, but that consumers should have already taken it into account when planning their consumption pattern a year in advance. Consumers who smooth their consumption in response to the Permanent Fund payment dont fully smooth their tax refund: during the quarter in which tax refunds arrive, consumption rises by about 30 cents for every dollar of tax refund. He interprets this evidence as suggesting that the LC/PI hypothesis works well for large and easy-to-predict changes in income but less well for small and harder-to-predict shocks.

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.

 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

 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.

When calculating MPK other aspects must be taken into account. The richer framework includes:
Corporate income taxes Investment tax credits Depreciation allowances

 A second determinant of investment

The firms 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 policys 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.

 What matters for consumption today? The permanent-income hypothesis says:

what 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 and particularly after 1933 with F. D. Roosevelt 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.

Net Exports If the trade balance is a deficit

The economy imports more than it exports

If the trade balance is a surplus

The economy imports less 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

 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 governments 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