ECO 302

Intermediate Macroeconomic Theory I

The IS Curve
(Jones Chapter 11)

Instructor: Nazmul Hoque

East West University
 Lecture outline
• 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.
• 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 central bank 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:
↑ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 ⇒↓ 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ⇒↓ 𝑜𝑢𝑡𝑝𝑢𝑡
 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.
 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
𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡 + 𝐺𝑡 + 𝐸𝑋𝑡 − 𝐼𝑀𝑡
where 𝑌𝑡 is output, 𝐼𝑀𝑡 is import, 𝐶𝑡 is consumption, 𝐼𝑡 is
investment, 𝐺𝑡 is government purchase and 𝐸𝑋𝑡 is export
 Setting Up the Economy
• We need five additional equations to solve the model:
𝐶𝑡 = 𝑎ത𝑐 𝑌ത𝑡
𝐺𝑡 = 𝑎ത𝑔 𝑌ത
𝐸𝑋𝑡 = 𝑎ത𝑒𝑥 𝑌ത𝑡
𝐼𝑀𝑡 = 𝑎ത𝑖𝑚 𝑌ത𝑡
𝐼𝑡
= 𝑎ത𝑖 − 𝑏(𝑅ത 𝑡 − 𝑟)ҧ
𝑌ത𝑡
 Consumption and Friends
• Level of potential output is given exogenously.
• Consumption C, 𝐶𝑡 = 𝑎ത𝑐 𝑌ത𝑡
• Government purchases G, 𝐺𝑡 = 𝑎ത𝑔 𝑌ത
• Exports EX, and imports IM, depend on the economy’s potential
output. 𝐸𝑋𝑡 = 𝑎ത𝑖𝑚 𝑌ത𝑡 , 𝐼𝑀𝑡 = 𝑎ത𝑖𝑚 𝑌ത𝑡
• Each of these components of GDP is a constant fraction of potential
output.
• the fraction is a parameter
 Consumption
• 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.
 Investment
𝐼𝑡
= 𝑎ത𝑖 − 𝑏(𝑅ത 𝑡 − 𝑟)ҧ
𝑌ത𝑡
where 𝑎ത𝑖 is long-run fraction of potential output that goes to
investment, 𝑏ത is sensitivity of investment to changes in interest rate,
𝑅𝑡 is real interest rate and 𝑟ҧ is marginal product of capital.
 Investment
• The MPK
• Is an exogenous parameter
• Is time invariant
• If the MPK is low relative to the real interest rate
• Firms should save more and invest less
• 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.
 Deriving the IS Curve
• Divide the national income accounting identity by potential
output.
𝑌𝑡 𝐶𝑡 𝐼𝑡 𝐺𝑡 𝐸𝑋𝑡 𝐼𝑀𝑡
= + + + −
𝑌ത𝑡 𝑌ത𝑡 𝑌ത𝑡 𝑌ത𝑡 𝑌ത𝑡 𝑌ത𝑡
• Substitute the five equations into this equation.
𝑌𝑡
= 𝑎ത𝑐 + 𝑎ത𝑖 − 𝑏ത 𝑅𝑡 − 𝑟ҧ + 𝑎ത𝑔 + 𝑎ത𝑒𝑥 − 𝑎ത𝑖𝑚
𝑌ത𝑡
 Deriving the IS Curve
• Recall the definition of short-run output. Simplifies the equation
for the IS curve:
𝑌𝑡 − 𝑌ത
𝑌෨𝑡 ≡
𝑌ത
𝑌𝑡
− 1 = 𝑎ത𝑐 + 𝑎ത𝑖 − 𝑏ത 𝑅𝑡 − 𝑟ҧ + 𝑎ത𝑔 + 𝑎ത𝑒𝑥 − 𝑎ത𝑖𝑚 − 1
𝑌ത𝑡
෩𝒕 = 𝒂
⇒𝒀 ഥ 𝑹𝒕 − 𝒓ത
ഥ−𝒃
where 𝑎ത = 𝑎ത𝑐 + 𝑎ത𝑖 + 𝑎ത𝑔 + 𝑎ത𝑒𝑥 − 𝑎ത𝑖𝑚 − 1
 Deriving the IS Curve
⇒ 𝑌෨𝑡 = 𝑎ത − 𝑏ത 𝑅𝑡 − 𝑟ҧ
• 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.
• 𝑎ത is called the aggregate demand shock
• Will equal zero when potential output is equal to actual output
• In the short run, however, 𝑎ത can be different from zero
 Using the IS Curve
• The Basic IS Curve
• When the demand shock parameter equals zero, the IS curve has a
short run 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
 The Effect of a Change in the Interest Rate
• 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 higher when 𝑎ത is
higher
• This means the IS curve shifts out
𝑌෨𝑡 = 𝑎ത − 𝑏ത 𝑅𝑡 − 𝑟ҧ
 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.
 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 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.
 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.
 Multiplier Effects
• We can modify the consumption equation to include a term that is
proportional to short-run output.
𝐶𝑡
= 𝑎ത𝑐 + 𝑥ҧ 𝑌෨𝑡
𝑌ഥ𝑡
 Multiplier Effects
• 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
1
𝑌෨𝑡 = × (𝑎ത − 𝑏ത 𝑅𝑡 − 𝑟ҧ )
1 − 𝑥ҧ
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑆 𝑐𝑢𝑟𝑣𝑒
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
 Multiplier Effects
• 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
 Investment
• 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.
 Investment
• 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.
 Investment
• The potential output term in the investment equation incorporates
cash flows.
ത 𝑡 − 𝑟)ҧ 𝑌ത𝑡
𝐼𝑡 = 𝑎ത𝑖 𝑌ത𝑡 − 𝑏(𝑅
• Captures the cash flow effect in the presence of 𝑌ത𝑡
• 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
 Government Purchases
• 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 works as automatic 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.
 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: 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.
 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 short run output
• If foreigners demand more American exports
• The IS curve shifts right
 Conclusion
• Higher interest rates
• Raise the cost of borrowing to firms and households
• Reduce the demand for investment spending
• Decrease short-run output