Goods Market (IS Curve)

Macroeconomics
Session 5

11th Edition: chapter 14 ( page 347 to 352), chapter 10: ( page 220 to 232)
12th Edition: chapter 15 ( page 352 to 357), chapter 11: ( page 223 to 236)
 Investment
• Links the present to the future
– Through enhancing capital stock leading to economic growth

• Links the goods and money markets

– Through interest rates

• Determine aggregate demand and output in the short

run
– Most volatile component of the aggregate demand
– Investment demand drives much of the business cycle
 Capital Stock and Investment
• Investment is the flow of spending that adds to the stock of
capital
– Both GDP and investment are flow variables

• Capital is the value of all the buildings, machines, and

inventories at a given point in time  stock

• Investment is the amount spent by businesses to add to the

existing capital stock over a given period
– Flow of investment is quite small compared to the stock of
capital
Change in Demand for Capital Stock Translates into Bigger
Change in Investment Demand:
Why Investment Demand can be so volatile

• Output is produced by capital stock and labour

• Presume that the existing capital stock is nearly 4 times the

GDP (with a 2 percent annual depreciation rate)

• This translate into replacement demand of the capital stock

(depreciation) at 8 percent of the GDP

• If the desired level of capital stock declines by 1 percent, the

investment demand will decline by 4 percent (may take some
time to materialize)
 Why inventory investment fluctuate
• Your sales is 30 cars/month.

• You keep 1 month's sale as inventory to smoothen supply.

• Sales fall to 25 cars/month due to demand shock, and you take one month to respond to
the change in demand.

• Your inventory increases to 35 but the new desired inventory level is 25 cars.

• You produce only 25 – (35- 25) = 15 cars.

(New inventory demand – (existing stock – sale))

• Fall in production could be higher than fall in demand.

• Once the inventories are brought down to desired level production goes upto 25 cars.

• What if the sales again recover to 30 cars.

 The Desired Capital Stock
• Firms use capital, along with labor and other resources, to
produce output

• The desired level of capital stock is the level where marginal

product of capital is equal to marginal cost of capital
– The marginal product of capital is the increase in output
produced by using one more unit of capital in production
– Marginal cost of capital can be defined as the rental (user) cost
of capital: the cost of using one more unit of capital for
production
 Rental (user) cost of capital
•• The
  firms finance the purchase of capital by borrowing over time, at an
interest rate of i
– In the presence of inflation, the nominal dollar value of capital rises
over time. Thus the real cost of borrowing is only the real part of the
interest rate
– Capital wears out over time at a rate of depreciation d
– The rental cost of capital is
 𝑟𝑐=𝑟 +𝑑 =𝑖 − 𝜋 +𝑑
– Where
rc= rental (user) cost of capital
r = real rate of interest
d = rate of depreciation
= rate of inflation
 The Desired Stock of Capital
• Firms add capital until the
marginal product of the last
unit = rental cost of capital

• A higher rental cost (rc)

leads to lower demand for
capital stock

• Rate of depreciation is a
technical parameter

• But the interest rate can be

influenced in the short-run
 Determinants of Investment
• Interest rates
– Influence the cost of capital

• Replacement demand
– Higher level of capital stock would lead to higher level of
depreciation, which in turn create higher replacement
demand.

• Profit expectations on growth and business

confidence
– Influence the revenues/returns on investment
Nominal Weighted Average Lending
Rates of Indian Banks

10
 Treasury Bills Rates in the US
• Interest rate on Treasury bills = the payment received by
someone who lends to the U.S. government
 Is there a Pattern
• Interest rates: a) are high just before a recession, b) drop during the
recession, and c) Rise during the recovery
 The IS-LM model
• IS-LM model is the core of short-run macroeconomics
– Maintains the conceptual ground of earlier multiplier model,
but adds the interest rate as an additional determinant of
aggregate demand
– Includes the goods market and the money market, and their
link through interest rates
Structure of the IS-LM Model
 The Goods Market and the IS Curve
• The IS curve shows combinations of interest rates and levels
of output such that planned spending equals income/Output
(recall the vertical and horizontal axes of the multiplier model)
– Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD

• Thus, at equilibrium, investment equals savings at the

given interest rate

10-15
 Investment and Interest Rate
• Investment is no longer treated as
exogenous, but dependent upon interest
rates (endogenous)

– Investment demand is lower the higher are

interest rates
• Interest rates are the cost of borrowing money
• Increased interest rates raise the price to firms of
borrowing for capital equipment  reduce the quantity
of investment demand
 i
Interest rate

0 Planned investment spending I

THE INVESTMENT SCHEDULE
 Investment and the Interest Rate
• The investment spending
function can be specified
as:
where b > 0 (1)
– i = rate of interest
– b = the responsiveness of
investment spending to the
interest rate
– = autonomous
investment spending
(political climate, public
infra)
– Negative slope reflects
assumption that a reduction
in i increases the quantity
of I
10-18
 Investment and the Interest Rate
(1) [Insert Figure 10-4 here]
• The position of the I schedule is
determined by:
– The slope, b
• If investment is highly
responsive to i (elastic), the
investment schedule is almost
flat
• If investment responds little
to I (inelastic), the investment
schedule is close to vertical
– Level of autonomous spending
• An increase in shifts the
investment schedule out
• A decrease in shifts the
investment schedule in
(leftward)
10-19
 The Interest Rate and AD: The IS Curve
• Need to modify the AD function (discussed in the previous session)
to reflect the new planned investment spending schedule

 ¿ [𝐶
¯ +𝑐 𝑇
¯𝑅¯ + 𝑐(1 −𝑡 ) 𝑌 ] +( 𝐼¯0 −𝑏𝑖 )+ 𝐺
¯ +𝑁
¯ 𝑋
¯

𝐴
¯ + 𝑐 (1 − 𝑡 ) 𝑌 −
(2) 𝑏𝑖

• An increase in i reduces AD for a given level of income

• At any given level of i, can determine the equilibrium level of income
and output
• A change in i will change the equilibrium
 is autonomous component of the investment (non-interest rate sensitive)
10-20
 AD AD=Y

Aggregate demand
E2 Ā+c(1-t)Y-bi2

Ā-bi2 Ā+c(1-t)Y-bi1
i2< i1

Ā-bi1 E1

Y1 Y2 Y
Income, output
(a)
i
Interest rate

i1 E1

i2 E2

IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
 The Interest Rate and AD: The IS Curve

(2)
• Derive the IS curve
i2< i1
– For a given interest rate, i1, the
last term of RHS in equation (2)
is constant  can draw the AD
function with an intercept of

• The equilibrium level of

income is Y1 at point E1
– Plot the pair (i1, Y1) in the
bottom panel as point E1  a
point on the IS curve
• Combination of i and Y that
clears the goods market
10-22
 The Interest Rate and AD: The IS Curve

• Consider a lower interest

rate, i2 i2< i1
• Shifts the AD curve upward to
AD’ with an intercept of
  𝐴 −𝑏 𝑖 2
¯
• Given the increase in AD, the
equilibrium shifts to point E2,
with an associated income
level of Y2
• Plot the pair (i2, Y2) in panel
(b) for another point on the IS
curve 10-23
 The Interest Rate and AD: The IS Curve
• We can apply the same
procedure to all levels of i to
generate additional points
on the IS curve
i2< i1
– All points on the IS curve
represent combinations of i
and income at which the
goods market clears  goods
market equilibrium schedule
• Notice the negative
relationship between i and Y
– Downward sloping IS curve

10-24
 The Interest Rate and AD: The IS Curve
• We can also derive the IS curve using the goods
market equilibrium condition:
𝑌 =𝐴𝐷 = ¯
 
𝐴 +𝑐 (1 −𝑡 ) 𝑌 −𝑏𝑖 (3)
  𝑌 − 𝑐 (1 − 𝑡 ) 𝑌 = 𝐴 ¯ − 𝑏𝑖
 𝑌 (1 −𝑐 (1 −𝑡 ))= ¯
𝐴 − 𝑏𝑖
 𝑌 𝐴 − 𝑏𝑖 )
=𝛼 𝐺 ( ¯ (4)

where , the multiplier from Chapter 10

Equation (4) is the equation for the IS curve.
10-25
 AD AD=Y

Aggregate demand
E2 Ā+c(1-t)Y-bi2

Ā-bi2 Ā+c(1-t)Y-bi1
i2< i1

Ā-bi1 E1

Y1 Y2 Y
Income, output
(a)
i
Interest rate

i1 E1

i2 E2

IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
 The Slope of the IS Curve
• The steepness of the IS curve depends on:
– How sensitive investment spending is to changes in i
– The multiplier, G
• Suppose investment spending is very sensitive to i  the
slope, b, is large
– A given change in i produces a large change in AD (large shift)
– A large shift in AD produces a large change in Y
– A large change in Y resulting from a given change in i  IS curve
is relatively flat
• If investment spending is not very sensitive to i, the IS
curve is relatively steep
10-27
 AD=Y
AD A̅+c’(1-t)Y-bi2

Aggregate demand
A̅+c(1-t)Y-bi2
A̅+c’(1-t)Y-bi1

A̅+c(1-t)Y-bi1
c’> c
-b ∆i

Y1 Y’1 Y2 Y’2 Y
Income, output
(a)
i
Interest rate

i1

i2

IS’
IS
Y1 Y’1 Y2 Y’2 Y
Income, output (b)
EFFECT OF THE MULTIPLIER ON THE SLOPE OF THE IS CURVE
 The Role of the Multiplier
c’> c
• Notice the changes in i2< i1
interest rate and multiplier
and their impact on AD
curves
– The coefficient c on the solid
black AD curve is smaller than
that on the dashed AD curve
 multiplier larger on the
dashed AD curves
• A given reduction in i to i2
raises the intercept of the
AD curves by the same
vertical distance
– Because of the different
multipliers, income rises to Y’2
on the dashed line and Y2 on
the solid line
10-29
 The Role of the Multiplier
• The smaller the sensitivity of investment
spending to the interest rate AND the smaller
the multiplier, the steeper the IS curve
– This can be seen in equation (5):
• We can solve equation (5) for i:
 
For a given change in Y, the
associated change in i will be   𝑌 − 𝛼𝐺 𝐴
¯
larger in size as b is smaller 𝑖=
− 𝛼𝐺𝑏
and as the multiplier is smaller.
  𝐴 𝑌
𝑖= −
𝑏 𝛼𝐺 𝑏
10-30
 AD AD=Y

Aggregate demand
E2 Ā’+c(1-t)Y-bi1

A’ Ā+c(1-t)Y-bi1
∆A̅

A E1

∆Y=αG ∆A̅

Y1 Y2 Y
Income, output
(a)
i
Interest rate

E1 E2
i1
∆Y=αG ∆A̅

IS’
IS
Y1 Y2 Y
Income, output (b)

A SHIFT IN THE IS CURVE CAUSED BY A CHANGE IN AUTONOMOUS SPENDING

 The Position of the IS Curve

• Figure shows two different

IS curves  differ by levels
of autonomous spending
– Initial AD with and i1 
corresponding point E1 on IS
curve in panel (b)
– If autonomous spending
increases to , equilibrium
level of income increases at
i1  point E2 in panel (b),
shifting out IS
• The change in income as a
result from a change in
autonomous spending is
10-32
• A stable government is elected improving the
investment climate.

• How would this impact be captured by the IS

curve ?