Grasping Reality on TypePad, by Brad DeLong

October 5: Investment, Net Exports, and the Real Interest Rate: The IS Curve

Last time we started with our behavioral relationships:

C = C₀ + C_y(1-t)Y; consumption function
I = I₀ - I_rr; business investment demand
G = G; government purchases
IM = IM_yY; import demand
X = X_fY^f + X_ee; export demand
e = e₀ + e_r(r^f - r)

And we made the key sticky-price assumptions:

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

And we derived:

Output as a function of autonomous spending A:

A = I + G + X + C₀
Y = A/(1-(C_y(1-t) - IM_y))

The multiplier: 1/(1-(C_y(1-t) - IM_y))

Now let's go one step further...

Investigating the dependence of autonomous spending on the real interest rate r, and thus of output on the real interest rate r...

• Interest Rates and Planned Expenditure

  • The importance of investment spending
  • The interest rate is not set in the loanable funds market in the sticky-price model
  • The interest rate is set by a combination of
    • Demand and supply for liquidity--money, and
    • The term structure of interest rates
  • Hence no presumption that fluctuations in investment--whether driven by "animal spirits" or movements in interest rates--are stable or stabilizing
  • Why investment depends on the real interest rate
    • The long-term, risky, real interest rate
  • Exports and autonomous spending
    • The exchange rate depends on the interest rate
    • Exports depend on the exchange rate
    • Hence exports are another interest-sensitive component of autonomous spending
  • The stock market as an indicator of investment

• The IS Curve

  • Autonomous spending and the interest rate
  • From the interest rate to investment to planned expenditure
  • The slope and position of the IS curve
    • (Inverse) Slope: (1-MPE)/(I_r + X_ee_r)
    • Position: A₀/((1-MPE)

• Equilibrium

  • Moving the economy to the IS curve
  • Interest rates adjust immediately
  • Inventories: output and demand levels adjust more slowly
  • Shifting the Is curve
    • Example: a change in government purchases
  • Moving along the IS curve
    • A change in monetary policy: open market operations
    • Difficulties in monetary management

• Using the IS curve to understand the U.S. economy

  • The 1960s: Federal Reserve keeps interest rates stable; Great Society and Vietnam War shift the IS curve outward
  • The late 1970s: The Volcker disinflation--raising real interest rates
  • The early 1980s: The Reagan deficits
  • The late 1980s: easing monetary policy as inflation dangers recede
  • The 1990s: initial sharp inward shift of IS curve; subsequent "new economy" boom
  • The 2000s: inward shift of IS curve coupled with substantial reduction in real interest rates...