Lecture: October 3: Sticky-Price Unemployment Business-Cycle Model
First Midterm Exam: Fall 2005: Economics 101b

Lecture: October 5: The IS Curve

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

Last time we started with our behavioral relationships:

C = C0 + Cy(1-t)Y; consumption function
I = I0 - Irr; business investment demand
G = G; government purchases
IM = IMyY; import demand
X = XfYf + Xee; export demand
e = e0 + er(rf - 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-(Cy(1-t) - IMy))

The multiplier: 1/(1-(Cy(1-t) - IMy))

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)/(Ir + Xeer)
      • 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...