Learning Objectives

21.1 Explain the rela-

Preview
D
tionship of planned uring the Great Depression of the 1930s, aggregate output fell precipitously, by
expenditure and aggre- 30%, with unemployment rising to 25%. Although the recession of 2007–2009
gate demand. was not as severe, the contraction in economic activity led unemployment to
21.2 List and describe rise to over 10%. With the coronavirus pandemic, the unemployment rate rose to a
the factors that deter- peak of 14.7% in April 2020. To understand why these contractions in economic activ-
mine the four com- ity occur, economists make use of the concept of aggregate demand, the total amount of
ponents of aggregate output demanded in the economy. This concept was developed by John Maynard
demand (or planned Keynes in his revolutionary book The General Theory of Employment, Interest, and Money,
expenditure). published in 1936, in which he argued that short-run changes in aggregate output,
21.3 Solve for the such as the decline in output that occurred during the Great Depression, are deter-
goods market equilib- mined by changes in aggregate demand. The concept of aggregate demand is a central
rium. element in the aggregate demand–aggregate supply (AD/AS) model, the basic macroeco-
21.4 Describe why the
nomic model used to explain short-run fluctuations in aggregate output.
IS curve slopes down-
In this chapter, we develop the first building block in understanding aggregate
ward and why the econ-
demand, the IS curve, which describes the relationship between real interest rates and
omy heads to a goods
aggregate output when the market for goods and services (more simply referred to as the
market equilibrium.
goods market) is in equilibrium. We begin by deriving the IS curve and then go on to
explain what factors cause the IS curve to shift. With our understanding of the IS curve,
21.5 List the factors we can examine why fluctuations in economic activity occur and how the fiscal stimulus
that shift the IS curve,
package of 2009 affected the economy. Then, in the next chapter, we make use of the IS
and describe how they
curve to understand the role played by monetary policy in economic fluctuations.
shift the IS curve.

21.1 PLANNED EXPENDITURE AND AGGREGATE DEMAND

LO 21.1 Explain the relationship of planned expenditure and aggregate demand.

We start our analysis by discussing the concept of planned expenditure, the total
amount that households, businesses, the government, and foreigners want to spend on
domestically produced goods and services. In contrast, actual expenditure is the amount
that these entities actually do spend, which equals the total amount of output produced
in the economy. Note that all of the analysis in this chapter refers to expenditure in real
terms, that is, in terms of actual physical amounts of goods and services. Keynes viewed
aggregate demand, the total amount of output demanded in the economy, as being

538
 CHAPTER 21 The IS Curve 539

the same as planned expenditure. As we shall see shortly, planned expenditure—and

hence aggregate demand—explains the level of aggregate output when the goods mar-
ket is in equilibrium, that is, when aggregate demand for goods and services is equal to
the actual amount of goods and services produced.
The total amount of aggregate demand (planned expenditure) is the sum of four
types of spending:
1. Consumption expenditure (C), the total demand for consumer goods and ser-
vices (e.g., hamburgers, iPhones, rock concerts, visits to the doctor)
2. Planned investment spending (I), the total planned spending by businesses on
new physical capital (e.g., machines, computers, factories), plus planned spending
on new homes
3. Government purchases (G), the spending by all levels of government on goods
and services (e.g., aircraft carriers, salaries of government employees, red tape), not
including transfer payments (which redistribute income from one person to another)
4. Net exports (NX), the net foreign spending on domestic goods and services, equal
to exports minus imports
We represent the total aggregate demand (Yad) with the following equation:
Yad = C + I + G + NX (1)

21.2 THE COMPONENTS OF AGGREGATE DEMAND

LO 21.2 List and describe the factors that determine the four components of aggregate
demand (or planned expenditure).

To understand what determines aggregate demand (total planned expenditure) in the

economy, let’s look at each of its components in detail.

Consumption Expenditure
What determines how much you spend on consumer goods and services? Your income
is likely the most important factor; if your income rises, you most likely will be willing
to spend more. Keynes reasoned similarly that consumption expenditure is related to
disposable income (denoted by YD), the total amount of income available for spend-
ing, equal to aggregate output Y minus taxes T1Y - T2.1

Consumption Function Keynes called the relationship between disposable

income YD and consumption expenditure C the consumption function, and expressed
it as follows:
C = C + mpc * YD (2)
or, alternatively,
C = C + mpc * 1Y - T2 (3)

1
More precisely, taxes T refers to taxes minus net transfers (government payments to households and businesses
that are, in effect, negative taxes). Examples of government transfers include Social Security payments and unem-
ployment insurance payments.
540 PART 6 Monetary Theory

FYI Meaning of the Word Investment

Economists use the word investment somewhat dif- newly produced goods and services. But when econ-
ferently than other people do. When noneconomists omists speak of investment spending, they are refer-
say that they are making an investment, they are nor- ring to the purchases of new physical assets, such as
mally referring to the purchase of common stocks new machines or new houses—purchases that add to
or bonds, purchases that do not necessarily involve aggregate demand.

The term C stands for autonomous consumption expenditure, the amount of

consumption expenditure that is exogenous (independent of variables in the model,
such as disposable income). Autonomous consumption is related to consumers’ opti-
mism about their future income and household wealth, both of which are positively
related to consumer spending.
The term mpc, the marginal propensity to consume, reflects the change in con-
sumption expenditure that results from an additional dollar of disposable income.
Keynes assumed that mpc was a constant between the values of 0 and 1. If, for example,
a $1.00 increase in disposable income leads to an increase in consumption expenditure
of $0.60, then mpc = 0.6.

Planned Investment Spending

Investment spending is another key component of total expenditure. There are two
types of investment spending: fixed and inventory. (Note that economists’ use of the
word investment differs from the everyday use of the term, as explained in the FYI box.)

Fixed Investment Fixed investment is planned spending by firms on equipment

(machines, computers, airplanes) and structures (factories, office buildings, shopping
centers), plus planned spending on new residential housing.

Inventory Investment Inventory investment is spending by firms on addi-

tional holdings of raw materials, parts, and finished goods, calculated as the change in
holdings of these items in a given time period—say, a year.
Inventory investment is a much smaller component of investment than fixed
investment. We discuss inventory investment in detail at this juncture because it plays
an important role in the determination of aggregate output. To illustrate, consider the
following scenarios:
1. Suppose that Ford Motor Company has 100,000 cars sitting in its factory lots on
December 31, 2022, ready to be shipped to dealers. If each car has a wholesale
price of $20,000, Ford has an inventory worth $2 billion. If by December 31, 2023,
its inventory of cars has risen to 150,000, with a value of $3 billion, its inventory
investment in 2023 is $1 billion, the change in the level of its inventory over the
course of the year ($3 billion in 2023 minus $2 billion in 2022).
2. Instead suppose that by December 31, 2023, Ford’s inventory of cars has dropped
to 50,000, with a value of $1 billion. Its inventory investment in 2023 is now
- $1 billion, the change in the level of its inventory over the course of the year
($1 billion in 2023 minus $2 billion in 2022).
 CHAPTER 21 The IS Curve 541

3. Ford will have additional inventory investment if the level of raw materials and
parts that it is holding to produce these cars increases over the course of the year. If
on December 31, 2022, it holds $50 million of steel to be used to produce its cars,
and on December 31, 2023, it holds $100 million of steel, it has an additional
$50 million of inventory investment in 2023.
An important feature of inventory investment is that some inventory investment
can be unplanned (in contrast, fixed investment is always planned). Suppose that the
reason Ford finds itself with an additional $1 billion of cars on December 31, 2023, is
because it sold $1 billion less of its cars than expected in 2023. This $1 billion of inven-
tory investment in 2023 was unplanned. In this situation, Ford is producing more cars
than it can sell, and it will cut production to avoid accumulating unsold goods. The act
of adjusting production to eliminate unplanned inventory investment plays a key role
in the determination of aggregate output, as we shall see.

Planned Investment Spending and Real Interest Rates Planned investment

spending, a component of aggregate demand Yad, is equal to planned fixed investment plus
the amount of inventory investment planned by firms. Keynes considered the level of the
real interest rate for investments as a key determinant of planned investment spending.
To understand Keynes’s reasoning, we need to recognize that businesses make
investments in physical capital (machines and factories) as long as they expect to earn
more from the physical capital than the interest cost of a loan to finance the investment.
When the real interest rate for investments is high—say, at 10%—few investments in
physical capital will earn more than the 10% interest cost of borrowing funds, and so
planned investment spending will be low. When the real interest rate for investments is
low—say, 1%—many investments in physical capital will earn more than the 1% inter-
est cost of borrowing funds. Therefore, when the real interest rate for investments and
hence the cost of borrowing are low, business firms are more likely to undertake invest-
ments in physical capital, and planned investment spending increases.
Even if a company has surplus funds and does not need to borrow to undertake
an investment in physical capital, its planned investment spending still will be affected
by the real interest rate for investments. Instead of investing in physical capital, the
company could purchase a corporate bond. If the real interest rate on this security
were high—say, 10%—the opportunity cost (forgone interest earnings) of an invest-
ment in physical capital would be high. Planned investment spending would then be
low, because the firm probably would prefer to purchase the security and earn the high
10% return than to invest in physical capital. As the real interest rate for investments
and the opportunity cost of investing fall—say, to 1%—planned investment spending
will increase because investments in physical capital are likely to earn greater income
for the firm than the measly 1% that would be earned by investing in the security.

Planned Investment and Business Expectations Keynes also believed that

planned investment spending is heavily influenced by business expectations about the
future. Businesses that are optimistic about future profit opportunities are willing to
spend more, whereas pessimistic businesses cut back their spending. Thus Keynes
posited a component of planned investment spending, which he called autonomous
investment, I, that is completely exogenous and so is unexplained by variables in his
model, such as output or interest rates.
Keynes believed that changes in autonomous spending are dominated by these
unstable exogenous fluctuations in planned investment spending, which are influenced
542 PART 6 Monetary Theory

by emotional waves of optimism and pessimism—factors he labeled “animal spirits.”

His view was colored by the collapse in investment spending during the Great
Depression, which he saw as the primary reason for the economic contraction.

Investment Function By combining the two factors that Keynes theorized drive
investment, we can derive an investment function that describes how planned invest-
ment spending is related to autonomous investment and the real interest rate for invest-
ments. We write this function as follows:
I = I - dri (4)
where d is a parameter reflecting the responsiveness of investment to the real interest
rate for investments, which is denoted by ri.
However, the real interest rate for investments reflects not only the real interest rate
r on short-term, safe, debt instruments, which is controlled by the central bank, but
also financial frictions, denoted by f , which are additions to the real cost of borrow-
ing caused by barriers to the efficient functioning of financial markets. (We discussed
the origins of these frictions—the asymmetric information problems of adverse selec-
tion and moral hazard—in detail in Chapter 8.) Financial frictions make it harder for
lenders to ascertain the creditworthiness of a borrower. Lenders need to charge a higher
interest rate to protect themselves against the possibility that the borrower may not pay
back the loan, which leads to an increase in the credit spread, the difference between the
interest rate on loans to businesses and the interest rate on completely safe assets that
are sure to be paid back. Hence financial frictions add to the real interest rate for invest-
ments, and we can write:
ri = r + f (5)
Substituting in Equation 4 the real cost of borrowing from Equation 5 yields:
I = I - d(r + f ) (6)
Equation 6 states that investment is positively related to business optimism as repre-
sented by autonomous investment and negatively related to the real interest rate and
financial frictions.

Government Purchases and Taxes

Now we bring the government into the picture. The government affects aggregate
demand in two ways: through its purchases and through taxes.

Government Purchases As we saw in the aggregate demand equation, Equation 1,

government purchases add directly to aggregate demand. Here we assume that
government purchases are exogenous, and we write government purchases as follows:
G = G (7)
Equation 7 states that government purchases are set at a fixed amount G.

Taxes The government affects spending through taxes because, as discussed earlier,
disposable income is equal to income minus taxes, Y - T, and disposable income
affects consumption expenditure. Higher taxes T reduce disposable income for a given
level of income and hence cause consumption expenditure to fall. The tax laws in a
 CHAPTER 21 The IS Curve 543

country like the United States are very complicated, so to keep the model simple, we
assume that government taxes are exogenous and are set at a fixed amount T:2
T = T (8)

Net Exports
As with planned investment spending, we can think of net exports as being made up of
two components: autonomous net exports and the part of net exports that is affected by
changes in real interest rates.

Real Interest Rates and Net Exports Real interest rates influence the amount of net
exports through the exchange rate. Recall that the exchange rate is the price of one cur-
rency, say, the dollar, in terms of another currency, say, the euro.3 We examined a model
that explains the link between the exchange rate and real interest rates in Chapter 18, but
here we will only outline the intuition. When U.S. real interest rates rise, U.S. dollar assets
earn higher returns relative to foreign assets. People then want to hold more dollars, so they
bid up the value of a dollar and thereby increase its value relative to the values of other cur-
rencies. Thus a rise in U.S. real interest rates leads to a higher value of the dollar.
A rise in the value of the dollar makes U.S. exports more expensive in foreign cur-
rencies, so foreigners will buy less of these exports, thereby driving down net exports.
A rise in the value of the dollar also makes foreign goods less expensive in terms of
dollars, so U.S. imports will rise, also causing a decline in net exports. We therefore see
that a rise in the real interest rate, which leads to an increase in the value of the dollar,
in turn leads to a decline in net exports.

Autonomous Net Exports The amount of exports is also affected by the demand
by foreigners for domestic goods, while the amount of imports is affected by the demand
by domestic residents for foreign goods. For example, if the Chinese have a poor harvest
and want to buy more U.S. wheat, U.S. exports will rise. If the Brazilian economy is
booming, then Brazilians will have more money to spend on U.S. goods, and U.S. exports
will rise. In contrast, if U.S. consumers discover how good Chilean wine is and want to
buy more, then U.S. imports will rise. Thus we can think of net exports as being deter-
mined by real interest rates as well as by a component called autonomous net exports,
NX, which is the level of net exports that is treated as exogenous (outside the model).4
2
For simplicity, we assume here that taxes are unrelated to income. However, because taxes increase with income,
we can describe taxes more realistically with the following tax function:
T = T + tY
Using this equation instead of Equation 9 in the derivation of Equation 12 later in the chapter would lead to mpc
being replaced by mpc(1 – t) in Equation 12.
3
If a government pegs the exchange rate to another country’s currency, so that the rate is fixed in what is called a
fixed exchange rate regime (see Chapter 19), then real interest rates do not directly affect net exports as in Equation 9,
and NX = NX. Taking out the response of net exports to the real interest rates does not change the basic analysis
of the chapter but does lead to a slightly different Equation 12 later in the chapter.
4
Foreign aggregate output is outside the model, and so its effect on net exports is exogenous and hence is a factor
that affects autonomous net exports. U.S. domestic output, Y, could also affect net exports because greater domes-
tic disposable income would increase spending on imports and thus would lower net exports. To build this factor
into the IS curve, we could modify the net export function given in Equation 9 as follows:
NX = NX - xr - iY
where i is the marginal propensity to spend on imports. This change would lead to a modification of Equation 12
later in the chapter, in which the mpc term would be replaced by mpc - i.
544 PART 6 Monetary Theory

Net Export Function Putting these two components of net exports together, we
can write a net export function:
NX = NX - xr (9)
where x is a parameter that indicates how net exports respond to the real interest rate.
This equation tells us that net exports are positively related to autonomous net exports
and are negatively related to the level of real interest rates.

21.3 GOODS MARKET EQUILIBRIUM

LO 21.3 Solve for the goods market equilibrium.

Keynes recognized that equilibrium will occur in the economy when the total quantity of
output is equal to the total amount of aggregate demand (planned expenditure). That is,

Y = Yad (10)

When this equilibrium condition is satisfied, planned spending for goods and services
is equal to the amount that is produced. Producers are able to sell all of their output
and have no reason to change their production levels, because there is no unplanned
inventory investment. By examining the factors that affect each component of planned
spending, we can understand why aggregate output goes to a certain level.

Solving for Goods Market Equilibrium

With our understanding of the factors that drive the components of aggregate demand,
we can see how aggregate output is determined by using Equation 1, the aggregate
demand equation, to rewrite the equilibrium condition given in Equation 10 as follows:
Y = C + I + G + NX (11)

aggregate output = consumption expenditure + planned investment spending

+ government purchases + net exports

Now we can use our consumption, investment, and net export functions in
Equations 3, 6, and 7, along with Equations 8 and 9, to determine aggregate output.
Substituting all of these equations into the equilibrium condition given by Equation 11
yields the following:

Y = C + mpc * 1Y - T2 + I - d1r + f 2 + G + NX - xr

Collecting terms, we can rewrite this equation as follows:

Y = C + I - df + G + NX + mpc * Y - mpc * T - 1d + x2r

Subtracting mpc * Y from both sides of the equation, we have

Y - mpc * Y = Y11 - mpc2 = C + I - df + G + NX - mpc * T - 1d + x2r

 CHAPTER 21 The IS Curve 545

Then, dividing both sides of the equation by 1 - mpc, we obtain an equation that gives
us a means of determining aggregate output when the goods market is in equilibrium:5
1 d + x
Y = 3C + I - df + G + NX - mpc * T4 * - * r (12)
1 - mpc 1 - mpc

Deriving the IS Curve

We refer to Equation 12 as the IS curve, and it shows the relationship between aggregate
output and the real interest rate when the goods market is in equilibrium. Equation 12
is made up of two terms. Since mpc is between 0 and 1, 1> 11 - mpc2 is positive, so the
first term tells us that an increase in autonomous consumption, investment, government
purchases, or net exports, or a decrease in taxes or financial frictions, leads to an increase
in output at any given real interest rate. In other words, the first term tells us about shifts
in the IS curve. The second term tells us that an increase in real interest rates results in a
decrease in output, which can be shown as a movement along the IS curve.

21.4 UNDERSTANDING THE IS CURVE

LO 21.4 Describe why the IS curve slopes downward and why the economy heads to a
goods market equilibrium.

To gain a deeper understanding of the IS curve, we will proceed in several steps. In this sec-
tion, we begin by looking at the intuition behind the IS curve, and then we discuss a numer-
ical example. Then, in the following section, we outline the factors that shift the IS curve.

What the IS Curve Tells Us: Intuition

The IS curve traces out the points at which the goods market is in equilibrium. For each
given level of the real interest rate, the IS curve tells us the level of aggregate output
that is necessary for the goods market to be in equilibrium. As the real interest rate
rises, planned investment spending and net exports fall, which in turn lowers aggregate
demand; aggregate output must be lower if it is to equal aggregate demand and satisfy
goods market equilibrium. Hence the IS curve is downward-sloping.

What the IS Curve Tells Us: Numerical Example

We can analyze the IS curve with the following numerical example, which gives specific
values for the exogenous variables and the parameters in Equation 12.
C = $1.4 trillion
I = $1.2 trillion
G = $3.0 trillion
T = $3.0 trillion
NX = $1.3 trillion
f = 1
mpc = 0.6
d = 0.3
x = 0.1
5
Note that the term 1> 11 - mpc2 that multiplies G is known as the expenditure multiplier, and the term
- mpc> 11 - mpc2 that multiplies T is called the tax multiplier. The tax multiplier is smaller in absolute value than
the expenditure multiplier because mpc 6 1.
546 PART 6 Monetary Theory

Mini-lecture

Real Interest
Rate, r (%)

7% IS Region of Excess
Supply of Goods
6%

5% When there is an
excess supply of
goods, output falls.
4%
G
3%
A
Region of Excess
2%
Demand for Goods
H B
1%

0%
5 6 7 8 9 10 11 12
Aggregate Output, Y
When there is excess demand
($ trillions)
for goods, output rises.

FIGURE 1 The IS Curve

The downward-sloping IS curve represents points at which the goods market is in equilibrium—for
example, points A and B. Notice that output changes as necessary to return the market to equilibrium.
For example, at point G in the orange-shaded area, an excess supply of goods exists and firms will cut
production, decreasing aggregate output to the equilibrium level at point A. At point H in the blue-shaded
area, an excess demand for goods exists, so firms will increase production, and aggregate output will
increase toward the equilibrium level at point B.

Using these values, we can rewrite Equation 12 as follows:

1 0.3 + 0.1
Y = 31.4 + 1.2 - 0.3 + 3.0 + 1.3 - 0.6 * 3.04 * - * r
1 - 0.6 1 - 0.6

Plugging these values into Equation 12 yields the equation of the IS curve shown in
Figure 1:

4.8 0.4
Y = - * r = 12 - r (13)
0.4 0.4

At a real interest rate of r = 3%, the equilibrium output Y is equal to

$12 trillion - $3 trillion = $9 trillion. We plot this combination of the real interest
rate and equilibrium output as point A in Figure 1. At a real interest rate of r = 1%,
the equilibrium output Y is equal to $12 trillion - $1 trillion = $11 trillion, which
we plot as point B. The line connecting these points is the IS curve and, as you can see,
it is downward-sloping.
 CHAPTER 21 The IS Curve 547

Why the Economy Heads Toward Equilibrium

The concept of equilibrium is useful only if there is a tendency for the economy to settle
there. Let’s first consider what happens if the economy is located to the right of the IS curve
(the orange shaded area), where an excess supply of goods exists. In Figure 1 at point G,
actual output is above aggregate demand, and firms are saddled with unsold inventory. To
keep from accumulating unsold goods, firms will continue cutting production. As long as
production is above the equilibrium level, output will exceed aggregate demand and firms
will continue cutting production, sending aggregate output toward the equilibrium level, as
indicated by the leftward arrow from point G to point A. Only when the economy moves to
point A on the IS curve will there be no further tendency for output to change.
What happens if aggregate output is below the equilibrium level of output (the blue
shaded area to the left of the IS curve), where an excess demand for goods exists? At point
H in Figure 1, actual output is below aggregate demand, so firms will want to increase
production because inventories are declining more than they desire, and aggregate output
will increase, as shown by the rightward arrow. When the economy has moved to point B
on the IS curve, there will again be no further tendency for output to change.

21.5 FACTORS THAT SHIFT THE IS CURVE

LO 21.5 List the factors that shift the IS curve, and describe how they shift the IS curve.

You have now learned that the IS curve describes equilibrium points in the goods mar-
ket—the combinations of the real interest rate and equilibrium output. The IS curve shifts
whenever change occurs in autonomous factors (factors independent of aggregate output
and the real interest rate). Note that a change in the real interest rate that affects equilib-
rium aggregate output causes only a movement along the IS curve. A shift in the IS curve,
by contrast, occurs when equilibrium output changes at each given real interest rate.
In Equation 12, we identified six autonomous factors that can shift aggregate
demand and hence affect the level of equilibrium output. Although Equation 12
directly tells us how these factors shift the IS curve, we will develop some intuition as to
how each autonomous factor does so.

Changes in Government Purchases

Let’s look at what happens if government purchases rise from $3 trillion to $4 trillion
in Figure 2. IS1 represents the same IS curve that we developed in Figure 1. We deter-
mine the equation for IS2 by substituting the $4 trillion value into Equation 12:
1 0.3 + 0.1
Y = 31.4 + 1.2 - 0.3 + 4.0 + 1.3 - 0.6 * 3.04 * - * r
1 - 0.6 1 - 0.6
5.8
= - r = 14.5 - r
0.4
On the basis of these results, at a real interest rate of r = 3%, equilibrium output Y
is equal to $14.5 trillion - $3 trillion = $11.5 trillion, which we mark as point
C on Figure 2. At a real interest rate of r = 1%, equilibrium output has increased to
Y = $14.5 trillion - $1 trillion = $13.5 trillion, which we mark as point D. The
increase in government purchases therefore shifts the IS curve to the right from IS1 to IS2.
548 PART 6 Monetary Theory

Mini-lecture

Real Interest
Rate, r (%)
Step 1. A rise in government
purchases increases equilibrium
output at each real interest rate . . .
7%
IS1 IS2
6%

5%
Step 2. causing a rightward
shift in the IS curve.
4%
C
3%
A
2%
D
1%
B
0%
5 6 7 8 9 10 11 11.5 12 13 13.5 14
Aggregate Output, Y ($ trillions)

FIGURE 2 Shift in the IS Curve from an Increase in Government Purchases

IS1 represents the IS curve we derived in Figure 1. IS2 reflects a $1.0 trillion increase in government pur-
chases. The increase in government purchases causes aggregate output to rise, shifting the IS curve to the
right by $2.5 trillion at each real interest rate, from IS1 to IS2.

Intuitively, we can see why an increase in government purchases leads to a right-

ward shift of the IS curve by recognizing that an increase in government purchases
causes aggregate demand to increase at any given real interest rate. Since aggregate out-
put equals aggregate demand when the goods market is in equilibrium, an increase in
government purchases that causes aggregate demand to rise also causes equilibrium
output to rise, thereby shifting the IS curve to the right. Conversely, a decrease in
government purchases causes aggregate demand to fall at any given real interest rate
and leads to a leftward shift of the IS curve.

A P P L I C AT I O N The Vietnam War Buildup, 1964–1969

The United States’ involvement in Vietnam began to escalate in the early 1960s. After 1964,
the United States was fighting a full-scale war. Beginning in 1965, the resulting increases in
military expenditure raised government purchases. When government purchases are ris-
ing rapidly, central banks will usually raise real interest rates to keep the economy from
overheating. The Vietnam War period, however, was unusual in that the Federal Reserve
decided to keep real interest rates constant. Hence, this period provides an excellent exam-
ple of how policymakers might make use of IS curve analysis to inform policy.
 CHAPTER 21 The IS Curve 549

Mini-lecture

Real IS1964 IS1969

Interest
Rate, r Step 1. Increasing military spending
shifted the IS curve rightward . . .
(%)

2
2% Step 3. raising
1 aggregate output.
Step 2. while Federal
Reserve actions kept the
interest rate constant . . .

3.7 4.7 Aggregate Output, Y

($ trillions, 2009 dollars)

FIGURE 3 Vietnam War Buildup

Increases in military spending beginning in 1965 caused the IS curve to shift from IS1964 to IS1969. Because
the Federal Reserve decided to keep real interest rates constant at 2% during this period, equilibrium
output rose from $3.7 trillion (in 2009 dollars) in 1964 to $4.7 trillion in 1969, setting the stage for an
increase in inflation.

The rise in government purchases shifted the IS curve to the right, from IS1964 to
IS1969 in Figure 3. Because the Federal Reserve decided to keep real interest rates con-
stant at 2% during this period, equilibrium output rose from $3.7 trillion (in 2009 dol-
lars) in 1964 to $4.7 trillion by 1969, with the unemployment rate falling steadily from
5% in 1964 to 3.4% in 1969. However, all was not well for the economy: The combina-
tion of an increase in government purchases and a constant real interest rate led to an
overheating of the economy that eventually resulted in high inflation. (We will discuss
the link between an overheating economy and inflation in the coming chapters.) ◆

Changes in Taxes
Now let’s look at Figure 4 to see what happens if the government raises taxes from
$3 trillion to $4 trillion. IS1 represents the same IS curve that we developed in Figure 1.
We determine the equation for IS2 by substituting the $4 trillion value into Equation 12:
1 0.3 + 0.1
Y = 31.4 + 1.2 - 0.3 + 3.0 + 1.3 - 0.6 * 4.04 * - * r
1 - 0.6 1 - 0.6
4.2
= - r = 10.5 - r
0.4
550 PART 6 Monetary Theory

Mini-lecture

Real Interest
Rate, r (%)

7%
IS2 IS1
6%

5%

4% Step 1. An increase in
taxes causes equilibrium
A output to fall at each real
3% interest rate . . .
E
Step 2. causing a leftward
2% shift in the IS curve.
B
1%
F
0%
4 5 6 7 7.5 8 9 9.5 10 11 12
Aggregate Output, Y ($ trillions)

FIGURE 4 Shift in the IS Curve from an Increase in Taxes

IS1 represents the IS curve we derived in Figure 1. IS2 reflects a $1.0 trillion increase in government tax
revenues. The increase in taxes decreases aggregate output levels by $1.5 trillion, shifting the IS curve to
the left, from IS1 to IS2.

At a real interest rate of r = 3%, equilibrium output Y = $10.5 trillion -

$3 trillion = $7.5 trillion, which we mark as point E in Figure 4. At this real interest
rate, equilibrium output has decreased from point A to point E, as shown by the leftward
arrow. Similarly, at a real interest rate of r = 1%, equilibrium output has decreased to
Y = $10.5 trillion - $1 trillion = $9.5 trillion, causing a leftward shift from point B
to point F. The IS curve shifts to the left, from IS1 to IS2, as a result of the increase in taxes.
We have the following result: At any given real interest rate, a rise in taxes causes
aggregate demand and hence equilibrium output to fall, thereby shifting the IS curve
to the left. Conversely, a cut in taxes at any given real interest rate increases dispos-
able income and causes aggregate demand and equilibrium output to rise, shifting the
IS curve to the right.
Policymakers use both tax and government purchase policies to stimulate the
economy when it enters a recession, as illustrated in the following Application.

A P P L I C AT I O N The Fiscal Stimulus Package of 2009

In the fall of 2008, the U.S. economy was in crisis. By the time the new Obama
administration took office, the unemployment rate had risen from 4.7% just before the
recession began in December 2007 to 7.6% in January 2009. To stimulate the economy, the
 CHAPTER 21 The IS Curve 551

Obama administration proposed a fiscal stimulus package that, when passed by Congress,
included $288 billion in tax cuts for households and businesses and $499 billion in
increased federal spending, including transfer payments. What does our IS curve analysis
suggest should have happened to the economy?
As the analyses in Figure 2 and Figure 4 indicate, these tax cuts and spending
increases should have increased aggregate demand, thereby raising the equilibrium
level of aggregate output at any given real interest rate and so shifting the IS curve to
the right. Unfortunately, things didn’t work out quite as the Obama administration
had planned. Most of the government purchases did not kick in until after 2010,
while the declines in autonomous consumption and investment were much larger than
anticipated. The fiscal stimulus was more than offset by the weak consumption and
investment caused by an increase in financial frictions and worries about the economy.
As a result, aggregate demand ended up contracting rather than rising, and the IS curve
did not shift to the right as hoped. Despite the good intentions of the fiscal stimulus
package, the unemployment rate ended up rising to 10% in 2009. Without the fiscal
stimulus package, however, the IS curve likely would have shifted even further to the
left, resulting in even more unemployment. ◆

Changes in Autonomous Spending

As you can see from Equation 12, autonomous consumption, investment, and net
exports—C, I, and NX, respectively—all are multiplied by the term 1> 11 - mpc2 in
the same way the G term is. Thus an increase in any of these variables has the same
impact on the IS curve as an increase in government purchases. For this reason, we can
lump these variables together as autonomous spending, exogenous spending that is
unrelated to variables in the model such as output or real interest rates. We look intui-
tively at how changes in each of these variables affect the IS curve in turn.

Autonomous Consumption Suppose consumers find that their wealth has

increased courtesy of a stock market boom or that they have become increasingly opti-
mistic about their future income prospects because a positive productivity shock to
the economy has occurred. Both of these events are autonomous; that is, they are not
affected by the level of the real interest rate. The resulting rise in autonomous con-
sumption would raise aggregate demand and equilibrium output at any given real
interest rate, shifting the IS curve to the right. Conversely, a decline in autonomous
consumption expenditure would cause aggregate demand and equilibrium output to
fall, shifting the IS curve to the left.

Autonomous Investment Spending Earlier in the chapter, we learned that

changes in the real interest rate affect planned investment spending and hence the equi-
librium level of output. This change in investment spending merely causes a movement
along the IS curve, not a shift. An autonomous rise in planned investment spend-
ing unrelated to the real interest rate—say, because companies become more confi-
dent about investment profitability after the stock market rises—increases aggregate
demand. An increase in autonomous investment spending therefore increases equi-
librium output at any given real interest rate, shifting the IS curve to the right. In
contrast, a decrease in autonomous investment spending causes aggregate demand
and equilibrium output to fall, shifting the IS curve to the left.
552 PART 6 Monetary Theory

SUMMARY TABLE 1
—— — — —
Shifts in the IS Curve from Autonomous Changes in C , I , G , T , NX, and f
Variable Change in Variable Shift in IS Curve Reason
Autonomous consumption c r CcYc
expenditure, C

IS1 IS2

Y
Autonomous investment, I c r IcYc

IS1 IS2

Y
Government spending, G c r GcYc

IS1 IS2

Y
Taxes, T c r Tc1CTYT

IS2 IS1

Y
Autonomous net exports, NX c r NX c Y c

IS1 IS2

Y
Financial frictions, f c r ITYT

IS2 IS1

Y
Note: Only increases (c) in the variables are shown; the effects of decreases in the variables on aggregate output would be the opposite of those
indicated in the last two columns.

Autonomous Net Exports An autonomous rise in net exports unrelated to

the real interest rate—say, because American-made handbags become more chic
than French-made handbags, or because foreign countries have a boom and thus
buy more U.S. goods—causes aggregate demand to rise. An autonomous increase in
net exports thus leads to an increase in equilibrium output at any given real
interest rate and shifts the IS curve to the right. Conversely, an autonomous fall in
net exports causes aggregate demand and equilibrium output to decline, shifting the
IS curve to the left.
 CHAPTER 21 The IS Curve 553

Changes in Financial Frictions

An increase in financial frictions, as occurred during the financial crisis of 2007–2009,
raises the real interest rate for investments and hence causes investment spending
and aggregate demand to fall. An increase in financial frictions leads to a decline in
equilibrium output at any given real interest rate and shifts the IS curve to the left.
Conversely, a decrease in financial frictions causes aggregate demand and equilibrium
output to rise, shifting the IS curve to the right.

Summary of Factors That Shift the IS Curve

As a study aid, Summary Table 1 on the previous page shows how each factor shifts the
IS curve and the reason the shift occurs. Now that we have a full understanding of the
IS curve, we can use this building block to examine the relationship between monetary
policy and the aggregate demand curve in the following chapter.

SUMMARY
1. Planned expenditure, the total amount of goods aggregate demand, or via taxes, which indirectly affect
demanded in the economy, is the same as aggregate aggregate demand by influencing disposable income
demand, which is the sum of four types of spending: and hence consumption expenditure.
consumption expenditure, planned investment spend- 3. The level of aggregate output when the goods market
ing, government purchases, and net exports. We repre- is in equilibrium is determined by the condition that
sent the total aggregate demand (Yad) with Equation 1: aggregate output equals aggregate demand.
Yad = C + I + G + NX.
4. The IS curve traces out the combinations of the real
2. Consumption expenditure is described by the con- interest rate and aggregate output at which the goods
sumption function, which indicates that consumption market is in equilibrium. The IS curve slopes down-
expenditure will rise as disposable income increases. ward because higher real interest rates lower planned
Planned expenditure and hence aggregate demand are investment spending and net exports and so lower
negatively related to the real interest rate because a rise equilibrium output.
in the real interest rate reduces both planned invest-
5. The IS curve shifts to the right when there is a rise
ment spending and net exports. An increase in financial
in autonomous consumption, a rise in autonomous
frictions raises the real interest rate for investments
investment, a rise in government purchases, a rise in
and hence lowers planned investment spending and
autonomous net exports, a fall in taxes, or a decline in
aggregate demand. The government also affects planned
financial frictions. Movements of these six factors in the
expenditure via spending, which directly changes
opposite direction will shift the IS curve to the left.

KEY TERMS
aggregate demand, p. 538 consumption expenditure, p. 539 inventory investment, p. 540
“animal spirits”, p. 542 consumption function, p. 539 IS curve, p. 545
autonomous consumption disposable income, p. 539 marginal propensity to
expenditure, p. 540 exchange rate, p. 543 consume, p. 540
autonomous investment, p. 541 exogenous, p. 540 net exports, p. 539
autonomous net exports, financial frictions, p. 542 planned expenditure, p. 538
p. 543 fixed investment, p. 540 planned investment
autonomous spending, p. 551 government purchases, p. 539 spending, p. 539
554 PART 6 Monetary Theory

QUESTIONS
1. “Planned investment spending is equal to the total 12. Why do companies cut production when they find that
spending by businesses on new physical capital.” Is their unplanned inventory investment is greater than
this statement true, false, or uncertain? Explain your zero? If they didn’t cut production, what effect would
answer. this have on their profits? Why?
2. Why is inventory investment counted as part of aggre- 13. You read in a blog, that companies in India are
gate spending if it isn’t actually sold to the final end becoming less confident about investment profitability,
user? so they decrease planned investment spending in
3. “Since inventories can be costly to hold, firms’ planned the near future. What do you think will happen to
inventory investment should be zero, and firms should aggregate demand?
acquire inventory only through unplanned inventory 14. In each of the cases below, determine whether the IS
accumulation.” Is this statement true, false, or uncer- curve shifts to the right or left, does not shift, or is
tain? Explain your answer. indeterminate in the direction of shift.
4. During and in the aftermath of the financial crisis of a. The real interest rate decreases in China.
2007–2009, planned investment fell substantially b. The marginal propensity to consume by the
despite significant decreases in the real interest rate. population declines.
What factors related to the planned investment function
c. Financial frictions increase in India.
could explain this?
d. Autonomous consumption decreases.
5. If households and firms believe the economy will be in
a recession in the future, will this necessarily cause a e. The new Italian government decreases both taxes
recession, or have any impact on output at all? and government spending by the same amount.
f. The sensitivity of net exports to changes in the real
6. Why do increases in the real interest rate lead to
interest rate decreases.
decreases in net exports, and vice versa?
g. The new Spanish government provides tax incentives
7. Why does equilibrium output increase as the marginal
for research and development programs for firms.
propensity to consume increases?
15. “The fiscal stimulus package of 2009 caused the
8. If firms suddenly become more optimistic about the
IS curve to shift to the left, since output decreased
profitability of investment and planned investment
and unemployment increased after the policies
spending rises by €150 billion, while consumers
were implemented.” Is this statement true, false, or
become more pessimistic and autonomous consumer
uncertain? Explain your answer.
spending falls by €150 billion, what happens to aggre-
gate output? 16. When the Reserve Bank of Australia reduced its policy
interest rate in 2020, how, if at all, should the IS curve
9. If an increase in autonomous consumer expenditure is
have been affected? Briefly explain.
matched by an equal increase in taxes, will aggregate
output rise or fall? 17. Suppose you read that prospects for stronger future
economic growth have led the dollar to strengthen and
10. If a change in the real interest rate has no effect on
stock prices to increase.
planned investment spending or net exports, what does
this imply about the slope of the IS curve? a. What effect does the strengthened dollar have on the
IS curve?
11. Inventories typically increase starting at the beginning
of recessions, and begin to decline near the end of b. What effect does the increase in stock prices have on
recessions. What does this say about the relationship the IS curve?
between planned spending and aggregate output over c. What is the combined effect of these two events on
the business cycle? the IS curve?
 CHAPTER 21 The IS Curve 555

APPLIED PROBLEMS
18. Your sister Yennefer asks you to help her to calcu- 24. Consider an economy described by the following data:
late the value of the consumption function at each
level of income in the table below if autonomous C = $3.25 trillion
consumption = 200, taxes = 100, and mpc = 0.5. I = $1.3 trillion
G = $3.5 trillion
T = $3.0 trillion
Disposable NX = - $1.0 trillion
Income Y Income YD Consumption C f = 1
0 mpc = 0.75
100 d = 0.3
200 x = 0.1
300 a. Derive simplified expressions for the consumption
400 function, the investment function, and the net export
function.
b. Derive an expression for the IS curve.
19. Assume that autonomous consumption is £1,625 billion, c. If the real interest rate is r = 2, what is equilibrium
and disposable income is £11,500 billion. Calculate output? If r = 5, what is equilibrium output?
consumption expenditure if an increase of £1,000 d. Draw a graph of the IS curve showing the answers
in disposable income leads to an increase of £750 in from part (c) above.
consumption expenditure. e. If government purchases increase to $4.2 trillion,
20. Suppose that Dell Corporation has 20,000 computers what will happen to equilibrium output at r = 2?
in its warehouses on December 31, 2022, ready to be What will happen to equilibrium output at r = 5?
shipped to merchants (each computer is valued at $500). Show the effect of the increase in government pur-
By December 31, 2023, Dell Corporation has 25,000 chases in your graph from part (d).
computers ready to be shipped, each valued at $450. 25. Consider an economy described by the following data:
a. Calculate Dell’s inventory on December 31, 2022.
C = $4 trillion
b. Calculate Dell’s inventory investment in 2023.
I = $1.5 trillion
c. What happens to inventory spending during the
G = $3.0 trillion
early stages of an economic recession?
T = $3.0 trillion
21. Suppose that the consumption function in Argentina
NX = $1.0 trillion
is C = 100 + 0.75YD, I = 200, government spending
is 200, and net exports are zero, what will be the equi- f = 0
librium level of output? What will happen to aggregate mpc = 0.8
output if government spending rises by 200? d = 0.35
22. If the marginal propensity to consume in Italy is 0.75, x = 0.15
by how much would government spending have to rise
to increase output by €1,000 billion? By how much a. Derive an expression for the IS curve.
would taxes need to decrease to increase output by b. Assume that the Federal Reserve controls the interest
€1,000 billion? rate and sets the interest rate at r = 4. What is the
23. Assuming both taxes and government spending increase equilibrium level of output?
by the same amount, derive an expression for the effect c. Suppose that a financial crisis begins and f increases
on equilibrium output. to f = 3. What will happen to equilibrium output?
556 PART 6 Monetary Theory

If the Federal Reserve can set the interest rate, then Will the change in the interest rate implemented by
at what level should the interest rate be set to keep the Federal Reserve in part (c) be effective in stabiliz-
output from changing? ing output? If not, what additional monetary or fiscal
d. Suppose the financial crisis causes f to increase as policy changes could be implemented to stabilize
indicated in part (c) and also causes planned autono- output at the original equilibrium output level given
mous investment to decrease to I = $1.1 trillion. in part (b)?

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyLab Economics “quarterly,” and download the data into a spreadsheet.
and are available for practice or instructor assignment. For each quarter, add the (FII10) and (BAA10YM) series
1. Real-time Data Analysis Go to the St. Louis Federal to create ri, the real interest rate for investments for that
Reserve FRED database, and find data on Personal quarter. Then calculate the change in both investment and
Consumption Expenditures (PCEC), Personal ri as the change in each variable from the previous quarter.
Consumption Expenditures: Durable Goods (PCDG), a. For the eight most recent quarters of data
Personal Consumption Expenditures: Nondurable Goods available, calculate the change in investment
(PCND), and Personal Consumption Expenditures: from the previous quarter, and then calcu-
Services (PCESV). late the average change over the eight most
a. According to the most recent data, what recent quarters.
percentage of total household expenditures b. Assume there is a one-quarter lag between
is devoted to the consumption of goods movements in ri and changes in investment;
(both durable and nondurable goods)? in other words, if ri changes in the current
What percentage is devoted to services? quarter, it will affect investment in the
b. Given these data, which specific component next quarter. For the eight most recent
of household expenditures would be most lagged quarters of data available, calculate
impacted by a reduction in overall house- the one-quarter-lagged average change in ri.
hold spending? Explain. c. Take the ratio of your answer from part (a)
divided by your answer from part (b). What
2. Real-time Data Analysis Go to the St. Louis Federal
does this value represent? Briefly explain.
Reserve FRED database, and find data on Real Private
d. Repeat parts (a) through (c) for the period
Domestic Investment (GPDIC1), a measure of the
2008:Q3 to 2009:Q2. How do financial
real interest rate; the 10-year Treasury Inflation-
frictions help explain the behavior of invest-
Indexed Security, TIIS (FII10); and the spread between
ment during the financial crisis? How do
Baa corporate bonds and the 10-year U.S. treasury
the coefficients on investment compare
(BAA10YM), a measure of financial frictions. For
between the current period and the finan-
(FII10) and (BAA10YM), convert the frequency setting to
cial crisis period? Briefly explain.