Monetary Theory and Policy
Chapter 20：The IS Curve
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Planned Expenditure and Aggregate Demand
Planned expenditure is the total amount of spending on
domestically produced goods and services that
households, businesses, the government, and foreigners
want to make.
Aggregate demand is the total amount of output
demanded in the economy.
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Planned Expenditure and Aggregate Demand
The total quantity demanded of an economy’s output is
the sum of 4 types of spending:
-Consumption expenditure (C)
-Planned investment spending (I )
-Government purchases (G )
-Net exports (NX )
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The Components of Aggregate
Demand
● Consumption expenditure and the consumption function:
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Planned Investment Spending
Fixed investment are always planned.
Inventory investment can be unplanned.
Planned investment spending
Interest rates
Expectations
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Net Exports
Made up of two components: autonomous net exports
and the part of net exports that is affected by changes in
real interest rates
Net export function:
NX
= N X − xr
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Government Purchases and Taxes
The government affects aggregate demand in two ways:
through its purchases and taxes
Government purchases:
G = G
Government taxes:
T =T
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Goods Market Equilibrium
Keynes recognized that equilibrium would occur in the
economy when the total quantity of output produced in
the economy equals the total amount of aggregate
demand (planned expenditure).
Solving for goods market equilibrium:
Aggregate Output = Consumption Expenditure + Planned
Investment Spending + Government Purchases + Net Exports
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Understanding the IS Curve
What the IS curve tells us: traces out the points at which
the goods market is in equilibrium
Examines an equilibrium where aggregate output equals
aggregate demand
Assumes fixed price level where nominal and real
quantities are the same
IS curve is the relationship between equilibrium
aggregate output and the interest rate.
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Figure 1 The IS Curve
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Why the Economy Heads Toward the Equilibrium
Interest rates and planned investment spending
Negative relationship
Interest rates and net exports
Negative relationship
IS curve: the points at which the total quantity of goods
produced equals the total quantity of goods demanded
Output tends to move toward points on the curve that satisfies
the goods market equilibrium.
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Factors that Shift the IS Curve
The IS curve shifts whenever there is a change in
autonomous factors (factors independent of aggregate
output and the real interest rate).
One example is changes in government purchases, as in
Figure 2.
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Figure 2 Shift in the IS Curve from an Increase in
Government Purchases
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Application: The Vietnam War Buildup, 1964–
1969
The United States’ involvement in Vietnam began to escalate
in the early 1960s.
Usually during a period when government purchases are
rising rapidly, central banks raise real interest rates to keep
the economy from overheating.
The Vietnam War period, however, is unusual because the
Federal Reserve decided to keep real interest rates constant.
Hence, this period provides an excellent example of how
policymakers could make use of the IS curve analysis to
inform policy.
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Figure 3 Vietnam War Build Up
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Changes in Taxes
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 disposable income and causes aggregate
demand and equilibrium output to rise, shifting the IS
curve to the right.
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Figure 4 Shift in the IS Curve from an Increase in
Taxes
Another example of what shifts the IS curve is changes in taxes, as in Figure 4
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Application: 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 had taken 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 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.
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Application: The Fiscal Stimulus Package of 2009
These tax cuts and spending increases were predicted to increase
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, most of the government purchases did not kick in
until after 2010, while the decline in autonomous consumption
and investment were much larger than anticipated.
The fiscal stimulus was more than offset by weak consumption and
investment, with the result that the aggregate demand ended up
contracting rather than rising, and the IS curve did not shift to the
right, as hoped.
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Factors that Shift the IS Curve
Changes in autonomous spending also affect the IS curve:
Autonomous consumption
Autonomous investment spending
Autonomous net exports
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Autonomous Consumption
A rise in autonomous consumption would raise
aggregate demand and equilibrium output at any given
interest rate, shifting the IS curve to the right.
Conversely, a decline in autonomous consumption
expenditure causes aggregate demand and equilibrium
output to fall, shifting the IS curve to the left.
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Autonomous Investment Spending
An increase in autonomous investment spending
increases equilibrium output at any given interest rate,
shifting the IS curve to the right.
On the other hand, a decrease in autonomous
investment spending causes aggregate demand and
equilibrium output to fall, shifting the IS curve to the left.
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Autonomous Net Exports
An autonomous increase in net exports leads to an
increase in equilibrium output at any given 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.
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Factors that Shift the IS Curve
Another factor that shifts the IS curve is changes in
financial frictions
An increase in financial frictions, as occurred during the
financial crisis of 2007-2009, raises the real cost of borrowing
to firms and hence causes investment spending and aggregate
demand to fall
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