Chapter 9PreviewPlanned ExpenditurePlanned Expenditure (cont’d)The Components of ExpenditureConsumption ExpenditureSlide 7Planned Investment SpendingPlanned Investment Spending (cont’d)Net ExportsGovernment Purchases and TaxesGoods Market EquilibriumSolving for Goods Market EquilibriumDeriving the IS CurveUnderstanding the Is CurveUnderstanding the Is Curve (cont’d)Why the Economy Heads Toward the EquilibriumWhy the Economy Heads Toward the Equilibrium (cont’d)FIGURE 9.1 The IS CurveWhy the IS Curve Has Its Name and Its Relationship With the Saving-Investment DiagramFIGURE 9.2 A Saving-Investment Derivation of the IS CurveFactors that Shift the IS CurveFIGURE 9.3 Shift in the IS Curve From an Increase in Government PurchasesApplication: Vietnam War Buildup, 1964-1969FIGURE 9.4 Vietnam War Build UpFactors that Shift the IS Curve (cont’d)FIGURE 9.5 Shift in the IS Curve From an Increase in TaxesPolicy and Practice: The Fiscal Stimulus Package of 2009Changes in Autonomous SpendingChanges in Autonomous Spending (cont’d)Slide 31Changes in Autonomous Net ExportsTABLE 9.1 Shifts in the IS Curve From Autonomous Changes inCopyright © 2012 Pearson Addison-Wesley. All rights reserved.Chapter 9The IS CurveCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-2Preview•To develop the IS curve as the first building block to understand aggregate demand•To examine factors that cause the IS curve to shift•To use the IS curve to discuss the economic contraction during the Great Depression and the effects of the fiscal stimulus package of 2009Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-3Planned Expenditure•Planned expenditure is the total amount of spending on domestically produced goods and services that households, businesses, the government, and foreigners want to make•Planned expenditure is not the same as actual expenditure, which is the amount actually spent on•Keynes viewed aggregate demand as planned expenditureCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-4Planned Expenditure (cont’d)•Total planned expenditure (aggregate demand) is: where C = consumption expenditure I = planned investment spending G = government purchases NX = net exports (exports minus imports)peY C I G NX= + + +Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-5The Components of Expenditure•Consumption expenditure•Planned investment spending•Net exports•Government purchases and taxesCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-6Consumption Expenditure•Keynes viewed that consumer expenditure is related to disposable income, YD, which is total income minus taxes (Y – T)•The consumption function C = (exogenous) = (the change in consumption expenditure as a result of an additional dollar ofmpcautonomous consumption expendituremarginal propensity to consume )DY ( )whereC C mpc Y T= + � -Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-7•Because consumption expenditure is negatively related to the real interest rate, r, the consumption function can be modified as: ( )where = responsiveness of to C C mpc Y T crc C r= + � - -Consumption ExpenditureCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-8•Two types of investment:1. Fixed investment—planned spending by firms on equipment and structures and planned spending on new residential housing2. Inventory investment—spending by firms on additional holdings of raw materials, parts, and finished goods in a given time period•Planned investment spending equals planned fixed investment plus the amount of inventory investment planned by firmsPlanned Investment SpendingCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-9•In the investment function, planned investment is:–negatively related to the real interest rate–affected by business expectations about the future (exogenous), as Keynes called “animal spirits”Planned Investment Spending (cont’d) where = = responsiveness of investment to the real interest rate I I drId= -autonomous investmentCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-10•In the net export function, net export includes:–the level of net exports that are exogenous–a component negatively related to the real interest rate: A higher real interest rate raises the demand for dollars and so its exchange rate (the price of the currency), which in turn lowers net exports as exports become more expensive for foreigners Net Exports where = = responsiveness of net exports to the real interest rate NX NX rNX= -autonomous net exportsxxCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-11•The government affects planned expenditure through:–Government purchases: assumed to be exogenous at –Taxes: assumed to be exogenous at Government Purchases and TaxesG GT T==GTCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-12•Equilibrium in the economy occurs when the total quantity of output produced equals the total amount of planned expenditure:Goods Market EquilibriumpeY Y=Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-13Solving for Goods Market EquilibriumY C I G NX= + + +•The equilibrium condition is:•Substituting in the consumption, investment and net export functions so that:•The IS curve is obtained by subtracting mpc×Y from both sides and divide both sides by 1-mpc: ( ) ( )Y C mpc Y T cr I dr G NX xrC I G NX mpc T mpc Y c d x r= + � - - + - + + -= + + + - � + � - + +1 [ ]1 1c d xY C I G NX mpc T rmpc mpc+ += + + + - � � - �- -Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-14Deriving the IS Curve•The IS curve shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium•The IS curve is made up of two terms:1. The first term tells us about shifts in the IS curve: Since mpc is between zero and one, 1/(1-mpc) >0, so this term tells us that a change in autonomous variables affects output at any given real interest rate. 2. The second term tells us about a movement along the IS curve: A change in the real interest rate affects output.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.