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

Last time we started with our behavioral relationships:

C = C

_{0}+ C_{y}(1-t)Y; consumption function

I = I_{0}- I_{r}r; business investment demand

G = G; government purchases

IM = IM_{y}Y; import demand

X = X_{f}Y^{f}+ X_{e}e; export demand

e = e_{0}+ 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 + C

_{0}

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_{e}e_{r}) - Position: A
_{0}/((1-MPE)

- (Inverse) Slope: (1-MPE)/(I

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...

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