The IS Curve, Fiscal Policy and the Position of the IS Curve

The IS Curve:

If we place the two interests rate terms in the equation for autonomous spending together:

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We see that a one-percentage-point rise in interest rates reduces autonomous spending by an amount Ir + Xεεr).

By how greatly does a change in the interest rate change equilibrium real GDP? The effect will be equivalent to the interest sensitivity of autonomous spending (Ir + Xεεr) times the multiplier. This relationship among the level of the real interest rate and the equilibrium level of real GDP has a name that was coined by economist John Hicks more than 60 years ago: the ‘IS curve’, where IS stands for ‘Investment-Saving curve.’

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Figure: IS curve

Legend: For every possible value of the real interest rate, there is a different level of autonomous spending. For every level of autonomous spending the income-expenditure process generates a different equilibrium level of real GDP. The IS curve notify us what equilibrium level of real GDP corresponds to each possible value of the real interest rate.

The algebra of the IS curve is undemanding, if a little crowded as well as complicated. We begin from the formula for autonomous spending in terms of the factors underlying aggregate demand:

1290_autonomous spending equation.jpg

Subsequently we divide the determinants of autonomous spending into (i) those that don’t depend on the interest rate and (ii) those that do, calling the initial set of determinants ‘baseline autonomous spending’ or A0

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We remember from the income-expenditure analysis that real GDP is equal to autonomous spending A divided by one minus the MPE:

Y = A/(1 - MPE)

Swapping A with its components we see that real GDP Y is:

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This equation is able to be expanded if we want to express the MPE and the baseline level of autonomous spending A0 in terms of the underlying model parameters and policy variables:

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Figure: The IS Curve

Legend: The position of the IS curve recapitulate all the determinants of equilibrium real GDP and how the level of equilibrium real GDP shifts in response to shifts in the interest rate.

The slope of the IS curve implies on three factors the entire clearly visible in its algebraic expression:

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The place of the IS curve depends on the baseline level of autonomous spending A0 times the multiplier 1/(1-MPE).

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A Change in Fiscal Policy and the Position of the IS Curve:

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Legend: Practically any shift in strategy or in the economic environment will change the position of the IS curve. In this case an raise in government purchases shifts the IS curve to the right.

Economic Fluctuations in the United States: the IS Curve as a Lens

How helpful is the IS curve in understanding economic fluctuations in the U.S. over the past generation or so? If we contrive on a graph the points corresponding to the long-term real interest rate and output relative to potential attained by the U.S. economy since 1960, we observe that the economy has been all over the map—or at least all over the diagram. Yet we are able to make sense of what has happened using shifts in and along the IS curve. That in reality is what the IS curve is for. It is a helpful tool: that is why we have spent several pages developing it. In the subsequently four sections we will apply the IS curve to gain insight into business cycle fluctuations in each of the past four decades.

The 1960s:

The 1960s saw a considerable rightward shift in the IS curve. Improved optimism on the part of businesses, the Kennedy-Johnson incise in income taxes, and the extra government expenditures required to fight the Vietnam War all increased aggregate demand. The IS curve rightward by possibly five percent of potential output in the 1960s.

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Figure: The IS Curve in the 1960s

Legend: The Vietnam War the Kennedy-Johnson tax incise as well as an increase in business optimism about the future all shifted the IS curve to the right between the start of the 1960s and the second half of the decade.

The late 1960s as well saw a movement downward and to the right along the IS curve as real interest rates declined. In huge part real interest rates declined by accident. The Federal Reserve didn’t fully gauge the amount by which inflation was rising. Increasing inflation increased the gap between the nominal interest rates directly controlled by monetary policy and the real interest rates that determine aggregate demand. The Federal Reserve didn’t recognize this as it was happening, and therefore allowed real interest rates to drift downward.

The Late 1970s:

The second half of the 1970s saw the level of real GDP in the U.S. considerably below the level of potential output. From 1977 to 1979 the U.S. economy moved down as well as to the right along the IS curve. Nevertheless the expansion of output toward potential was accompanied by unexpectedly high and rising inflation. This increase in inflation was further fueled by a supply shock: the sudden increase in oil prices triggered by the Iranian Revolution.

1979 saw a unexpected shift in Federal Reserve policy when Paul Volcker became Chair of the Federal Reserve replacing G. William Miller. In Miller fighting inflation had been a relatively low priority. In Volcker fighting inflation became the highest priority of all. The Federal Reserve increases annual real interest rates step-by-step from 1979 to 1982 up to nearly five percent. The enhance in real interest rates moved the economy up and to the left along the end-of-the-1970s position of the IS curve: the redundancy rate reached nearly ten percent in 1982 and real GDP fell to only 91 percent of the economy's potential output.

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Figure: Moving Along the IS Curve

Legend: Sharp increases in real interest rates at the end of the 1970s after Paul Volcker became Chair of the Federal Reserve pushed the U.S. economy up as well as to the right along the IS curve.

The 1980s:

The election of Ronald Reagan in 1980 was pursuing by a massive fiscal expansion. Military spending was improved and income taxes were cut in a series of steps that became effective between 1982 and 1985. The result of these raises in government purchases and cuts in taxes was an enormous government deficit and an outward shift in the IS curve. A concurrently increase in investor optimism triggered by falling inflation combined with the government’s fiscal stimulus to shift the IS curve outward relative to potential output by at least 12 percent.

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Figure: The IS Curve in the Mid-1980s

Legend: The Reagan budget shortfall of the 1980s shifted the economy's IS curve to the right.

The Federal Reserve take action to this outward shift in the IS curve by raising real interest rates. It required in the first half of the 1980s to ensure that the success it had achieved in reducing inflation did not unravel. The Federal Reserve dreaded that a rapid return of real GDP to potential GDP would put upward pressure on inflation once more. Therefore the rise in real interest rates to make sure that the large Reagan-era fiscal expansion didn’t have too large an effect.

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Figure: IS Curve in the Late 1980s

Legend: With the inflation of the 1970s broken as well as no longer a threat, the Federal Reserve gradually decreased interest rates in the late 1980s. As it decreased interest rates, the economy moved down as well as to the right along its IS Curve.

As inflation stay low throughout the mid and late 1980s Federal Reserve policymakers gained confidence. They turn into increasingly optimistic that higher real GDP levels relative to potential wouldn’t reignite inflation. Between 1985 and 1980 successive step-by-step reductions in real interest rates carried the U.S. economy back to filled employment and carried it down and to the right along the IS curve.

The 1990s [to be updated every year within editions…]

The principal maker of economic policy since the late 1980s has been Federal Reserve Chair Alan Greenspan—appointed and reappointed by three successive presidents Reagan, Bush and Clinton. Federal Reserve Chair Alan Greenspan as well is somewhat of a paradox a Federal Reserve Chair whom all trust to be a ferocious inflation fighter yet one who—in the policies that he has chosen—has frequently seemed willing to risk higher inflation in order to achieve higher economic growth, or to evade a recession.

Immediately subsequent to taking office Alan Greenspan faced a challenge: the unexpected stock market crash of October, 1987. How huge an effect would this crash have on aggregate demand? What would it do to investment expenditure? How greatly of a leftward shift in the IS curve would be generated by the unexpected change in investors’ expectations about the future that triggered the stock market crash? No one knew. If the crash turned out to be the forerunner of a large leftward shift in the IS curve then an unchanging monetary policy would lead to a important recession. Thus the Alan Greenspan-led FOMC  lowered interest rates and expanded the monetary base, in suspense that this shift in monetary policy would offset any leftward shift in the IS curve, and evade a recession.

In point of actuality the stock market crash of 1987 had next to no effect on investment spending or aggregate demand. Economists have still not arisen with a convincing story for why its effects were so small. The two years subsequent to 1987 saw higher output relative to potential and lower unemployment rates. The years between 1987 and 1990 didn’t see real interest rates rising--as they habitually do in the latter stages of an expansion--but real interest rates that were stable or falling.

As the unemployment rate cut down inflation accelerated. The economy moved up as well as to the left along the Phillips curve. 1988 and 1989 saw price-rises move up from three percent to four percent. The Federal Reserve found that it had productively avoided any chance of a (big) recession in 1988 in the aftermath of the stock market crash, however only at the price of letting inflation rise above four percent per year. In the second half of 1990 there come a sudden leftward shift in the IS curve: the Iraqi invasion of Kuwait served as a trigger for firms to decrease investment as they waited to see whether the world economy was about to experience another long-run upward spike in oil prices. The U.S. economy slid into recession at the end of 1990. The Federal Reserve concerned about the upward creep in inflation in the late 1980s took no steps to decrease real interest rates as the economy slid into recession.

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Figure: The Recession of 1990-1992

Legend: A sharp inward move in the IS curve triggered a recession at the beginning of the 1990s.

During the recession inflation cut down to two and a half percent. Unemployment increases to a peak of 7.6 percent—in the late spring of 1992 just in time to be salient for the 1992 presidential election. Recovery starts in mid-1992.

Soon subsequently Federal Reserve Chair Alan Greenspan made another decision to risk higher inflation in order to accomplish other goals. 1993 saw Greenspan signal that if Congress as well as the president took important steps to reduce the budget deficit, then the Federal Reserve would try as greatest as it could to maintain lower interest rates--a shift in the policy mix that would keep the target level of production as well as employment unchanged however that with lower interest rates would promise higher investment and faster productivity growth- an investment-led recovery.

This time the gamble turned out tremendously well. As fiscal policy tightened in 1994 as well as beyond, interest rates remained significantly lower than they had been in the 1980s even though output recovered to potential. Furthermore this time there was no significant acceleration of inflation even though by the end of the decade of the 1990s unemployment had fallen to the lowest level in a generation.

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