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Chapter 3
Income and
Interest Rates:
The Keynesian
Cross Model
and the IS Curve
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Theory of Business Cycles: Outline
• Ch 3: Spending, Income and Interest Rates
– Use the Keynesian Cross Model to derive the IS curve
• Ch 4: Monetary and Fiscal Policy in the IS/LM Model
– Use equilibrium in the money market to derive the LM curve
– Combine the IS and LM curves to determine Y and i
• Ch 5: Financial Markets, Financial Regulation and
Economic Instability
• Ch 6: The Government Budget, Government Debt
and the Limitations of Fiscal Policy
• Ch 7: International Trade, Exchange Rates and
Macroeconomic Policy
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3-2
The Volatile Business Cycle
• The goal of monetary and fiscal policy is to
dampen business cycle fluctuations and to
promote steady economic growth.
• The “Great Moderation” refers to the 1986-2007
period where business cycle fluctuations noticeably
diminished.
• The Global Economic Crisis or “Great
Recession” followed the “Great Moderation.”
– Casts doubt on belief of the improved effectiveness of
monetary and fiscal policy in the 1986-2007 period
– Alternate explanation: Shocks were moderate 1986-2007
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3-3
Figure 3-1 Real GDP Growth
in the United States, 1950–2010
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3-4
Aggregate Demand and Supply
•
Aggregate Demand (AD) is the total amount of desired
spending expressed in current (or nominal) dollars.
– A demand shock is a significant change in desired spending by
consumers, business firms, the government or foreigners.
• Algebraically, any change in C, I, G or NX
•
Aggregate Supply (AS) is the amount that firms are
will to produce at any given price level.
– A supply shock is a significant change in costs of production for
business firms, including wages and the prices of raw materials,
like oil.
• AS and supply shocks will be considered in Chapters 8 and 9.
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3-5
Modeling Preliminaries
•
Simplifying assumption:
– The price level (P) is fixed in the short run.
• Implication: All changes in AD automatically cause changes in real
GDP by the same amount and in the same direction.
•
The variables that an economic theory tries to explain
are called endogenous variables.
– Examples: Output and interest rates
•
Exogenous variable are those that are relevant
but whose behavior the theory does not attempt
to explain; their values are taken as given.
– Examples: Money supply, government spending, tax rates
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3-6
Consumption and Savings
•
•
The consumption function is any relationship that
describes the determinants of consumption spending.
General linear form: C = Cα + c(Y – T) where…
• Cα = Autonomous consumption
• c = marginal propensity to consume
• c(Y – T) = induced consumption
•
Savings (S) = Y – T – C
Substituting in C from above yields:
S = Y – T – [Cα + c(Y – T)]
 S =– Cα + (1 – c)(Y – T)]
where…
• (1 – c) = marginal propensity to save (s)
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3-7
Figure 3-2 A Simple Hypothesis
Regarding Consumption Behavior
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3-8
Factors Affecting Cα
• Interest Rates (r): When r↓  borrowing is cheaper
for consumers  Cα↑
– Example: Low interest rates in 2001-04 stimulated consumption of
automobiles and other consumer products.
• Household Wealth (W) is the total net value of all
household assets (minus any debt), including the market
value of homes, possessions such as automobiles, and
financial assets such as stocks, bonds and bank accounts.
– If W↑  HH spending can ↑ even if income is fixed  Cα↑
– Example: The 1990’s stock market boom raised consumption.
• The set of Financial Market Institutions determines the ease with
which households can borrow to buy “big-ticket” items.
– Example: From 2001-06, loans were easily obtained, which helped fuel the
housing bubble.
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3-9
Planned vs. Unplanned Expenditure
•
Recall the National Income Accounting Identity:
Y = C + I + G + NX
GDP or Output = Unplanned Expenditure
– Unplanned Expenditure always equals GDP because the equation
is an identity.
•
Planned Expenditure (EP) = C + IP + G + NX
– Only Investment has an unplanned spending component
• Goods that are produced, but not sold are counted as unplanned
inventories.
– EP = GDP only at equilibrium (when unplanned spending = 0)
•
Algebraically, EP = AP + c(Y – T)
where…
– AP = Autonomous Spending = Cα – cTα + IP + G + NX
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3-10
The Equilibrium of the Economy
•
At equilibrium, Y = EP
Y = AP + cY
(assuming T = 0)
To find equilibrium Y, solve the above equation for Y:
 (1 – c)Y = AP
 sY = Ap
 Y = (1/s) AP
•
If the level of AP changes over time by ∆AP , then the
change in output, ∆Y, is given by:
∆Y = (1/s) ∆AP
•
1/s is called the multiplier because it shows how each
additional dollar of autonomous spending results in a greater
than $1 increase in equilibrium output.
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3-11
Figure 3-3 How Equilibrium Income Is
Determined
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3-12
Table 3-1 Comparison of the
Economy’s “Always True” and Equilibrium
Situations
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3-13
Figure 3-4 The Change in Equilibrium
Income Caused by a $500 Billion Increase in
Autonomous Planned Spending
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3-14
Shifts in Planned Spending
• Recall: EP = C + IP + G + NX = AP + cY
where AP = Cα – cTα + IP + G + NX
• Any increase in AP will shift up EP on the
Keynesian
Cross Diagram.
– Effect on Y: ∆Y = (1/s) ∆AP
where
• If c changes, the EP line will rotate
• If the effect on Y is negative, fiscal policy can be
used to offset the effect.
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3-15
Government Budget Deficit and its
Financing
• Suppose an increase in G is financed by issuing
bonds
– Cα , Tα , IP and NX are unchanged  ∆Y = (1/s) ∆G
– What happens to the “Magic Equation” ?
•
•
•
•
Recall: (T – G) = (S – I ) + NX
In “∆” form: (∆T – ∆G ) = (∆S – ∆I) + NX
Since T, I and NX are constant  ∆G = ∆S
Using ∆Y = (1/s) ∆G  ∆G = s∆Y… but s∆Y = ∆S !!!
– Result: The higher level of government
purchases leads to an increase in income, which
yields the higher level of savings needed for
households to purchase the bonds to pay for the
increase in G!
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3-16
The Balanced Budget Multiplier
• Suppose an increase in G is paid for by raising taxes
(i.e. the government is running a balanced budget)
–
–
–
–
∆G = ∆Tα (while IP and NX are unchanged)
∆Y = (1/s) ∆AP = (1/s)(∆G – c∆Tα) = (1/s)(∆G – c ∆G)
Recall: s = (1-c)
Then:
– Result: The balanced budget multiplier is 1!
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3-17
Figure 3-5 Relation of the Various Components
of Autonomous Planned Spending to the Interest
Rate
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3-18
Investment Volatility and Business
Cycles
Investment Falls Relative
to GDP in Every Recession
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3-19
Figure 3-6 Relation of the IS Curve to
the Demand for Autonomous Spending
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