1 Introduction to Macroeconomics
2 Measuring the Macroeconomy
3 An Overview of Long-Run Economic Growth
4 A Model of Production
5 The Solow Growth Model
6 Growth and Ideas
7 The Labor Market, Wages, and Unemployment
8 Inflation
9 An Overview of the Short-Run Model
10 The IS Curve
11 Monetary Policy and the Phillips Curve
12 Stabilization Policy and the AS/AD Framework
13 The Global Financial Crisis: Overview
14 The Global Financial Crisis and the Short-Run Model
15 The Government and the Macroeconomy
16 International Trade
17 Exchange Rates and International Finance
18 Parting Thoughts




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Chapter 10: The IS Curve

Chapter Outline

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Key Concepts

  1. The IS curve describes how output in the short run depends on the real interest rate and on shocks to the aggregate economy.

  2. When the real interest rate rises, the cost of borrowing faced by firms and households increases, leading them to delay their purchases of new equipment, factories, and housing. These delays reduce the level of investment, which in turn lowers output below potential. Therefore, the IS curve shows a negative relationship between output and the real interest rate.

  3. Shocks to aggregate demand can shift the IS curve. These shocks include (a) changes in consumption relative to potential output, (b) technological improvements that stimulate investment demand given the current interest rate, (c) changes in government purchases relative to potential output, and (d) interactions between the domestic and foreign economies that affect exports and imports.

  4. The life-cycle/permanent-income hypothesis says that individual consumption depends on average income over time rather than current income. This serves as the underlying justification for why we assume consumption depends on potential output.

  5. The permanent-income theory does not seem to hold exactly, however, and consumption responds to temporary movements in income as well. When we include this effect in our IS curve, a multiplier term appears. That is, a shock that reduces the aggregate demand parameter by 1 percentage point may have an even larger effect on short-run output because the initial reduction in output causes consumption to fall, which further reduces output.

  6. A consideration of the microfoundations of the equations that underlie the IS curve reveals important subtleties. The most important are associated with the no-free-lunch principle imposed by the government's budget constraint. The direct effect of changes in government purchases is to change . However, depending on how these purchases are financed, they can also affect consumption and investment, partially mitigating the effects of fiscal policy on short-run output.

10.1 Introduction

10.2 Setting Up the Economy

  • Consumption and Friends
  • The Investment Equation

10.3 Deriving the IS Curve

  • Case Study: Why Is It Called the "IS Curve"?

10.4 Using the IS Curve

  • The Basic IS Curve
  • The Effect of a Change on the Interest Rate
  • An Aggregate Demand Shock
  • Case Study: Moving Along or Shift? A Guide to the IS Curve
  • A Shock to Potential Output
  • Other Experiments

10.5 Microfoundations of the IS Curve

  • Consumption
  • Case Study: Permanent Income and Present Discounted Value
  • Case Study: Behavioral Economics and Consumption
  • Multiplier Effects
  • Investment
  • Government Purchases
  • Case Study: Fiscal Policy and Depressions

10.6 Conclusion

10.7 Additional Resources

  • Summary
  • Key Concepts
  • Review Questions
  • Exercises
  • Worked Exercises
« Return to Chapter 10 Study Plan