Notes on the IS Curve and Economic Relationships

IS Curve and its Implications

• The IS curve describes the relationship between output and the real interest rate.
  • Purpose: Analyze how real interest rates influence spending and output.
  • Connection: Links economic activity (Main Street) with financial markets (Wall Street).

Real Interest Rate

• Definition: The real interest rate is derived from the nominal interest rate minus the inflation rate.
• Opportunity Cost of Spending: It represents the decision-making metric for whether to spend or save money.
  • High real interest rates discourage spending (higher cost of using money).
  • Low real interest rates encourage spending (lower cost of using money).

Importance of Real Interest Rate

• Affects aggregate expenditure significantly.
  • Low real interest rates: Encourage higher consumption and investment.
  • High real interest rates: Encourage saving and reduce current consumption.
• Policy Implications: Policymakers often manipulate interest rates to control economic demand.
  • Increasing interest rates leads to reduced spending, while lowering interest rates promotes spending.

Aggregate Expenditure Components

1. Consumption :
   • Dependent on real interest rates due to opportunity cost.
   • Negative relationship between interest rates and consumption (as rates decrease, consumption increases).
2. Planned Investment:
   • Highly sensitive to real interest rates. Lower rates increase investments due to lower borrowing costs.
3. Government Expenditure:
   • Lower real interest rates enable the government to manage its debt more efficiently, leading to increased spending.
   • Less sensitive to interest rate changes compared to investment.
4. Net Exports:
   • A lower real interest rate can result in decreased demand for the dollar from foreign investors, making U.S. exports cheaper and thus increasing net exports.

Overall Market Relationships

• All components of aggregate expenditure rise when real interest rates fall:
  • Increased consumption, investment, government spending, and net exports lead to higher aggregate expenditure.
  • Aggregate Expenditure Formula: Sum of consumption, investment, government purchases, and net exports.

Output and Aggregate Demand

• Businesses adjust production levels based on aggregate expenditure changes.
• Output Gap: The difference between actual output and potential output. Changes in aggregate expenditure directly influence the output gap, leading to either a positive or negative gap.

The IS Curve Visualization

• Represents the direct relationship between real interest rates and the output gap.
  • X-axis: Output gap
  • Y-axis: Real interest rate
  • Typically a downward-sloping curve similar to demand curves.

Practical Applications of the IS Curve

• Used to forecast output gaps based on interest rates.
  • For example, at a 3% interest rate, if output is below potential (e.g., -5% gap), lowering interest rates can help close this gap.
• Movement along the curve indicates changes in interest rates; shifts in the curve indicate factors other than interest rates affecting output.

Historical Context and Lessons

• Notable examples:
  • 1980s inflation crisis led to very high interest rates to combat inflation, causing an output drop (artificial recession).
  • Recent changes from 0% to 5% interest rates raise concerns about inflation and recession.
• Fundamental takeaway: IS curve is pivotal in understanding how real interest rates impact the economy and output levels.