GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 4: Keynesian AD Curve (2): The Goods Market and the IS Curve
Junichi Fujimoto
December 8, 2016

The Keynesian Cross

Let us rst study the Keynesian cross (Figure 1), which is a building block of the IS curve. The Keynesian cross
models Keynes's idea that in the short run, total income of an economy is mainly determined by spending of
households, businesses, and government.

1.1 Planned and Actual Expenditure

Planned expenditure is the amount households, rms and the government would like to spend on goods and services.
Actual expenditure is the actual amount these agents spend on goods and services. The dierence between the two
is the rms' unplanned inventory investment.

1.2 Model
Consumption function: C = C(Y T )
T = T
Government purchases and net taxes (assumed to be exogenous variables): G = G,

Planned investment (for now, assumed to be an exogenous variable): I = I

Planned expenditure: E = C(Y T) + I + G
Equilibrium condition: Planned expenditure=Actual expenditure (E = Y )

1.3 The Eect of Fiscal policy: Government Purchases

Suppose government purchases increase from G1 to G2 . As shown in Figure 2, planned expenditure E = C + I + G
shifts upwards by G = G2 G1 , which results in a rise in equilibrium income from Y1 to Y2 . How is the rise in
Y , Y = Y2 Y1 , related to G ?
In order to answer this question, we start from the equilibrium condition Y = C + I + G and derive
Y = C + I + G.

(1)

Since I is assumed to be constant, I = 0. Also, C = M P C Y , where M P C (marginal propensity to

consume) indicates how many units of consumption households increase for one unit of increase in disposable
income. Households usually allocate income to both consumption and saving, so it is assumed that
M P C (0, 1).

Therefore, (1) becomes

Y = M P C Y + G,

(2)

from which we obtain

1
G.
(3)
1 MPC
Since M P C is greater than 0 and is smaller than 1, Y is greater than G. The economic reasoning is that,
Y =

when income increases due to an increase in government purchases, consumption increases and so does expenditure;
1

E =Y

E =C + I +G

E = C + I +G

MPC
1

45

equilibrium
income

Figure 1: The Keynesian Cross

this further raises income and accordingly consumption, and so on. Such feedback mechanism is called the multiplier
eect, and
Y
1
=
(4)
G

1 MPC

is called the government-purchases multiplier.

1.4 The Eect of Fiscal policy: Taxes

Next, let us examine the eect of taxes. Suppose taxes decrease by T . This immediately raises disposable income
Y T by T , and consequently, increases C by M P C T . As a result, planned expenditure increases as in
Figure 3, and the economy moves to the new equilibrium.
As with the case of government purchases, there is a multiplier eect in which the initial rise in income increases
consumption, which raises expenditure and hence income, which in turn increases consumption, and so on. However,
the tax multiplier is smaller in absolute value than the government purchases multiplier. That is, from (1) and
I = G = 0,
Y = C = M P C (Y T ),
(5)
and so
Y =

Thus, the tax multiplier is

MPC
T.
1 MPC

Y
MPC
=
,
T
1 MPC

(6)
(7)

which is smaller in absolute value than the government purchases multiplier. This can be explained as follows. An
increase in government purchases immediately raises expenditure by the same amount. In contrast, the immediate
increase in consumption is smaller than the size of tax reduction, so the impact on planned expenditure is smaller
than the case of government purchases. This is why people often claim that, in order to boost the economy during
recessions, increasing government purchases is more eective than decreasing taxes.
2. IS curve

2.1 Derivation of the IS Curve

The IS curve plots the combination of the real interest rate r and income Y which achieves equilibrium in the goods
market. We can derive the IS curve from the equilibrium condition that the actual and planned investment are
2

E =Y

E = C + I + G2
E = C + I + G1

E1 = Y1

E2 = Y2

Figure 2: Increase in Government Purchases

E =Y

E = C2 + I + G
E = C1 + I + G

MPC T

E1 = Y1

E2 = Y2

Figure 3: Tax Reduction

E =Y

E = C + I ( r2 ) + G
E = C + I ( r1 ) + G

Y1

Y2

r1
r2
IS

Y1

Y2

Figure 4: Deriving the IS Curve

equal. What is dierent from Section 1 is that investment I is no longer an exogenous variable, but is assumed to
be a decreasing function of r. Thus, the expression for the IS curve is

Y = C(Y T) + I(r) + G.

(8)

To plot the IS curve, draw the planned expenditure E for two dierent values of r, r1 and r2 , as in the upper
panel of Figure 4. Then, nd out the values of Y at the respective intersection of these two planned expenditures
with the 45 degree line (which are Y1 , Y2 ). Finally connect the two points, (r1 , Y1 ) and (r2 , Y2 ) to obtain the
downward sloping IS curve (To be precise, we need to compute Y for all possible values of r.). The intuition for
the downward sloping IS curve is as follows. Suppose the goods market is initially in equilibrium. A fall in the
real interest rate raises rms' investment, so planned expenditure increases and exceeds actual expenditure. So, in
order to recover the equilibrium in the goods market, income (= actual expenditure) Y must rise.

2.2 The Loanable Funds Interpretation of the IS curve

Above, we interpreted the IS curve as the equilibrium condition in the goods market. Another approach is to
interpret the IS curve as the equilibrium condition in the loan market. To see this, note that the national income
account identity
Y =C +I +G

can be rewritten as
I

= Y C(Y T) G,

or
I = S.

I (r )

S (Y1 ) S (Y2 )

r1

r2
IS

Y1 Y2

S, I

Figure 5: The Loanable Funds Interpretation of the IS curve

If we plot, as in Figure 5, r on the vertical axis, and I and S on the horizontal axis, I becomes a downward sloping
curve since it is a decreasing function of r. On the other hand, S is an increasing function of Y , since M P C is
smaller than one. Thus, for Y1 < Y2 , the graph of S(Y2 ) lies to the right of that of S(Y1 ). The intersections of I(r)
and S(Y1 ), S(Y2 ) give the real interest rates r1 , r2 , which respectively correspond to Y1 , Y2 . By connecting the two
points (r1 , Y1 ) and (r2 , Y2 ), we obtain the downward sloping IS curve.

2.3 Fiscal Policy and the IS curve

How do scal policies, that is, changes in G and T , aect the IS curve ? The answer is as follows. An expansionary
scal policy which increases demand for goods and services (increase in G, decrease in T ) shifts the IS curve to the
right, and a contractionary scal policy (decrease in G, increase in T ) shifts the IS curve to the left.
Let us conrm this in an example in which the government purchases increase from G1 to G2 . As in Figure 6,
an increase in G increases the planned expenditure E , so for any r, the corresponding value of Y becomes larger.
Therefore, the IS curve shifts to the right.
How large is the rightward shift (the size of the horizontal shift, or Y in Figure 6) ? Key here is that when we
are thinking of the horizontal shift, we are considering the change in Y for a given r, so we do not need to consider
the eect of change in r on I(r). Thus, as in Section 1.3, Y is obtained as
Y =

1
G.
1 MPC

2.4 Practice Questions

Answer whether the following statements about the IS curve are true or false.
1. The larger the marginal propensity to consume, the larger the horizontal shift resulting from scal policies.
2. If the government nances the increase in government purchases by an increase in taxes of the same magnitude,
the IS curve shifts to the left.
3. The greater the interest sensitivity of investment (i.e., the larger the decrease in investment for a given increase
in the real interest rate), the steeper the IS curve.

E =Y

E = C + I ( r1 ) + G2
E = C + I ( r1 ) + G1

Y1

Y2

r1

IS1

Y1

IS 2

Y2

Y
Figure 6: Government Purchases and the IS Curve