copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 10-1 chapter 10...

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.10-1

CHAPTER 10

Investment, Net Exports, and Interest Rates


Questions• How are the determinants of

investment different in a sticky-price than in a flexible-price model?

• How are the determinants of net exports different in a sticky-price than in a flexible-price model?

• How do changes in interest rates affect the equilibrium level of production and income in a sticky-price model?


Questions

• What is the “IS Curve”?– What use is it?

• What determines the equilibrium level of real GDP when the central bank’s policy is to keep the real interest rate constant?


The Importance of Investment

• Changes in investment are the driving force behind the business cycle– reductions in investment have played a

powerful role in every recession and depression

– increases in investment have spurred every boom


The Importance of Investment

• Understanding the causes and consequences of changes in investment will help us to understand business cycles


Figure 10.1 - Investment as a Share of Real GDP, 1970-2000


The Role of Investment• In the flexible-price model, the real

interest rate is a market-clearing price– it is pushed up or down by supply and

demand to equate the flow of savings to the flow of investment


The Role of Investment• In the sticky-price model, the interest

rate is not set in the loanable funds market– it is set directly by the central bank or

indirectly by the combination of the stock of money and the liquidity preferences of households and businesses

– businesses match the quantity they produce to aggregate demand• automatically creates balance in the financial

market


Fluctuations in Investment• Fluctuations in investment have two

sources– changes in the real interest rate– shifts in investors’ expectations about

future growth, profits, and risk

rI-II r0


Investment and theInterest Rate

• The opportunity cost of an investment project is the real interest rate– the higher the interest rate, the lower the

number and value of investment projects that will return more than their current cost and the lower the level of investment spending



• The interest rate that is relevant for determining investment spending is a long-term interest rate– when considering an investment project,

a manager must compare the potential profits of the project to the opportunity to make money from a long-term commitment of the funds elsewhere



• Long-term and short-term interest rates are different and do not always move in step– long-term interest rates are usually

higher than short-term interest rates– the term premium is the premium in the

interest rate that the market charges on long-term loans vis-à-vis short term loans


Figure 10.2 - Bond Yield Curves



• The interest rate that is relevant for investment spending decisions is the real interest rate


Figure 10.3 - Gaps between Real and Nominal Interest Rates



• The interest rate that a firm faces is the interest rate charged to risky borrowers– the premium that lenders charge for

loans to companies rather than to safe government borrowers is called the risk premium


Figure 10.4 - The Risk Premium: Safe and Risky Interest Rates



• In the investment function the relevant interest rate (r) is the long-term, real, risky interest rate

• As r rises, the level of investment spending will decline

rI-II r0


Figure 10.5 - Investment as a Decreasing Function of the Long-Term, Real,

Risky Interest Rate


Exports and Autonomous Spending

• Gross exports depend on– foreign total incomes (Yf)– the real exchange rate ()

• the real exchange rate depends on the domestic real interest rate (r)

• Like investment, gross exports are affected by changes in the real interest rate


Exports and Autonomous Spending

• A higher interest rate reduces autonomous spending (A) by reducing exports (Xr r) as well as by reducing investment (Ir r)

rX-)rXXY(XGr)I-I(CA rf

rf

fr00 0


Exports and theInterest Rate

• A higher real interest rate reduces gross exports– investing in the home country is more

attractive• foreign exchange speculators shift their

portfolio holdings to include more home currency-denominated assets

– the exchange rate falls• exports are more expensive to foreigners


Figure 10.6 - From the Real Interest Rate to the Change in Exports


Autonomous Spending and the Real Interest Rate

• A one-percentage-point increase in the real interest rate (r) reduces autonomous spending by (Ir + Xr)

r)X(I-)]rXXY(XGIC[A rrf

rf

f00 0


Figure 10.7 - Autonomous Spending as a Function of the Real Interest Rate


The Investment-Saving(IS) Curve

• Because a change in the real interest rate changes autonomous spending, it will change the equilibrium level of real GDP– the effect will be equal to the interest

sensitivity of autonomous spending (Ir + Xr) times the multiplier



• The relationship between the level of the real interest rate and the equilibrium level of real GDP is the IS curve– IS stands for “Investment-Saving”



• To find a point on the IS curve:– pick a value for the real interest rate and

determine the level of autonomous spending at that interest rate

– use the income-expenditure diagram to determine the equilibrium level of real GDP

• Repeat this procedure to find other points on the IS curve


Figure 10.8 - The IS Curve


The IS Curve

• Define baseline autonomous spending (A0) to include the determinants of autonomous spending that do not depend on the real interest rate

r)X(I-)]rXXY(XGIC[A rrf

rf

f00 0

)]rXXY(XGIC[A fr

ff000 0

r)X(I-AA rr0


The IS Curve• Recall that real GDP is equal to

autonomous spending (A) divided by (1-MPE)

• Substituting, we get

MPE-1r)X(I-A

Y rr0

r)IM-t)-(1(C-1

)X(I-

)IM-t)-(1(C-1)]rXXY(XGI[C

Yyy

rr

yy

fr

ff00

0


The IS Curve

• The term on the left is the horizontal intercept of the IS curve– the value of equilibrium real GDP if the real

interest rate was equal to zero

• The term on the right is the slope of the IS curve– the responsiveness of real GDP to changes

in the interest rate

r)IM-t)-(1(C-1

)X(I-


Yyy

rr

yy

fr

ff00

0


Figure 10.9 - The IS Curve


The Slope of the IS Curve

• The first term is the multiplier (1/1-MPE)

• The second term shows how large a change in investment or exports is generated by a change in the real interest rate

)X(I)IM-t)-(1(C-1

1slope IS rr

yy


The Position of the IS Curve• The position of the IS curve depends

on the baseline level of autonomous spending times the multiplier

• Changes in any of these determinants will shift the position of the IS curve


MPE-1A

yy

fr

ff000

0


Figure 10.10 - A Change in Fiscal Policy and the Position of the IS Curve


Changes in the Interest Rate• To calculate how much a change in the

interest rate will shift the equilibrium level of real GDP, you need to know four things:– the marginal propensity to spend (MPE)

– the interest sensitivity of investment (Ir)

– the interest sensitivity of the exchange rate (r)

– the exchange rate sensitivity of exports (X)


Moving to the IS Curve• If the economy is above the IS curve:

– real GDP > planned expenditure• inventories rise• firms cut production• employment, real GDP, and national income

fall

• If the economy is below the IS curve:– planned expenditure > real GDP

• inventories fall• firms expand production• employment, real GDP, and national income

rise


Figure 10.11 - Off of the IS Curve


Shifting the IS Curve• Two kinds of government policies

directly affect the position of the IS curve– a shift in tax rates changes both the

position and the slope of the IS curve– a change in the level of government

purchases changes the position of the IS curve


Shifting the IS Curve• Example - an increase in government

spending G = $200 billion– MPE = 0.5

– Ir = $0.11

– Xr = $0.015

– r = 4%

rMPE-1XI

-MPE-1A

Y rr0

trillion $0.400.5-1$0.015$0.11

-0.5-1

0.2$Y


Moving along the IS Curve• Changes in the real interest rate will

move the economy along the IS curve– a higher real interest rate will produce a

lower level of aggregate demand and equilibrium real GDP

– a lower real interest rate will produce a higher level of aggregate demand and equilibrium real GDP


Moving along the IS Curve• Example - cutting interest rates to

boost equilibrium real GDP by $500 billion– MPE = 0.5– Ir = $0.11– X = 5% r = $0.003 trillion $0.25

0.5-1$0.003)5($0.11

MPE-1XI

slope IS rr

• To boost real GDP by $500 billion, the real interest rate must fall by 2 percentage points


Figure 10.12 - Cutting Target Interest Rates and Raising Real GDP


Changing Interest Rates

• The Federal Reserve controls interest rates through open market operations– buying and selling short-term

government bonds for cash


Open Market Operations• When the Federal Reserve buys

government bonds– the total cash in the hands of the public

and bank reserves increases– households, businesses, and banks find

that they are holding more money than they would like• use the money to buy assets (such as bonds)

– bond prices rise and interest rates fall


Open Market Operations• When the Federal Reserve sells

government bonds– the total cash in the hands of the public

and bank reserves decreases– households, businesses, and banks find

that they are holding less money than they would like• try to get money by selling assets (such as

bonds)

– bond prices fall and interest rates rise


Figure 10.13 - Open Market Operations


Difficulties• Our knowledge of the structure of the

economy is imperfect• Even when policies have their

expected effects, these effects do not necessarily arrive on schedule

• The interest rates the Federal Reserve can control are short-term, nominal, safe interest rates


The IS Curve of the 1960s• In the 1960s, there was a rightward

shift in the IS curve– increased optimism on the part of

businesses– a cut in income taxes– extra government expenditures (Vietnam

War)


Figure 10.14 - Real GDP and the Interest Rate, 1960-1999


The IS Curve of the 1960s• In the late 1960s, there was a

movement down along the IS curve as real interest rates declined– the drop in real interest rates was caused

(in part) by an increase in inflation


Figure 10.15 - Shifting Out and Moving along the IS Curve, 1960s


The IS Curve of theLate 1970s

• From 1977 to 1979, the U.S. economy moved down and to the right of the IS curve– the expansion toward potential output was

accompanied by high and rising inflation

• In 1979, the Federal Reserve began fighting inflation– raised real interest rates from 1979 to

1982


Figure 10.16 - Moving along the IS Curve, Late 1970s


The IS Curve of the 1980s

• The 1980s began with a large outward shift in the IS curve– an increase in military spending– a cut in income taxes– an increase in investor optimism

• The Federal Reserve responded to this shift by raising real interest rates


Figure 10.17 - Shifting the IS Curve Out, Early 1980s


The IS Curve of the 1980s• As inflation remained low through the

mid- and late- 1980s, Federal Reserve policymakers gained confidence– began reducing real interest rates

causing a movement along the IS curve


Figure 10.18 - Moving along the IS Curve, Late 1980s


The IS Curve of the 1990s• In the second half of 1990, there was

a leftward shift of the IS curve– a drop in investment as firms worried

about the price of oil after the Iraqi invasion of Kuwait

• The Federal Reserve took no steps to reduce real interest rates to offset the recession


The IS Curve of the 1990s• In 1993, the Federal Reserve began a

policy of maintaining lower interest rates in response to the reduction in the federal budget deficit– the goal of the policy was to increase

investment

• During the last half of the 1990s, interest rates remained low

• Inflation remained low as well


Figure 10.19 - The Recession of 1990-1992


Chapter Summary• In the sticky-price model, the

investment function is the same as in the flexible-price model– in the flexible price model, the level of

savings determined investment and the investment function determined the real interest rate

– in the sticky-price model, the real interest rate is determined outside the IS framework, and the level of investment powerfully affects the level of real GDP


Chapter Summary• The international sector of the sticky-

price model is essentially the same as the international sector of the flexible-price model


Chapter Summary• The income-expenditure diagram

takes autonomous spending as given, and then determines the equilibrium levels of real GDP, aggregate demand, and national income as functions of autonomous spending and the marginal propensity to spend


Chapter Summary• The IS curve incorporates the effect of

changing interest rates on autonomous spending and adds this effect of changing interest rates on autonomous spending to the income-expenditure diagram


Chapter Summary• The IS curve slopes downward

because a higher interest rate lowers both investment and exports and these reductions in autonomous spending in turn lower aggregate demand and equilibrium real GDP


Chapter Summary• When the central bank’s policy involves

targeting the real interest rate, the position of the IS curve and the central bank’s interest rate target together determine the equilibrium level of aggregate demand and real GDP

copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 10-1 chapter 10...

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