C

+

It + Gt

(18.2.12)

where Y = national income

C = consumption spending I = planned or desired net investment G = given level of government expenditure T = taxes

Yd = disposable income r= interest rate

(Continued )

3"The goods market equilibrium schedule, or IS schedule, shows combinations of interest rates and levels of output such that planned spending equals income.'' See Rudiger Dornbusch and Stanley Fischer, Macroeconomics, 3d ed., McGraw-Hill, New York, 1984, p. 102. Note that for simplicity we have assumed away the foreign trade sector.

722 PART FOUR: SIMULTANEOUS-EQUATION MODELS

EXAMPLE 18.4 (Continued)

If you substitute (18.2.10) and (18.2.8) into (18.2.7) and substitute the resulting equation for C and Eq. (18.2.9) and (18.2.11) into (18.2.12), you should obtain

Equation (18.2.13) is the equation of the IS, or goods market equilibrium, that is, it gives the combinations of the interest rate and level of income such that the goods market clears or is in equilibrium. Geometrically, the IS curve is shown in Figure 18.3.

What would happen if we were to estimate, say, the consumption function (18.2.7) in isolation? Could we obtain unbiased and/or consistent estimates of 0O and fS^? Such a result is unlikely because consumption depends on disposable income, which depends on national income Y, but the latter depends on r and G as well as the other parameters entering in n0. Therefore, unless we take into account all these influences, a simple regression of C on Yd is bound to give biased and/or inconsistent estimates of 00 and 01.

Income

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