IS Curve Microfoundations (PIH)
Deriving the IS curve properly, including what the Permanent Income Hypothesis does to fiscal policy.
Definition
Deriving the IS curve from household optimization rather than a fixed MPCMPCMarginal propensity to consume: the fraction of an extra dollar of income that gets spent rather than saved., under the Permanent Income Hypothesis, consumption tracks lifetime resources, not current income.
Key equation
C = f(permanent income); temporary ΔT ⇒ small ΔC (consumption smoothing)
The intuition
If people smooth consumption, a one-off tax rebate is mostly saved, gutting the textbook multipliermultiplierThe amount total output changes per dollar of initial spending change, powered by respending: 1/(1−MPC) in the simplest case.. The IS curve still slopes down through investment, but fiscal shifts are far weaker than the Keynesian cross promises, the heart of the stimulus-effectiveness debate.
Exam tip
Always ask whether the fiscal change is TEMPORARY or PERMANENT, under PIH the two have completely different consumption effects.
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