Page 169 - DECO402_Macro Economics

Macroeconomic Theory

Notes we also derive the Aggregate Demand Curve from IS-LM Analysis and will concentrate on the thing
that how the shift in IS or LM brings the shift in Aggregate Demand Curve.

Notes Interest rate affects the investment level.

18.1 IS Curve and Its Derivation (Product Market Equilibrium)

The IS Curve shows that coincidence of interest rate and actual GDP which establishes the equality
between saving and investment. According to, Lipsey and chrystal “The IS Curve is the locus of
interest rate and actual GDP that are consistent with equality between desired spending and output,
or what is the same thing, injection and leakages. It is drawn for given value of the government
expenditure, exports, and automatic consumption as well as forgiven tax rates and a given price
level.” Therefore the IS Curve or IS function indicates the commodity market equilibrium.
Two situations come in derivation of IS Curve. In first situation, the relation between investment and
interest rate is established by investment demand function and in second situation; we’ll explain how
the change in investment spending affects the actual GDP. On combining the interest rate and actual
GDP, we’ll establish the equilibrium in commodity market.

I. The Investment Demand Function

Relationship between r and I

It means the inverse relationship between investment and interest rate. The desired rate of investment
will be low on the high interest rate, and will be high on the low interest rate. The working relationship
between investment and interest rate can be written as following-

I = I – br, b > 0
a
[Here I: Investment; I : autonomous investment; r: interest rate; b: the responsiveness of investment
a
spending from interest rate.]
The above investment function shows that the means of low interest rate is high investment or vice-
versa.
In figure 18.1, II is the investment demand curve, which shows the negative relationship between
1
investment and interest rate. On the low interest rate ‘Or ’ , investment spending is ‘OI ’ and on high
1
0
interest rate ‘Or’, it is ‘OI’. If there is any change in the autonomous component ‘I ’ of investment, then
a
there is a shift in investment demand. Rise in ‘I ’, rise in II Rise in ‘I ’ will shift the II Curve towards
1
a
1
a
right and the reduction in it (I ) will shift the II towards left.
a
1
Did You Know? The change in investment spending affects the actual GDP by the change
in investment spending.

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