Page 155 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes 9.2.1 Derivation of the IS-curve

Figure 9.2b shows how the IS-curve is derived. At an interest rate r , equilibrium in the goods
1
market is at point E, with an income level of y .
1
In Figure 9.2c the same is denoted by point E . Now a fall in interest rate to r raises aggregate
1 2
demand, increasing the level of spending at each income level. The new equilibrium income is
Y . F shows the new equilibrium in the goods market corresponding to an interest rate r .
2 1 2
!
Caution The IS-curve is also a locus of points showing alternate combinations of interest
rates and income (output) at which the commodity market clears. That is why the IS-curve
is called the commodity market equilibrium schedule. The IS-curve is a graphic
representation of the product market equilibrium condition that planned investment be
equal to saving and it shows the level of income that will yield equality of planned
investment and saving at different possible interest rates.

9.2.2 Properties of the IS-curve

The Slope of the IS-curve: The IS-curve is negatively sloped because a higher level of
interest rate reduces investment spending, thereby reducing aggregate demand and thus
the equilibrium level of income. The steepness of the curve depends on the interest elasticity
of investment (i.e., how sensitive investment spending is to changes in the interest rate) as
also on the (investment) multiplier.
Shifts in the IS-curve: The position of the IS-curve depends on the level of autonomous
spending. If autonomous spending increases, the IS-curve will shift to the right (with or
without a change in slope).

Example: Let us suppose that expectations or technology change so as to make investment
spending appear more profitable. This will shift the investment schedule to the right indicating
that at each rate of interest more investment spending takes place.
For equilibrium, the higher level of investment must be matched by a higher level of
saving. Since saving increases only if income increases, to maintain equilibrium an increase
in autonomous investment must be associated with an increase in income – an increase
large enough to generate extra saving in an amount equal to the increase in investment.
This shows that an increase in investment means higher income levels at each rate of
interest. Thus the IS-curve shifts to the right. The shift is horizontal and equal to the
amount of shift in the investment schedule times the multiplier or the reciprocal of the
marginal propensity to save.
Shifts in the consumption function (or saving function) also cause a shift of IS-curve.

Example: Suppose that an autonomous shift upward takes place in the consumption
function (which is the same as upward shift in saving function). As a result, the volume of saving
of any level of income is reduced. To maintain sufficient saving to offset the investment that
takes place at any selected interest rate the level of income would have to rise.

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