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IS-LM analysis: deriving the IS curve

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IS-LM analysis: deriving the IS curve

Extension Class Presentation

Ruth Tarrant

45⁰ line

Income = consumption

Consumption (C)

C = a + bY

a = y-intercept = autonomous consumption (i.e. the level of consumption when income is zero)

b = slope of the line = marginal propensity to consume

Yo

Income (Y)

At Yo, we say there is equilibrium, as consumption = income

45⁰ line

AD

AD

1. At Yo, the goods market in the economy is in equilibrium: AD = Y

2. In equilibrium, injections = withdrawals

3. So, we can assume that Savings = Investment

Income

Yo

- An IS (Investments = Savings) curve shows the different combinations of income (Y) and interest rates (r) at which the goods market is in equilibrium

45⁰ line

Aggregate Demand

Assume that the rate of interest in the economy is r0. At this rate of interest, aggregate demand is shown as AD1. So, when the rate of interest is r0, the goods market of the economy is in equilibrium at y0.

AD1

Y0

Income

Interest Rate

r0

We can now plot a point on the bottom diagram, at the intersection of r0 and y0.

At this point we know that the goods market in the economy is in equilibrium

Y0

Income

45⁰ line

Aggregate Demand

Now suppose that interest rates are lowered, to r1. Lower interest rates boost consumer spending and investment, and so AD rises.

AD2

AD1

We draw a new AD curve at AD2. At this higher level of AD, the economy’s goods market equilibrium is achieved at Y1.

Y1

Y0

Income

Interest Rate

Now we plot a point at the intersection of Y1 and r1to indicate the point at which the goods market is in equilibrium.

r0

r1

Y0

Income

Y1

45⁰ line

Aggregate Demand

AD2

AD1

We can repeat this process for all interest rates, and then plot all of the relevant points on the bottom diagram.

If we join the dots, we create an IS curve.

Y1

Y0

Income

Interest Rate

r0

r1

IS

Y0

Income

Y1

- Why might the IS curve be steep? Shallow?
- The slope of the IS curve depends on the sensitivity of AD to interest rate changes
- If changes in interest rates only lead to a small change in AD, the IS curve will be steep
- If changes in interest rates lead to a large change in AD, the IS curve will be shallow

- Remember, the IS curve shows the effect of interest rates in shifting AD and the resultant level of income
- If anything else changes, the IS curve will shift

- What would happen to the IS curve if:
- Government spending increased?
- Consumer confidence fell?
- Business optimism about future profits improved?