The Goods Market and the IS
Curve
• Summary so far:
– We are using the IS-LM model to derive the
aggregate demand curve to study economic
fluctuations in the economy in the short run
– IS-LM model is an interpretation of John Maynard
Keyne’s theory on aggregate demand
– We need to first derive the IS Curve, which relates to
the goods market. IS = Investment and Saving
– To derive the IS Curve we use the Keynesian Cross
– From the Keynesian Cross, we studied the
Government purchases multiplier and the tax
multiplier (you need to know the formulae for these)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
1
The Goods Market and the IS
Curve
• The IS Curve plots the relationship between the
interest rate and the level of income that arises
in the market for goods and services
• The Keynesian Cross is one part of deriving the
IS Curve, i.e. it will give us the level of income
• The Investment function as the other part of
deriving the IS Curve, i.e. it will give us the
interest rate
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
2
The Goods Market and the IS
Curve
Investment function:
• We write the level of planned investment
as :
I = I(r)
where, I = Investment, r = real interest rate
• Because the interest rate is the cost of
borrowing to finance investment projects,
an increase in the interest rate reduces
planned investment
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
3
The Goods Market and the IS
Curve
Investment Function:
• Investment function slopes downward
• Negative relationship between investment
and the real interest rate
• Note: we met the investment function
already in chapter on income
• See graph on investment function
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
4
Investment Function
Interest rate (r)
r1
I (r)
I(r1)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
Investment (I)
5
The Goods Market and the IS
Curve
• To derive the IS Curve we use:
– The Keynesian Cross and
– The Investment Function
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
6
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
7
The Goods Market and the IS
Curve
Deriving the IS Curve (see previous graph):
• Initially we start with interest rate r1
• This gives us a quantity of investment of
I(r1)
• At this amount of investment, the planned
expenditure line crosses actual
expenditure in the Keynesian cross to give
an income level of Y1 in the economy
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
8
The Goods Market and the IS
Curve
Deriving the IS Curve:
• Therefore, at interest rate r1 ,income is Y1
• Plot this as one point showing the
relationship between interest rates and
income in the goods market
• Then assume the interest rate rises to r2
and see what happens to income
• If the interest rate rises, investment falls to
I(r2)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
9
The Goods Market and the IS
Curve
Deriving the IS Curve:
• If investment falls, the planned expenditure line
must shift downward because at any level of
income, expenditure is now lower than it was
before – this is represented by a shift downward
of the planned expenditure line
E (Planned Expenditure) = C(Y-T) + I + G
• New line crosses 45 degree line (actual
expenditure) and this shift causes income to fall
to Y2
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
10
The Goods Market and the IS
Curve
Deriving the IS Curve:
• Therefore, at interest rate r2, income is Y2
• An increase in interest rate led to a
decrease in income
• Plot this as another point showing the
relationship between interest rates and
income in the goods market
• Join the two dots together and you get a
downward sloping IS Curve
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
11
The Goods Market and the IS
Curve
• IS Curve: summarises this relationship
between interest rates and income
• Because an increase in the interest rate
causes planned investment to fall, which in
turn causes income to fall, the IS Curve
slopes downward.
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
12
The Goods Market and the IS
Curve
How fiscal policy shifts the IS Curve:
• Fiscal policy means a change in Government
Purchases or taxes
• When we constructed the IS Curve we held G
and T fixed
• What if government purchases increase from G1
to G2 (assume r and therefore I are held
constant)
• We saw already that this would cause the
planned expenditure line to shift upwards
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
13
The Goods Market and the IS
Curve
How fiscal policy shifts the IS Curve:
• This upward shift in the expenditure line
would result in higher income: from Y1 to
Y2
• Interest rates have stayed the same, but
income has increased, therefore, this
would be represented by a shift outward of
the IS curve: from IS1 to IS2
• See Graph
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
14
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
15
The Goods Market and the IS
Curve
How fiscal policy shifts the IS Curve:
• In summary:
• Expansionary Fiscal Policy (increase in
Government Purchases or decrease in
taxes) will shift the IS Curve to the right
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
16