Question

IS-LM Model:

Why is the full employment curve a vertical line that crosses the IS-LM intersect?

Answer 1

The label IS comes from the fact that in a closed economy (one with no trade) the curve gives the combinations of income and the interest rate for which desired savings equals desired investment. In an open economy this curve gives the combinations of income and the interest rate for which the desired net capital outflow, represented by savings minus investment, equals the the desired current account balance---that is, for which S − I = BT + DSB. When there is no international trade, this condition becomes simply S − I = 0 .

A fall in the interest rate leads to an expansion of investment, causing equilibrium output, income and emloyment to increase as we move down along the IS curve. A fall in the real exchange rate shifts world demand onto domestic goods, increasing income at each level of the real interest rate and shifting IS to the right. An increase in rest-of-world income, or exogenous increase in consumption or investment or net exports at any given level of the real interest rate also causes the IS line to shift to the right and the equilibrium level of output, income and employment to increase.