Question

What would cause the IS curve to be vertical? Assuming that the IS curve is vertical, what will the corresponding AD curve look like?

Answer 1

The IS curve is a downward sloping curve towards the right. So it has a negative slope. This shows that with rise in interest rate, the national income decreases. As interest rate rises, availability of loans become difficult. As a result, businesses do not expand and thus hire less people. So wages also decrease. Thus there is lessening of national income.

Now let us consider a situation where the investment by businesses is irrespective of the interest rate. So no matter what the interest rate be, the businesses will expand as per pre-determined planning. So they will hire people as they had decided and hence the national income will remain same. So there will be no change in national income even with rise in interest rates. So when the investment is completely inelastic with respect to interest rate, the IS curve is vertical.

Assuming that the IS curve is vertical, change in the price level will shift the LM curve. However, the national income will not change since the IS curve is vertical. The AD curve is basically a plot of how the national income changes with change in price levels.

Since change in price levels is not causing the equilibrium national income to change in the IS-LM model, so the AD curve will also be vertical. It will depict that the national income remains same with change in price levels.

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