Question

Derive carefully the IS curve and discuss the determinants of its slope and its position.

Answer 1

The IS Curve explains the relationship between the real rate of interest and the corresponding equilibrium levels of real output in product market.

SLOPE AND ITS POSITION

The IS curve is negatively sloped. This is because higher the rate of interest lower will be the investment spendings. This decreases the aggregate demand And thus the equilibrium level of income. The first determinant of the slope is the steepness of the slope of IS curve depends on how sensitive the investment spending is to the corresponding changes in interest rates. If the investment spending is very sensitive to th e interest rates then there would be a large change in the aggregate demand . And further the large change in the aggregate demand results in the large change of equilibrium level of income.

If there is a large change in income due to the change in interest rates then the IS curve will be flat. This was the situation in which investment spending is sensitive to the changes in interest rates. If the investment spending is not sensitive to the change in rates then the IS curve is relatively steep.

The second determinant of the IS curve is MPC (marginal propensity to consume). More the MPC steeper will be the aggegate demand curve.

The last determinant of the IS Curve is Tax rate. The increased taxes will result in the reduction in the slope of aggregate demand curve. Flatter aggregate demand curve means steeper IS curve due to increase in taxes.

POSITION OF IS CURVE

(Exogenous demand)

An increase in the exogenous demand results in an upward shift of the aggregate demand curve.