Question

How do we drive the IS curve - what is the base for the derivation? Clearly state your argument.

Answer 1

IS curve shows combination of interest rate and income output such that planned spending equals income. So we have to find out equilibrium level of national income which is determined by the equilibrium in the goods market by level of investment which is determined by the given interest rate. Is curve connect different rate of interest with different equilibrium level. When interest rate falls planned investment increase and cause upward shift in aggregate demand function leads to higher level of equilibrium in goods market at higher level of national income. So, the IS curve is the base of combination of rate of interest and income output at which goods market is in equilibrium.

As shown in diagram interest rate fall from R2 to R1 and planned investment shift from C+I to C+I' which leads to shift in equilibrium from E to E' at different income output. In other diagram IS curve is derived from the combination of income output and rate of interest at different market equilibrium.

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