Question

Derive the IS curve (you should show 4 (four) graphs). Shortly explain the derivation.

Answer 1

IS Curve explanation with suitable diagrams and its derivation:

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Meaning or Definition of IS Curve:

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The IS curve is a locus of points showing alternative combi­nations of interest rates and income (output) at which the goods market clears. That is why the IS curve is called the goods market equilibrium schedule.

Derivation of IS Curve with Four Graphs is explained below:

The derivation of IS curve can be made in terms of a four-part diagram as mentioned below:

Figure 1. In part (a), we have drawn investment function that shows the inverse relationship between investment and the rate of interest. Part (c) plots the saving function that represents direct relationship between income and saving. Part (b) is simply a 45° identity line, and part (d) plots the IS curve.

Suppose, the rate of interest is (ro). At this rate of interest, investment must be(Io) and thus, the volume of saving must be (So)necessary for equilibrium. This volume of saving implies an equilibrium income of Yonecessary for equilibrium. This establishes one point on part (d), say point M. If the rate of interest rises to r1, investment declines to I1. This results in a decline in national income to Y1. With this level of income the volume of saving becomes S1 (< Sn). This establishes another point on part (d), say point N.

The procedure may be repeated for each level of income (interest) to obtain corresponding values of interest rate (income value) that ensures equality between saving and investment. By joining all these equilibrium points, we get an IS curve drawn in part (d).

*Thus, the IS curve shows various combina­tions of income and interest rate that brings commodity market in equilibrium.

*The IS curve is negatively sloped. Its slope depends on the nature of saving and investment functions.

*The IS curve may shift if there is a change in autonomous consumption, private investment and government expenditure and taxes.

Autonomous increase in consumption demand, private investment expenditure and government spending cause IS schedule to shift to the rightward direction while an autonomous increase in taxes causes a leftward shift of the IS schedule. However, an equal increase in both taxes and government spending leads to a rightward shift of the IS curve.

Conclusion: We can discussion of IS Curve by mentioning below its Properties:

1. The IS curve is the equilibrium combinations of income and interest rate such that the product market or goods market is in equilibrium.

2. The IS curve slopes downward to the right because an increase in interest rate causes investment expenditure to decline, therefore, reduces aggregate demand and, hence, equilibrium national income.

3. Its slope depends on the saving and investment functions. The IS curve will be relatively steep (flat) if investment is less (more) sensitive to interest rate changes.

4.This IS curve will shift by an autonomous change in investment spending or government spending.

5. Any point on the IS curve shows that there is neither excess supply nor excess demand for goods. Any point off the IS curve shows either excess supply of goods (ESG) or excess demand for goods (EDG).

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