Question

Explain in words how investment multiplier and the interest sensitivity of aggregate demand affect the slope of the IS curve.

Answer 1

The steepness of the IS curve depends on how sensitive investment spending is to changes in the interest rate, and also on the multiplier (K).

1. INVESTMENT MULTIPLIER:

Investment multiplier is a relationship between initial increment in investment and the resulting increment in national income. It is a measure of change in national income caused by change in investment.

We know that changes in investment spending bring about changes in income depending upon the value of multiplier. If investment spending is very sensitive to changes in interest rate, the value of multiplier is large and hence the change in income is also large which leads to flattening of the IS curve.

2. INTEREST SENSTIVITY OF AD

If investment spending is very sensitive to interest rate, then a given change in the interest rate produces a large change in aggregate demand, and thus shifts the aggregate demand curve up by a large distance.

a) Reduction in Interest Senstivity: A reduction in the interest rate results in an upward shift in the aggregate demand curve. This results in a higher equilibrium level of national income. So the interest rate went down and the equilibrium income went up.

b) Increase in Interest Senstivity: An increase in interest sensitivity results in a downward shift in both aggregate demand curves. The downward shift is more pronounced for the curve with the higher interest rate (i-1). This means that the distance between the two resulting equilibrium levels of income is larger.