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IS-LM analysis: deriving the IS curve Extension Class Presentation Ruth Tarrant

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Consumption functions 45⁰ line C = a + bY Consumption (C) Income (Y) Yo a = y-intercept = autonomous consumption (i.e. the level of consumption when income is zero) b = slope of the line = marginal propensity to consume Income = consumption At Yo, we say there is equilibrium, as consumption = income

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Transferring this to Aggregate Demand 45⁰ line AD Income AD Yo 1. At Yo, the goods market in the economy is in equilibrium: AD = Y 2. In equilibrium, injections = withdrawals 3. So, we can assume that Savings = Investment

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Developing the IS curve An IS (Investments = Savings) curve shows the different combinations of income (Y) and interest rates (r) at which the goods market is in equilibrium

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r0r0 45⁰ line AD1 Income Aggregate Demand Income Interest Rate Assume that the rate of interest in the economy is r 0. At this rate of interest, aggregate demand is shown as AD1. So, when the rate of interest is r 0, the goods market of the economy is in equilibrium at y 0. Y0Y0 Y0Y0 We can now plot a point on the bottom diagram, at the intersection of r 0 and y 0. At this point we know that the goods market in the economy is in equilibrium

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r0r0 45⁰ line AD1 Income Aggregate Demand Income Interest Rate Y0Y0 Y0Y0 Now suppose that interest rates are lowered, to r 1. Lower interest rates boost consumer spending and investment, and so AD rises. We draw a new AD curve at AD 2. At this higher level of AD, the economy’s goods market equilibrium is achieved at Y 1. AD2 Y1Y1 Now we plot a point at the intersection of Y 1 and r 1 to indicate the point at which the goods market is in equilibrium. r1r1 Y1Y1

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r0r0 45⁰ line AD1 Income Aggregate Demand Income Interest Rate Y0Y0 Y0Y0 AD2 Y1Y1 r1r1 Y1Y1 We can repeat this process for all interest rates, and then plot all of the relevant points on the bottom diagram. If we join the dots, we create an IS curve. IS

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The slope of the IS curve Why might the IS curve be steep? Shallow? The slope of the IS curve depends on the sensitivity of AD to interest rate changes – If changes in interest rates only lead to a small change in AD, the IS curve will be steep – If changes in interest rates lead to a large change in AD, the IS curve will be shallow

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Shifts in the IS curve Remember, the IS curve shows the effect of interest rates in shifting AD and the resultant level of income If anything else changes, the IS curve will shift

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Shifts in the IS curve What would happen to the IS curve if: – Government spending increased? – Consumer confidence fell? – Business optimism about future profits improved?

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