The Goods Market and the IS Curve Summary so far: We are using the IS-LM model to derive the aggregate demand curve to study economic fluctuations in the economy in the short run IS-LM model is an interpretation of John Maynard Keyne’s theory on aggregate demand We need to first derive the IS Curve, which relates to the goods market. IS = Investment and Saving To derive the IS Curve we use the Keynesian Cross From the Keynesian Cross, we studied the Government purchases multiplier and the tax multiplier (you need to know the formulae for these) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve The IS Curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services The Keynesian Cross is one part of deriving the IS Curve, i.e. it will give us the level of income The Investment function as the other part of deriving the IS Curve, i.e. it will give us the interest rate Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Investment function: We write the level of planned investment as : I = I(r) where, I = Investment, r = real interest rate Because the interest rate is the cost of borrowing to finance investment projects, an increase in the interest rate reduces planned investment Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Investment Function: Investment function slopes downward Negative relationship between investment and the real interest rate Note: we met the investment function already in chapter on income See graph on investment function Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Investment Function Interest rate (r) r1 I (r) I(r1) Investment (I) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve To derive the IS Curve we use: The Keynesian Cross and The Investment Function Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Deriving the IS Curve (see previous graph): Initially we start with interest rate r1 This gives us a quantity of investment of I(r1) At this amount of investment, the planned expenditure line crosses actual expenditure in the Keynesian cross to give an income level of Y1 in the economy Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Deriving the IS Curve: Therefore, at interest rate r1 ,income is Y1 Plot this as one point showing the relationship between interest rates and income in the goods market Then assume the interest rate rises to r2 and see what happens to income If the interest rate rises, investment falls to I(r2) Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Deriving the IS Curve: If investment falls, the planned expenditure line must shift downward because at any level of income, expenditure is now lower than it was before – this is represented by a shift downward of the planned expenditure line E (Planned Expenditure) = C(Y-T) + I + G New line crosses 45 degree line (actual expenditure) and this shift causes income to fall to Y2 Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve Deriving the IS Curve: Therefore, at interest rate r2, income is Y2 An increase in interest rate led to a decrease in income Plot this as another point showing the relationship between interest rates and income in the goods market Join the two dots together and you get a downward sloping IS Curve Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve IS Curve: summarises this relationship between interest rates and income Because an increase in the interest rate causes planned investment to fall, which in turn causes income to fall, the IS Curve slopes downward. Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: Fiscal policy means a change in Government Purchases or taxes When we constructed the IS Curve we held G and T fixed What if government purchases increase from G1 to G2 (assume r and therefore I are held constant) We saw already that this would cause the planned expenditure line to shift upwards Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: This upward shift in the expenditure line would result in higher income: from Y1 to Y2 Interest rates have stayed the same, but income has increased, therefore, this would be represented by a shift outward of the IS curve: from IS1 to IS2 See Graph Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

The Goods Market and the IS Curve How fiscal policy shifts the IS Curve: In summary: Expansionary Fiscal Policy (increase in Government Purchases or decrease in taxes) will shift the IS Curve to the right Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10