1. 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

2. 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

3. 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

4. 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

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

6. 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

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

8. 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

9. 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

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

11. 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

12. 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

13. 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

14. 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

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

16. 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