Macroeconomics

Lecture 13:
The IS Curve
Santosh Kumar Dash
IRMA, Anand
17-01-2024

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Agenda for Today’s Class

• The Construction of the IS Schedule

• Factors Determining the Slope of the 𝐼𝑆 Schedule
• Factors Shifting the 𝐼𝑆 Schedule
▪ Changes in Government Spending
▪ Changes in Taxes
▪ Changes in Autonomous Investment Spending
• Summary of the 𝐼𝑆 Schedule

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The Derivation of the IS Schedule
• The Keynesian cross is only a beginning step on our path to the IS–LM model and
derivation of the AD Curve.

• The Keynesian cross shows how the spending plans of households, firms, and the
government determine the economy’s income.

• Yet it neglects the role of interest rate 𝑟.

▪ Planned/desired investment depends on the interest rate 𝑟.

• The IS curve summarizes the relationship between the interest rate and the level of
income.
• The label 𝐼𝑆 comes from this simple version of the product market equilibrium
curve, an equality between investment (𝐼) and saving (𝑆).

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• Recall that the condition for equilibrium in the product market is
𝑌 =𝐶+𝐼+𝐺 (6.7)
• An equivalent statement of this equilibrium condition is
𝐼+𝐺 =𝑆+𝑇 (6.8)
• Absence of the government sector (i.e., 𝐺 = 𝑇 = 0)
• We can rewrite (6.8) as
𝐼(𝑟) = 𝑆(𝑌) (6.9)
• Equation (6.9) also indicates that investment depends on the interest rate and
saving depends on income.
• Our task is to find combinations of the interest rate and income that equate
investment with saving.

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• The interest-rate–income combinations (𝑟0 , 𝑌0 ), (𝑟1 , 𝑌1 ), and (𝑟2 , 𝑌2 ) are points
(A, B, C) along the 𝐼𝑆 schedule in part 𝑏.
• The 𝐼𝑆 schedule has a negative slope.
▪ For higher interest rate, the corresponding equilibrium income level is lower.

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Factors Determining the Slope of the 𝐼𝑆
Schedule
• Next, we consider the factors that determine the degree of the slope of the 𝐼𝑆
schedule.
• We know that the schedule will be negatively sloped, but will it be steep or
flat?
• Why it is important?
▪ The steepness of the 𝐼𝑆 schedule is a factor determining the relative effectiveness
of monetary and fiscal stabilization policies.

• In constructing the 𝐼𝑆 schedule, we saw how investment changes as interest

rate changes and then at the required change in income to move saving to
equal the new investment level.

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• In considering the steepness of the 𝐼𝑆 schedule, we are asking:
▪ Whether, at progressively lower interest rates, equilibrium in the product market
requires much higher income levels (the schedule is relatively flat) or
▪ only slightly increased income levels (the schedule is steep).

• The answer depends on the slopes of the investment and saving functions.

• Schedule 𝐼 is very steep, indicating that investment is not very sensitive to changes in
the interest rate;
▪ The interest elasticity of investment demand is low.

• Schedule 𝐼′ is relatively flat, indicating that investment is very sensitive to changes in

the interest rate;
▪ The interest elasticity of investment demand is high.

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• Where the investment schedule is steep (𝐼) in part 𝑎, a fall in the interest rate
will increase investment by a small amount. In part 𝑏, therefore, only a small
increase in saving and, hence, income is required to restore product market
equilibrium. Therefore, the 𝐼𝑆 schedule in part 𝑐 (𝐼𝑆 in this case) will be steep.

• Where the investment schedule is relatively flat (𝐼′), investment will increase
by a greater amount with a fall in the interest rate. Saving, and therefore
income, must then increase by a greater amount; the 𝐼𝑆 schedule for this case
(𝐼𝑆′) will be relatively flat.

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• This is the first of the factors determining the slope of the 𝐼𝑆 schedule.
▪ The schedule will be relatively steep if the interest elasticity of investment is low.
▪ The schedule will be flatter if the interest elasticity of investment is high.

• One extreme case for the slope of the 𝐼𝑆 schedule is when the interest
elasticity of investment demand is zero.
▪ i.e., , investment is completely insensitive to the interest rate.
▪ In this case, the investment schedule will be vertical and the 𝐼𝑆 schedule will also
be vertical.

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Factors Determining the Shift of the 𝐼𝑆
Schedule
• Next, consider the factors that determine the position of the 𝐼𝑆 schedule and
changes that shift the schedule.
• Here we drop the assumption that government expenditures and taxes are
zero; we bring the government sector back into the model.
• The 𝐼𝑆 schedule will shift when any or all of the components of autonomous
expenditures change: 𝑎, 𝑇, 𝐼, and 𝐺.
• With the government sector in the model, the condition for product market
equilibrium is given by (6.8), which we rewrite as:

𝐼(𝑟) + 𝐺 = 𝑆(𝑌 − 𝑇) + 𝑇 (6.10)

• We assume that tax collections are fixed exogenously.

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• The 𝐼 + 𝐺 schedule is downward sloping only because investment depends on the
rate of interest.
▪ The 𝐼 + 𝐺 schedule lies to the right of the 𝐼 schedule by the fixed amount of government
spending.
• Since tax collections are fixed exogenously, the saving-plus taxes schedule lies above
the saving schedule by a fixed distance (equal to 𝑇).

• With the inclusion of the government sector, the condition for equilibrium in the
goods market becomes 𝐼 + 𝐺 = 𝑆 + 𝑇.
▪ At an interest rate of 𝑟1 in part 𝑎, investment plus government spending will be equal to
𝐼1 + 𝐺. Therefore, equilibrium in the goods market requires that saving plus taxes, as
shown in part 𝑏, equal 𝑆1 + 𝑇 ( 𝐼1 + 𝐺), which will be the case at an income level 𝑌1 .
▪ Thus, the combination 𝑟1 , 𝑌1 is one point (B) along the IS schedule in part 𝑐.

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• We can now look at factors that would cause a shift in the IS schedule.
• The equilibrium condition given by (6.10) shows that a change in either the
level of government spending (𝐺) or the level of taxes (𝑇) will disturb an
initial product market equilibrium position—this will be a shift in the 𝐼𝑆
schedule.

• Further, an autonomous investment change that shifts the investment

function will shift the IS schedule.

• Recall that the factors that shift the 𝐼𝑆 schedule are those that determined
autonomous expenditures in the simple Keynesian model.

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Changes in Government Spending
• At interest rate 𝑟0 , investment plus government spending will be 𝐼0 + 𝐺0 , as
shown in Figure 6-14𝑎.
▪ An income level of 𝑌0 generates saving plus taxes just equal to this amount of
government spending plus investment (𝑆0 + 𝑇0 = 𝐼0 + 𝐺0 ).

• Now let government spending increase to 𝐺1 Figure 6-14𝑎 shows that this
increase shifts the investment-plus-government-spending schedule to the
right.

• By what amount the 𝐼𝑆 schedule shifts to the right, the horizontal distance
from A to B in Figure 6-14𝑐.

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• For each 1-unit increase in government spending, with taxes assumed
unchanged, to restore equilibrium at a given interest rate in the product
market, saving must be higher by 1 unit.
𝐼(𝑟) + 𝐺 = 𝑆(𝑌 − 𝑇) + 𝑇 (6.10)

• The amount of the horizontal shift in the 𝐼𝑆 schedule is 1/(1 − 𝑏).

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Changes in Taxes
• Next, consider the shift in the IS schedule with a change in taxes.
• The effect on the position of the IS schedule of a tax increase from 𝑇0 to 𝑇1 is
depicted in Figure 6-15 .
• For each 1-dollar increase in taxes at a given income level, taxes are higher by
1 dollar and saving is less by 𝑀𝑃𝑆 = (1– 𝑏) dollars.

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• The amount by which the 𝐼𝑆 schedule shifts to the left for a 1-unit increase in
taxes, −𝑏/(1– 𝑏), is just the tax multiplier from the simple Keynesian model.

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Autonomous Changes in Investment
• What can change the autonomous investment?

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• A favorable shift in expectations about the future profitability of investment
projects increases investment demand corresponding to each interest rate,
shifting the 𝐼(𝑟) schedule and hence the investment-plus-government-
spending schedule to the right in Figure 6-14a.

• From the previous class we know that an autonomous change in investment

will have the same effect as that of change in government spending.
▪ 1/(1 − 𝑏)
• Thus, shift the investment spending schedule shifts the 𝐼𝑆 schedule to the
right by 1/(1 − 𝑏) units per unit increase in autonomous investment
expenditures.

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Summary of the IS Schedule
• The IS schedule slopes downward to the right.
• The IS schedule will be relatively flat (steep) if the interest elasticity of
investment is relatively high (low).
• The IS schedule will shift to the right (left) when there is an increase
(decrease) in government expenditures.
• The IS schedule will shift to the left (right) when taxes increase (decline).
• An autonomous increase (decrease) in investment expenditures will shift the
IS schedule to the right (left).

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 Thank You

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