IS Curve
Hey Mumbai University SYBA IDOL students! Today, we’re diving into the fascinating world of Macro Economics , exploring about – “IS Curve“. Don’t worry if these terms sound a bit complex right now — we’ll break them down together in a simple and clear way.
In today’s class, we’ll first take a look at the IS-LM Model, which helps us understand how the commodity market (goods) and the money market are connected. It shows us how interest rates and income levels interact in an economy.
Next, we’ll focus on the derivation of the IS Curve – this curve shows combinations of income and interest rates where the goods market is in equilibrium. We’ll also learn how the IS Curve can shift and what causes these changes, using easy-to-understand diagrams.
Finally, we’ll explain how the goods market reaches equilibrium, again with the help of a diagram, so that you can visually understand how everything fits together.
So, SYBA IDOL Mumbai University students, get ready to unwrap the “IS Curve” with customized IDOL notes just for you. Let’s jump into this exploration together
Question 1 :- Give note on IS-LM Model of Integration of Commodity and Money Market
Introduction:
The IS-LM model is a fundamental tool in macroeconomics that illustrates how the goods market and the money market interact to determine national income and interest rates. Developed by economists like J.R. Hicks in the Keynesian framework, this model demonstrates the relationship between investment, saving, money demand, and money supply. The main components of the model, the IS curve and the LM curve, represent two critical markets in an economy—the goods market and the money market, respectively. Understanding this model is crucial for analyzing economic fluctuations and guiding fiscal and monetary policy.
In the context of the IS-LM model, the IS curve signifies the set of combinations of interest rates and national income that leads to equilibrium in the goods market. Essentially, this curve shows where the total demand for goods and services equals total supply. On the other hand, the LM curve represents the equilibrium in the money market, where the demand for money equals the supply of money. Together, these curves help us understand how changes in economic policies, such as changes in interest rates or government spending, can influence overall economic activity.
Key Components of the IS-LM Model:
- IS Curve:
- The IS curve reflects the relationship between interest rates (i) and the level of income/output (Y) in the goods market.
- It is derived from the idea that, at any point on the IS curve, savings (S) equal investment (I). This means that when national income rises, total savings increase, necessitating a corresponding level of investment for equilibrium.
- The IS curve slopes downward, indicating that lower interest rates lead to higher levels of investment and income. As interest rates fall, borrowing becomes cheaper, encouraging businesses to invest more, thus increasing aggregate demand.
- LM Curve:
- The LM curve illustrates the relationship between interest rates and national income in the money market.
- It is based on the premise that the demand for money (L) is a function of income and the interest rate. Higher income leads to a higher demand for money for transactions, while higher interest rates reduce the demand for money as the opportunity cost of holding money increases.
- The LM curve typically slopes upward, meaning that higher levels of income require higher interest rates for the money market to stay in balance.
- Equilibrium:
- The overall equilibrium in the economy is determined by the intersection of the IS and LM curves. This point represents the simultaneous equilibrium in both the goods market and the money market, indicating a stable level of national income and interest rate that satisfies both markets.
- At this equilibrium, the economy’s total output matches the total demand for goods and services, and the money supply equals money demand.
- Shifts in the Curves:
- Various factors can cause shifts in the IS and LM curves. For example, an increase in government spending can shift the IS curve to the right, indicating higher demand for goods at every interest rate. Conversely, changes in the interest rates can also lead to a shift in the LM curve, affecting the overall equilibrium.
- Events such as changes in consumer confidence, investment levels, or monetary policy conducted by the central bank can result in shifts in these curves, significantly impacting the economy’s income and interest rates.
Conclusion:
The IS-LM model is a vital framework for understanding the interactions between the goods and money markets in an economy. By examining how interest rates and national income are determined through the IS and LM curves, economists can analyze the effects of fiscal and monetary policies, providing insights into how to stabilize the economy during fluctuations. The model serves as a foundational concept in macroeconomic theory, linking various economic variables in a coherent manner and highlighting the critical equilibrium in the goods and money markets. Thus, it is an essential tool for policymakers and economists alike in their quest to manage economic performance effectively.
Question 2 :- Explain Derivation of IS Curve and Shift in IS Curve with the help of diagram
Introduction:
In macroeconomics, the IS curve plays a very important role in understanding the relationship between the interest rate and national income (or output) in the goods market. The term “IS” stands for Investment-Saving, and the IS curve represents all combinations of interest rates and income levels where the goods market is in equilibrium — that is, where aggregate demand equals aggregate supply.
The IS curve is negatively sloped, meaning that as interest rates fall, investment increases, which in turn raises output or income. It is derived from the equilibrium conditions in the Keynesian Cross Model, where a fall in interest rate causes an increase in investment and thereby shifts the Aggregate Demand (AD) curve upward. This change is reflected in a new equilibrium output level. By tracing these changes at different interest rates, we derive the IS curve.
Further, the IS curve can also shift when there is a change in autonomous spending components such as government expenditure, private investment, or net exports, even when the interest rate remains the same. This shift represents a new equilibrium condition in the goods market.
A– Derivation of IS Curve:
Diagram:-
Explanation:-
1. Upper Panel – Aggregate Demand Curve:
The upper part of the diagram shows two aggregate demand (AD) curves.
When the interest rate falls from i₁ to i₂, it leads to an increase in investment.
As a result, the Aggregate Demand curve shifts upward from AD₁ to AD₂.
This upward shift causes the equilibrium income to rise from Y₁ to Y₂.
The two new equilibrium points are E₁ (with income Y₁ at interest rate i₁) and E₂ (with income Y₂ at interest rate i₂).
2. Lower Panel – Deriving IS Curve:
- In the lower diagram, we plot the same interest rate and income/output combinations from the upper panel.
By joining the points (i₁, Y₁) and (i₂, Y₂), we get a downward sloping IS curve.
This curve shows an inverse relationship between interest rate and income: as interest rate decreases, income increases, and vice versa.
3. Slope of IS Curve: The slope depends on two key factors:
- MPC (Marginal Propensity to Consume) – How much consumption increases when income increases.
- b (sensitivity of investment to interest rate) – A higher ‘b’ means investment is more sensitive to interest rate changes.
- A higher MPC and greater interest sensitivity (high b) lead to a flatter IS curve.
- A lower MPC or lower b makes the IS curve steeper.
B– Derivation of IS Curve:
Diagram:-
Explanation:-
The IS curve shifts when there is a change in any autonomous component of Aggregate Demand, such as:
Government spending (G),
Private investment (I),
Exports (X),
Or other components like autonomous consumption.
1. Cause of Shift:
In Diagram, the IS curve shifts from IS₁ to IS₂.
This happens due to an increase in autonomous investment (ΔA) or spending, without changing the interest rate.
In the upper panel, this is shown by the upward shift in AD curve from AD₁ to AD₂, raising income from Y₁ to Y₂ at the same interest rate i₁.
2. Representation in IS Curve (Lower Panel):
As a result of this change, the IS curve shifts to the right from IS₁ to IS₂.
Both curves are drawn at the same interest rate i₁, but due to increase in spending, the income level increases from Y₁ to Y₂.
This shows that even when interest rate is constant, a rise in autonomous demand causes a shift in IS curve to the right.
3. Horizontal Distance Between IS Curves:
The gap between IS₁ and IS₂ depends on:
The Multiplier (K) – Higher multiplier means greater shift.
The change in investment or spending (ΔA) – Bigger the change, wider the shift.
So, greater the multiplier and investment, more the IS curve will shift.
C– Key Points to Remember:
The IS curve shows equilibrium in the goods market.
It is downward sloping due to the inverse relationship between interest rate and income.
It is derived from changes in equilibrium income/output due to changes in interest rate.
A fall in interest rate → higher investment → higher income → moves along IS curve.
A change in autonomous spending → shifts the whole IS curve left or right.
The slope and shift depend on factors like MPC, sensitivity of investment to interest rate, and multiplier effect.
Conclusion:
To sum up, the IS curve helps in understanding how interest rates affect national income through investment and consumption. It is derived from changes in aggregate demand and output, and it shifts when there is a change in autonomous components of demand. Understanding the IS curve is essential in analyzing macroeconomic policies and the equilibrium of the goods market.
Important Note for Students :– Hey everyone! All the questions in this chapter are super important!