IS Curve

Monetary - Macro Economics. Hicks, Hansen analysis

1. THE IS CURVE
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. 2
Keynes’ Equilibrium
•Keynes showed equilibrium in the
commodity market.
•He assumed that Investment is
determined by a) rate of interest, and b)
marginal efficiency of capital.
•So investment is independent of the level
of national income.
•Investment determines NY, but level of NY
does not determine investment.
02/05/2016 Prabha Panth

3. 3
Keynes’ Equilibrium
•Keynes showed that change in money supply
affects Investment, and real output.
•When S
M, i , and Investment 
•Increase in investment leads to increase in
output and NY.
•Therefore when there is change in money
market, it affects the commodity or real
economy.
•But Keynes did not discuss how change in real
economy affects the money market, or the rate
of interest.
02/05/2016 Prabha Panth

4. 4
Interaction between Real and
Money markets
•Hicks, Hansen, Lerner and Johnson show that
there is a relationship between real and money
market.
•They show the interrelationship between I, NY, i,
D
M, and S
M.
•This is given by the IS-LM curves.
•It shows how the level of NY and i are jointly
determined by the simultaneous equilibrium in
the real and the money markets.
02/05/2016 Prabha Panth

5. 5
The IS curve
•The IS curve relates different equilibrium
levels of NY with various rates of i.
•When S
Mincreases, i falls, and planned or
private investment increases.
•When Investment increases, output and
income will also increase.
•At different interest rates, there will be
different impacts on Investment and NY.
02/05/2016 Prabha Panth

6. 6
Derivation of IS curve
0
Planned Investment
Rate of interest
I
i0
I0
I1
i1
I1
i2
I2
I2
C+I0
C+I1
C+I2
0
I
National Income
Y=C+S
Aggregate Demand
Y0
E0
I1
I2
Y1
E1
Y
E2
Y2
Y
Panel I
Panel II
A
B
C

7. 7
0
National Income
Y=C+S
Aggregate Demand
Y0
E0
I1
I2
Y1
E1
Y
E2
Y2
Y
National Income
0
Rate of interest
Y0
A
i0
i1
Y1
B
i2
Y2
C
IS
Panel II
Panel III
IS curve
derivation
continued

8. 8
The IS curve
•Definition: The IS curve is the locus of those
combinations of i and level of NY at which the
real or commodity economy is at equilibrium.
•When rate of interest fall, private investment
increases.
•This results in higher output and NY.
•So there is an inverse relationshipbetween
rate of interest and NY.
•The IS curve slopes down to the right.
02/05/2016 Prabha Panth

9. 9
The IS curve
•The position of the IS curve depends on
Government expenditure, or Autonomous
Investment and consumption.
•This investment is independent of i, or NY
•The steepness of the IS curve depends
on:
a) Elasticity of investment to i. The more the
responsiveness of I to i,the greater will NY
b) size of the multiplier k, the higher the value
of multiplier, the more NY will increase.
02/05/2016 Prabha Panth