Topic 1 The I-S Curve

Introduction
The I-S curve sets out all the possible combinations of real
income (y) and the interest rate ( r ) consistent with equilibrium
in the goods market
A change in the rate of interest, r, affects equilibrium national
income via the following route:-

Via the
multiplier

Where r is the change in the interest rate, Iis the change in

Investment and y is the change in real national income/output.
Consider each of these 2 steps in turn

STEP 1 Investment and the Rate of Interest

Investment is the purchase of capital goods ( i.e. plant,
machinery, land, buildings etc..). Investment is flow of
expenditure per period (e.g. per quarter or per annum). If the
volume of investment in a period is greater than the erosion of
the capital stock due to wear and tear (depreciation), the capital
stock will be increasing.
Typically, firms borrow to finance investment.
At high rates of interest, the cost of borrowed money will be
high and few investment projects will be viable.
As interest rates fall, more and more investment projects
become profitable.

Therefore there is a negative relationship between r and I as set

out in Figure 1
Figure 1 - The Investment Schedule

r0

Note that as interest rates fall from r0 to r1, investment rises from I0 to I1
r1 To sum up Step1:- r leads to I such that an increase in r reduces
investment expenditures and a fall in r increases investment
expenditures.
I= I(r)

Step 2:- Investment and Equilibrium IncomeI

I0 a simple
I1 model of national income determination for a
Consider
closed economy with a government sector.

Equation 1:- Aggregate Demand

AD = C + I + G
Where
and

AD is Aggregate Demand,
C is Consumers Expenditure or Consumption
I is the level of Investment
G is the level of Government Expenditure

Equation 2 :- The Consumption Function

C = a0 + byD
Where
and
Note

a0 is autonomous consumption
b is the marginal propensity to consume
yD is disposable or after tax income
yD = y ty where t is the income tax rate
= (1-t)y

ThereforeC = a0 + b (1-t) y
The Consumption Function is set out in Figure 2
C
Figure 2 - Consumption Function
C= a0+b(1-t)y
Slope of function is b(1-t)

a0
y

Equation 3:- The Investment Schedule

I = I(r ) as set out above.
N.B. we will assume a linear or straight line investment schedule.

Equation 4:- Government Spending

G = G0 i.e. government spending is exogenous it is the level
decided upon by the Government.
Equation 5 :- Equilibrium Condition
AD = y [ aggregate demand is equal to output]
Finding The Reduced Form
The above model contains 5 equations. We will simplify matters by
finding an expression for y in terms of
The structural parameters (i.e b and t)
The exogenous or autonomous variables (i.e. a0 , I(r ), and G0)
This process is termed computing the reduced form and involves
substituting Equations 2, 3 and 4 into Equation 1 and re-arranging
Thus
AD = y = C + I + G
y= a0 + [b(1-t)y] + I(r ) + G0
Note that we have y on both sides of this expression. Re-arranging
yields
y-[b(1-t)y] = a0 + I(r) + G0
Therefore
y(1-b(1-t)) = a0 + I(r) + G0

and by dividing both sides by (1-b(1-t)) we obtain Equation 6 which

is an expression for y in terms of the structural parameters and the
exogenous variables.
Equation 6 :- The Reduced Form

y = 1/(1-b(1-t)) * [a0 + I(r) + G0 ]

where
1/(1-b(1-t)) is termed the multiplier (Equation 7)
Equation 6 tells us that the level of equilibrium output in the goods
market is the product of the levels of the autonomous/exogenous
variables times the multiplier.
From Equation 6 we can derive Equation 8
y = 1/[1-b(1-t)] * [a0 + I(r ) + G0]
Equation 8 indicates that the change in the level of equilibrium
income equals the change in the levels of the autonomous variables
times the multiplier.

Derivation of the I-S Schedule

1/ Numerical Example
Recall that we defined the I-S curve as representing all the
combinations of r and y consistent with equilibrium in the goods
market. Equation 6 gives us an expression for y in terms of a number
of variables including I(r ). We can derive the I-S curve by varying r
and examining what happens to y.
Evaluation of the Multiplier
Let b = marginal propensity to consume = 0.8
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Let t = tax rate = 0.25

We can plug these numbers into Equation 7 to find a value for the
multiplier
Multiplier = 1/[1-b(1-t)] = 1/[1-(0.8(1-0.25))] = 1/[1-(0.8 * 0.75)]
= 1/[1-0.6]
= 1/[0.4]
= 2.5
Evaluation of the Exogenous/ Autonomous Components
The following table sets out the levels of the exogenous variables for
different rates of interest. Note that investment is the only
autonomous variable which varies with r.
r
5%
10%
15%

a0
100
100
100

I(r )
80
60
40

G0
60
60
60

A
240
220
200

ye
600
550
500

For r = 5% , A, the sum of the autonomous components is 240

Equilibrium y = ye = multiplier * A
= 2.5 * 240
= 600
Graphing r against y yields the downward sloping I-S schedule.

2/ Graphical Derivation
AD

AD = y
AD2 [r= 5%]
AD1 [r=10%]
AD0 [r=15%]

Figure 3 (a)

y
r
15%
Figure 3 (b)
10%
5%

I-S
y0

y1

y2

Figure 3(a) indicates that falls in the rate of interest from 15% to 10% to 5%
engender increases in investment resulting in aggregate demand rising from
AD0 to AD1 to AD2. These increases in AD cause equilibrium output to rise
from y0 to y1 to y2.
Figure 3(b) sets out the relationship between r and y. As r falls investment
increases driving up equilibrium output, via the multiplier, from y0 to y1 to y2
Note:- Every point along the I-S schedule represents a possible equilibrium
level of national income/output
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What Determines The Slope of the I-S Curve

The slope of the I-S curve depends on 2 factors
1. The slope of the Investment Schedule
2. The size of the Multiplier
Consider each in turn:-

1/ The Slope of the Investment Schedule

If investment is very sensitive to changes in interest rates, then a small change
in r will summon forth a large change in investment expenditure. This results
in a large change in equilibrium output. Thus, a flat or relatively interest
elastic investment curve results in a flat I-S curve.
If investment is not very sensitive to changes in the rate of interest, then a
small change in r will engender a relatively small increment in I and
corresponding small change in equilibrium output. Thus, a steep or interest
inelastic investment schedule produces a relatively steep I-S schedule.
Both cases are set out in Figure 4

Figure 4

I-S (interest
elastic investment
I-S (interest inelastic
investment)

2/ The Role of the Multiplier

The size of the multiplier determines the size of the change in equilibrium
output for a given A
The larger the multiplier, the larger the response of y to a given change in r
and I. Thus, the larger the multiplier, the flatter the I-S curve.
The smaller the multiplier, the smaller the y given r and I. Thus, the
smaller the multiplier, the steeper the I-S curve.
Recall Equation 7 which sets out the mathematical formula for the multiplier:-

Multiplier = 1/(1-b(1-t))
Clearly, a change in either b, the marginal propensity to consume or t, the tax
rate, will cause the size of the multiplier to change. Consider each in turn:The effect of an Increase in the mpc on the Multiplier.
If b=0.8 and t =0.25, then we have already established that the multiplier will
have a value of 2.5.
If b rises to 0.9
Multiplier = 1/(1-b(1-t)) = 1/[1-((0.9)(0.75))] = 1/(1-0.675) = 3.08
Thus, a rise in the mpc will increases the size of the multiplier and lead to a
larger impact on real income from an interest rate induced change in
investment.
Numerical Example
r
5
10
15

y (mult=2.5)
600
550
500

A
240
220
200

y (mult=3.08)
739.2
677.6
616.0

By plotting these outcomes you can establish that a rise in the mpc will cause
the I-S curve to shift out and flatten.
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The Effect of an increase in the Tax Rate on the Multiplier

Suppose b = 0.8 and the tax rate rises from 25% to 30%. For t=0.25, the
multiplier, D = 2.5.
For t = 0.3
D = 1/(1-(0.8*0.7)) = 1/(1-0.56) = 1/(0.44) = 2.27
A lower multiplier results in equilibrium output being lower for any rate of
interest. The higher ye , the greater the drop in ye ,(ye), for a given reduction in
the size of the multiplier.
The change in Equilibrium Output given a Change in the Multiplier
We have seen that
1. A rise (fall) in the mpc will increase (decrease) the multiplier
2. A rise (fall) in the tax rate will decrease (increase) the multiplier
Note further that, if the multiplier rises by x% then equilibrium output for a
given r will also rise by x%.
Proof
Let ye1 = D1*A and ye2 = D2*A
Where A is the sum of the autonomous components
and
D is the multiplier and D1< D2
ye2 - ye1 = (D1*A) (D2*A) = A (D1 D2)
The percentage change in y is given by
[(ye2 - ye1)/ ye1] * 100 = [A*(D1 D2)] / [A*D1] *100
= [(D1 D2)/ D2] *100
As ye increases, an x% increase in the multiplier will result in a
correspondingly greater difference between ye1 and ye2 . i.e. the I-S curve
flattens

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Numerical Example
Consider a 20% rise in the size of the multiplier (e.g. from 2.5 to 3.0)
r

Ye0 (d = 2.5)

A
20.0
17.5
15.0
12.5
10.0
7.5
5.0

40
50
60
70
80
90
100

Ye1 (d=3.0)

100
125
150
175
200
225
250

120
150
180
210
240
270
300

Plotting this data in Figure 5 shows the I-S curve flattening

Figure 5

I-S (high multiplier)

I-S (low multiplier)

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y
20
25
30
35
40
45
50

What Causes the I-S Curve to Shift

A rise in any of the autonomous components for a given rate of interest will
cause a parallel shift in the I-S schedule. Suppose the multiplier, D= 2.5 and
A rises by 20. Equilibrium output will rise as follows
r
5
10
15

A1
240
220
200

y1
600
550
500

A2
260
240
220

y2
650
600
550

This could result from

a0 = 20 [upward shift in the consumption function]
I(r) = 20 [outward shift in the investment function]
G = 20 [increase in government spending ]
Government spending can be increased at the behest of the government. We
will discuss shifts in a0 and I(r ) later when we consider consumer and business
confidence.

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Graphical Derivation

AD

AD = y
AD [r= 5%, A=A1]
AD [r= 5%, A=A0]
AD [r=10%, A=A1]
AD [r=10%, A=A0]

y
r
15%
10%
5%

I-S [A = A1]
I-S [A = A0]
y
y0

y1

y2 y3

A rise in either a0 or G0 (or any autonomous component of investment) will

causeA to rise, at any given rate of interest r. If A rises from A0 to A1, then y
= D* A will rise from y0 to y1 and from y2 to y3.
A rise in A results in a higher equilibrium y for any given rate of interest (i.e.
the I-S curve shifts out)

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Key Learning Objectives

After reading this handout you should be able to
Derive the I-S schedule, both graphically and mathematically
Understand the economics underlying it- i.e A change in the rate of interest
causes investment to change. A change in the volume of investment will alter
aggregate demand and thus, via the multiplier, equilibrium national output.
Thus, changes in r cause movements along the I-S curve.
Determine that the slope of the I-S curve depends on
1. The interest elasticity of investment. The more responsive investment is to
a change in the rate of interest (i.e. the more interest elastic investment is)
the greater the change in investment for a given change in interest rates and
thus the greater the impact on equilibrium national output for a given r .
Thus, the greater the interest elasticity of investment, the flatter the slope of
the I-S schedule
2. The size of the multiplier. The greater the size of the multiplier, the greater
the change in equilibrium output for a given change in investment. Thus,
the larger the multiplier the flatter the slope of the I-S curve
Determine the factors that cause the I-S curve to shift. The I-S curve is derived
by varying r and establishing what happens to equilibrium y. This exercise
assumes that a0, G0 (and any autonomous component of investment demand)
are held constant. If any of these autonomous components change, then the I-S
curve will shift. (e.g a rise in G0 will cause the I-S curve to shift out).
Jim Stevens
OCTOBER 2004.

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