IS Curve Derivation: Equilibrium in the Goods Market

IS Derivation: How do changes in interest rates affect the equilibrium in the goods market?
 Beginning at equilibrium, we know that AE=Y and S=I (Point A in the AE/Y model).

 An increase in the interest rate (Middle Graph: A-B) leads to lower investment spending (I-I’). The
lower investment spending leads to AE<Y (Left Graph A-B).
 In order for the goods market to be in equilibrium at the new interest rate, Output/Income must decrease
(Y*-Y1) to be at the same level as aggregate expenditure, which is now lower (iIAEY).
When we first studied the equilibrium adjustment in the goods market it was shown that either income
or the interest rate had to change (income adjustment or interest rate adjustment) whenever AE>Y or
AE<Y.
 The IS curve reflects the fact that as the interest rate changes, income must change as well to
compensate for the change in AE caused by the interest rate change to ensure that AE=Y.
 Therefore, at an interest rate of i*, equilibrium in the goods market occurs at Y* (Graph AbovePoint
A on the IS curve AE=Y*). At an interest rate of i’, equilibrium in the goods market occurs at Y1 (Point
B on the IS curve).
 iIAEY
 iIAEY
Disequilibrium in the IS Model:
 Starting at point A (Graph Below), an increase in income moves the
equilibrium to point B which is off the IS curve (to the right). This is because
income increased, but AE is still at A, so we have Y>AE. At point B two
things could happen, the interest rate could decrease increasing Investment
leading to an increase in AE to point E. On the other hand, income could
decrease moving back to point A.
o To the right of the IS curve, the goods market is in
disequilibrium with Y>AE.
 Starting at Point C, a decrease in the interest rate leads to point D. With output
unchanged, AE moves to point D as the lower interest rate increased
investment. Therefore, at point D, AE>Y. Either output increases to match
AE at Point A or the interest rate has to increase to decrease AE to point
C.
o To the left of the IS curve, the goods market is in disequilibrium
with AE>Y.

Open Economy IS Derivation: How Do Interest Rates Affect Output

 Beginning at equilibrium, we know that AE=Y and S=I (Point A in the AE/Y model).
 In an open economy, we know that net exports now become part of aggregate expenditures.
 o IS=AE=C+I+G+NX
Relationship between i and Y.
 Closed Economy Relationship: i S(C) & iInvestmentAEY: A-B & Multiplier Effect
to C
 Open Economy Relationship: iInflowsS€R ($ Appreciation)NXAEY: A-B &
Multiplier Effect to C
 i(C, I, NX)A-BMovement Up the IS Curve.

An increase in the interest rate (Second Graph: A-B) leads to lower investment spending (I-I’ A-B). The
higher interest rate increases capital inflows causing the Domestic Dollar ($) to appreciate leading to
lower exports and higher importsNX third graph (A-B). In addition, a higher interest rate leads to
higher savings and lower consumption.
 In order for the goods market to be in equilibrium at the new interest rate, Output/Income must decrease
(Y*-Y1) to be at the same level as aggregate expenditure, which is now lower (iI, NX,
CAEY). The decrease in aggregate spending causes output and expenditure to decrease
through the multiplier effect.

Shifts in the IS Curve

 All points along the IS curve show the combinations of interest rates and income that yield equilibrium
in the goods market (AE=Y & S=I).
 As we will see, when other factors, like changes in the money market, cause interest rates to adjust,
equilibrium income in the goods market changes by moving up and down the IS curve. However, other
factors can increase or decrease the equilibrium level of income in the goods market other than interest
rate changes.
 The important point to remember is if the shock or change is caused by the interest rate changing, it is a
movement along the IS curve.
 On the other hand, changes in AE not caused by interest rate changes will cause shifts in the IS curve.
When shifting the IS curve to the right, we are showing higher income levels with interest rates
unchanged. Similarly, when we shift the IS curve to the left, we are showing lower income with interest
rates unchanged.
 Changes in consumption/savings, government spending, investment, taxes, and net exports can all
change for reasons unrelated to the interest rate. Any time there is an increase in aggregated
expenditures (leading to AE>Y), we know that firms will increase production leading to higher income
without changes in the interest rate. Similarly, anytime there is a decrease in aggregate expenditures
(AE<Y), firms will cut back production leading to lower income at every level of the interest rate.
 As such, increases in aggregate expenditures (not caused by changes in interest rates) lead to higher
levels of equilibrium income at the same interest rate (Shift the IS curve to the right). Decreases in
aggregate expenditures (not caused by changes in the interest rate) lead to lower levels of equilibrium
income at the same interest rate (Shift the IS curve to the Left).
 Since increases in AE lead to higher income at the same interest rate, this
must be shown by a rightward shift in the IS curve.
 o AEIS (IS-IS’)Y*Y1 (Point A-C)No Change in interest rate
 In addition, since decreases in AE lead to lower income at the same interest rate, decreases in AE must
be shown by leftward shifts in the IS curve.
o AEIS (IS-IS’’)Y*Y-1 (Point A-B)No Change in interest rate

Variable Factors Affecting Variable ∆ AE IS ∆ AE IS

Consumption (YD(+), W(+), S(i)(-), YFuture(+), P(-))      
Tax Policy      
Government Sp. Policy      
Investment i(-), Exp. Profit(+), Financial Frictions(-)      
r (rI, C) & (rI, C)   MV   MV

IS C I G X M IS Curve
Wealth  
Future Income  
Savings  
Expansionary Fiscal Policy: G or T (T) (G) 
Price (W/P)   
Income   IS MV
Expectations   
i  (S)    IS MV

Any Increase in C, I, G, or NX below Full Employment

 Y=1000, I=150, S=150, X=0, M=0, MPC=0.6, MPS=0.25, and MPM=0.15.
 AE by 100:
o Y by 250, S by 62.50, M by 37.50

 As we can see, the increase in AE increases output/income by

250 with no change in the interest rate. Therefore, we show the
increase in C, I, G, or NX by rightward shift in the IS curve to
reflect increased output/income at every level of the interest rate.
 Any decrease in C, I, G , or NX would cause the IS to shift left reflecting a decrease in
output/income at every level of the interest rate.
 Key Issue:
o The increase in income shown in the IS model includes the multiplier effect.
Therefore, the IS curve rolls up all of the adjustments we have seen in the goods
market to reach equilibrium.
o If we were using taxes, a decrease in taxes would work the same, except the change
income would be a bit smaller since part of the decrease in taxes went back into
savings.
 What’s Missing from the Analysis: There are several key assumptions that we have made,
that when relaxed, will cause adjustments in goods market. These feedback mechanisms will
be incorporated as we move through the course.
o We have assumed that firms increase output without demanding higher prices.
However, what we will soon find out is that firms increase prices with higher output.
As such, once we get to the new equilibrium from increased AE (C, I, G, or NX),
firms raise their prices, which will cause a decrease in C, I, and NX. Therefore,
including prices will causes a small decrease in AE. Therefore, the 100 increase in
AE above may only lead to a 175 increase in income/output after we take into
account the price feedback mechanism.
o We have also assumed that economic agents always have access to cash to carry out
the transactions. Essentially this assumes that the central bank increases the supply of
money to support any increase in transactions in the economy. However, if we relax
this assumption, what we find is that when agents have more income coming in, but
do not have access to the cash yet (think of getting raise, but you have not been paid
yet), in order to spend they have to take the money from savings (this is also shown as
money demand being greater than money supply), which will cause a slight increase
in the interest rate and a slight decrease in consumption and investment. Therefore,
we have an additional feedback mechanism that reduces the final increase in
income/output.
o Finally, we have also assumed that every dollar that NX is negative (imports>exports) will be
met by a capital inflow without the need to increase the interest rate. If the interest does have
to increase that will cause a similar adjustment downward to income the same as the increase
money demand caused in the previous assumption. In addition, we may also see that instead
of foreigners lending money to us, they may choose to purchase our goods instead. In this
scenario, the shortage of loanable funds caused by the imports would be replenished through
the multiplier effect (at least partially) form the higher exports (AE) reducing the need for
inflows. Remember, if X increases, NX increases, and when NX=0 S-I=0NCO=0.