SESSION 11a

Reading
1. This set of slides
2. From the text material
Chapter - 5
THE GOODS MARKET
 Investment and interest rates

As interest rates (r) rise, planned investment spending (I)

decreases. Only planned investment decreases, not
inventory accumulation.

r I
Reason:

1. Most investment projects are financed by borrowing funds from the

banks and other financial intermediaries.

So, as interest rate (r) cost of borrowing Investment

2. Even if firm is using its own internal funds and not borrowing from
external sources to finance investment,
r investing in physical capital becomes less attractive relative to
lending out for higher interest rate Investment
A more subtle reason:

Suppose the firm considers investing in a project.

Suppose annual interest rate = r
The expected returns from the project :
R1 in 1st year, R2 in 2nd year, R3 in 3rd year,.. Rn in nth year

Net Present Value of this income stream = NPV

= [R1/(1+r)] + [R2 /(1+r)2] + [R3 /(1+r)3] .. + [Rn /(1+r)n] - Cost

The firm invests in the project if NPV > 0

If r then NPV , may be to 0 or < 0

Thus as r rises, firm decides not to undertake some of the less profitable
projects.
Hence number of investment projects fall.
 Interest rate r & consumption expenditure C

As interest rate rises consumers also decide to delay or reduce their

consumption of durable goods.

r C
Investment and aggregate demand

r I, C AD = [C + I + G]
 AS
AD, AS
AD (r2)
Deriving the IS curve:
AD (r1)
Relation between
interest rate and
output such that the
goods market is in Y
equilibrium r Y1 Y2

r1

r2
IS CURVE

Y
Y1 Y2
 r

r1
AD < AS

r2
AD > AS IS CURVE

Y
Y1 Y2

Initially the economy was in eqm. with int. rate = r1 and income Y1.
If r falls to r2 I rises AD rises off the eqm level Y rises to Y2
AD > AS at all points on the left of the IS curve.
Say, the economy is on equilibrium with int. rate r1 and income Y1.
If output rises to Y2 AS rises off the eqm level
AD < AS at all points on the right of the IS curve.
 Mathematically:
C = a + cY
I = f g.r
AD = C + I = a + f + cY gr
r
AS = Y

In equilibrium: AD = AS
Or, C + I = a + f + cY gr = Y
IS CURVE
Or r = (a+f)/g [(1-c)/g]Y
This is the equation to the IS curve.
Y
Slope = -(1-c)/g = -s/g
Intercept: (a+f) / g
 How will an expansionary fiscal
policy affect the IS curve?

G AD Y at the given
level of interest rate.
r
This implies a shift of the IS curve
right ward.

IS IS

Y
Exercise

State true or false:

1. The IS curve is downward sloping because goods market equilibrium
implies that an increase in taxes leads to a lower level of output.

1. The IS curve is downward sloping because increase in government

spending decreases private investment.

2. If both government spending and taxes increase by the same amount

the IS does not shift.