Goods Market

Equilibrium:
Derivation of the IS
Curve
 Derivation of IS Curve

The IS-LM curve model emphasizes the interaction between the goods and money markets. The
goods market is in equilibrium when aggregate demand is equal to national income. The
aggregate demand is determined by consumption demand and investment demand.
In the Keynesian model of goods market equilibrium we also now introduce the rate of interest as
an important determinant of investment. With this introduction of interest as a determinant of
investment, the latter now becomes an endogenous variable in the model. When the rate of
interest falls the level of investment increases and vice versa.
Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by
causing changes in the investment demand. When the rate of interest falls, it lowers the cost of
investment projects and thereby raises the profitability of investment. The businessmen will
therefore undertake greater investment at a lower rate of interest.
The increase in investment demand will bring about increase in aggregate demand which in turn
will raise the equilibrium level of income. In the derivation of the IS curve we seek to find out the
equilibrium level of national income as determined by the equilibrium in goods market by a level of
investment determined by a given rate of interest.

Thus IS curve relates different equilibrium levels of national income with various rates of
interest. With a fall in the rate of interest, the planned investment will increase which will
cause an upward shift in aggregate demand function (C + I) resulting in goods market
equilibrium at a higher level of national income.
The lower the rate of interest, the higher will be
the equilibrium level of national income. Thus,
the IS curve is the locus of those combinations
of rate of interest and the level of national
income at which goods market is in equilibrium.
How the IS curve is derived is illustrated in Fig. 20.1.
In panel (a) of Fig. 20.1 the relationship between
rate of interest and planned investment is depicted
by the investment demand curve II.

It will be seen from panel (a) that at rate of interest

Or0 the planned investment is equal to OI0. With OI0
as the amount of planned investment, the aggregate
demand curve is C + I0 which, as will be seen in
panel (b) of Fig. 20.1 equals aggregate output at
OY0 level of national income. Therefore, in the
panel (c) at the bottom of the Fig. 20.1, against rate
of interest Or0, level of income equal to OY0has
been plotted. Now, if the rate of interest falls to Or1,
the planned investment by businessmen increases
from OI0 to OI1 [see panel (a)].
With this increase in planned investment, the
aggregate demand curve shifts upward to the
new position C + I1 in panel (b), and the goods
market is in equilibrium at OY1 level of national
income. Thus, in panel (c) at the bottom of Fig.
20.1 the level of national income OY1 is plotted
against the rate of interest, Or1. With further
lowering of the rate of interest to Or2, the
planned investment increases to OI2 [see panel
(a)].

With this further rise in planned investment the

aggregate demand curve in panel (b) shifts
upward to the new position C +I2 corresponding
to which goods market is in equilibrium at OY2
level of income. Therefore, in panel (c) the
equilibrium income OY2 is shown against the
interest rate Or2.
By joining points A, B, D representing various
interest-income combinations at which goods
market is in equilibrium we obtain the IS curve. It
will be observed from Fig. 20.1 that the IS curve is
downward sloping (i.e., has a negative slope)
which implies that when rate of interest declines,
the equilibrium level of national income increases.
 5 Major Instruments of Fiscal Policy

Some of the major instruments of fiscal policy are as follows:

A.Budget
B. Taxation
C. Public Expenditure
D. Public Works
E. Public Debt.
A. Budget:

The budget of a nation is a useful instrument to assess the fluctuations in an economy.

Different budgetary principles have been formulated by the economists, prominently known as:
(1) Annual budget,
(2) cyclical balanced budget and
(3) fully managed compensatory budget.

Let us briefly explain them:

1. Annual Balanced Budget:
The classical economists propounded the principle of annually balanced budget. They defended it
with force till the deep rooted crisis of 1930’s.The reasons for their reacceptance of this principle are
as under:
(i) They maintained that there should be balance in income and expenditure of the government;

(ii) They felt that automatic system is capable to correct the evils;

(iii) Balanced budget will not lead to depression or boom in the economy;

(iv) It is politically desirable as it checks extravagant spending of the state;

(v) This type of budget assures full employment without inflation;

(vi) The principle is based on the notion that government should increase the taxes to get more
money and reduce expenditure to make the budget balanced.
2. Cyclically Balanced Budget:
The cyclical balanced budget is termed as the ‘Swedish budget’. Such a budget implies budgetary
surpluses in prosperous period and employing the surplus revenue receipts for the
retirement of public debt. During the period of recession, deficit budgets are prepared in
such a manner that the budget surpluses during the earlier period of inflation are balanced
with deficits. The excess of public expenditure over revenues are financed through public
borrowings. The cyclically balanced budget can stabilize the level of business activity. During
inflation and prosperity, excessive spending activities are curbed with budgetary surpluses while
budgetary deficits during recession with raising extra purchasing power.

3. Fully Managed Compensatory Budget:

This policy implies a deliberate adjustment in taxes, expenditures, revenues and public
borrowings with the motto of achieving full employment without inflation. It assigns only a
secondary role to the budgetary balance. It lays down the emphasis on maintenance of full
employment and stability in the price level. With this principle, the growth of public debt and the
problem of interest payment can be easily avoided. Thus, the principle is also called ‘functional
finance.’
B. Taxation:

Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly
effect the changes in disposable income, consumption and investment. An anti- depression tax
policy increases disposable income of the individual, promotes consumption and investment.
Obviously, there will be more funds with the people for consumption and investment purposes at the
time of tax reduction.
This will ultimately result in the increase in spending activities i.e. it will tend to increase effective
demand. In this regard, sometimes, it is suggested to reduce the rates of commodity taxes like
excise duties, sales tax and import duty. As a result of these tax concessions, consumption is
promoted. Economists like Hansen and Musgrave, with their eye on raising private investment, have
emphasized upon the reduction in corporate and personal income taxation to overcome
contractionary tendencies in the economy.
Now, a vital question arises about the extent to which unemployment is reduced or mitigated if a tax
reduction stimulates consumption and investment expenditure. In such a case, reduction of
unemployment is very small. If such a policy of tax reduction is repeated, then consumers and
investors both are likely to postpone their spending in anticipation of a further fall in taxes.
Furthermore, it will create other complications in the government budget.
C. Public Expenditure:
The active participation of the government in economic activity has brought public
spending to the front line among the fiscal tools. The appropriate variation in public
expenditure can have more direct effect upon the level of economic activity than even taxes. The
increased public spending will have a multiple effect upon income, output and employment exactly
in the same way as increased investment has its effect on them. Similarly, a reduction in public
spending, can reduce the level of economic activity through the reverse operation of the
government expenditure multiplier.
D. Public Works:

Keynes General Theory highlighted public works program as the most significant anti-depression
device. There are two forms of expenditure i.e., Public Works and ‘Transfer Payments. Public
Works according to Prof. J.M. Clark, are durable goods, primarily fixed structure, produced by the
government.

They include expenditures on public works as roads, rail tracks, schools, parks, buildings, airports,
post offices, hospitals, irrigation canals etc. Transfer payments are the payments such like interest
on public debt, subsidy, pension, relief payment, unemployment, insurance and social security
benefits etc. The expenditure on capital assets (public works) is called capital expenditure.
E. Public Debt:
Public debt is a sound fiscal weapon to fight against inflation and deflation. It brings about economic
stability and full employment in an economy. The government borrowing may assume any of the
following forms mentioned as under:
(a) Borrowing from Non-Bank Public: When the government borrows from non-bank public
through sale of bonds, money may flow either out of consumption or saving or private
investment or hoarding. As a result, the effect of debt operations on national income will vary from
situation to situation. If the bond selling schemes of the government are attractive, the people
induce to curtail their consumption, the borrowings are likely to be non inflationary. When
the money for the purchase of bonds flows from already existing savings, the borrowing may again
be non-inflationary. Has the government not been borrowing, these funds would have been used for
private investment, with the result that the debt operations by the government will simply bring about
a diversion of funds from one channel of spending to another with the similar quantitative effects on
national income. If the government bonds are purchased by non bank individuals and institutions by
drawing upon their hoarded money, there will be net addition to the circular flow of spending.
Consequently, the inflationary pressures are likely to be created.
(b) Borrowing from Banking System: The government may also borrow from the banking
institutions. During the period of depression, such borrowings are highly effective. In this period,
banks have excessive cash reserves and the private business community is not willing to borrow
from banks since they consider it unprofitable. When unused cash lying with banks is lent out to
government, it causes a net addition to the circular flow and tend to raise national income and
employment. Therefore, borrowing from banking institution have desirable and favorable effect
specially in the period of depression when the borrowed money is spend on public works programs.
Actually, demand is very high during inflation period, since profit expectation is high in business. The
banks, being already loaded up and having no excess cash reserves. Find it difficult to lend to the
government. If it is done, it is only through reducing their loans somewhere else. This leads to a fall
in private investment. As the government spending is off-set by a reduction in private investment,
there will be no net effect upon national income and employment.
(c) Drawing from Treasury: The government may draw upon the cash balances held in the
treasury for financing budgetary deficit. It demonstrates dishoarding resulting in a net addition in the
supply of money. It is likely to be inflationary in nature. But, generally, there are small balances over
and above what is required for normal day to day requirements. Thus, such borrowings from
treasury do not have any significant result.
(d) Printing of Money: Printing of money i.e. deficit financing is another method of public
expenditure for mobilizing additional resources in the hands of government. As new money is
printed, it results in a net addition to the circular flow. Thus, this form of public borrowing is said to be
highly inflationary. Deficit financing has a desirable effect during depression as it helps to raise the
level of income and employment but objection is often raised against its use at the time of inflation or
boom. Here, it must be added that through this device, the government not only gets additional
resources at minimum cost but can also create appropriate monetary effects like low interest rates
and easy money supply and consequently economic system is likely to register a quick revival.
If investors have improved expectations regarding
profit, the demand for capital goods would increase,
causing an increase in investment demand for any real
rate of interest. The result is a shift in the aggregate
demand function and in the IS curve. The IS function
will shift out from IS1 to IS2, as shown in figure 14.2.
With this shift the real rate of interest required to keep
the level of real output at Y will change from r1 to r2. And
the opposite situation also can happen in economy
If tax increased by the government, the demand for
consumption goods would decrease, consequently
investment reduced. The demand for capital goods
would decrease, causing an decrease in investment
demand for any real rate of interest. The result is a
shift in the aggregate demand function and in the IS
curve. The IS function will shift in from IS2 to IS1,
as shown in figure 14.2. With this shift the real rate of
interest required to keep the level of real output at Y
will change from r2 to r1. And the opposite
situation also can happen in economy
If government expenditure increased by the
government, the demand for consumption goods
would increase, consequently investment enhanced.
The demand for capital goods would increase,
causing an increase in investment demand for any
real rate of interest. The result is a shift in the
aggregate demand function and in the IS curve. The
IS function will shift out from IS1 to IS2, as shown
in figure 14.2. With this shift the real rate of interest
required to keep the level of real output at Y will
change from r1 to r2. And the opposite situation
also can happen in economy
 Dear students that’s all for today. If there
are any questions or queries regarding
this topic please feel free to ask me. In our
next class we will study another new topic.
Take care, good bye!!