Chapter 5: Goods and Financial Chapter 6

Markets: The IS-LM Model

Goods Market Equalibrium:

IS Model

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 The Goods Market
5-1
and the IS Relation
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Equilibrium in the goods market exists when

production, Y, is equal to the demand for goods,
Z. This condition is called the IS relation.
In the simple model developed in chapter 3, the
interest rate did not affect the demand for goods.
The equilibrium condition was given by:

Y  C (Y  T )  I  G

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 Investment, Sales,
and the Interest Rate
Chapter 5: Goods and Financial
Markets: The IS-LM Model

In this chapter, we capture the effects of two

factors affecting investment:
 The level of sales (+)
 The interest rate (-)

I  I (Y ,i)
(  , )

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 Determining Output
Chapter 5: Goods and Financial

I  I (Y ,i)
Markets: The IS-LM Model

(  , )
Taking into account the investment relation
above, the equilibrium condition in the goods
market becomes:

Y  C (Y  T )  I (Y ,i)  G

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 Determining Output
Chapter 5: Goods and Financial
Markets: The IS-LM Model

For a given value of the interest rate i, demand

is an increasing function of output, for two
reasons:
 An increase in output leads to an increase in
income and also to an increase in disposable
income.
 An increase in output also leads to an
increase in investment.

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 The Determination of Output
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Figure 5 - 1
Equilibrium in the Goods
Market

The demand for goods is

an increasing function of
output. Equilibrium
requires that the demand
for goods be equal to
output.

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 The Determination of Output
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Figure 5 - 1
Note two characteristics of ZZ:
 Because it’s not assumed
that the consumption and
investment relations in
Equation (5.2) are linear,
ZZ is, in general, a curve
rather than a line.
 ZZ is drawn flatter than a
45-degree line because it’s
assumed that an increase
in output leads to a less
than one-for-one increase
in demand.

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 Deriving the IS Curve
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Figure 5 - 2
The Effects of an
Increase in
the Interest Rate on
Output

An increase in the
interest rate decreases
the demand for goods
at any level of output.

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 Deriving the IS Curve
Chapter 5: Goods and Financial

Figure 5 - 3
Markets: The IS-LM Model

The Derivation of the IS

Curve

Equilibrium in the goods

market implies that an
increase in the interest
rate leads to a decrease
in output. The IS curve
is downward sloping.

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 Deriving the IS Curve
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Using Figure 5-3, we can find the relation

between equilibrium output and the interest rate.
 Panel 5-3(a) reproduces Figure 5-2. The
interest rate i implies a level of output equal to
Y.
 Panel 5-3(b) plots equilibrium output Y on the
horizontal axis against the interest rate on the
vertical axis.
 This relation between the interest rate and
output is represented by the downward –
sloping curve, or IS curve.

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 Deriving the IS Curve
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Figure 5 - 4
Shifts of the IS
Curve

An increase in taxes
shifts the IS curve to
the left.

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 Shifts of the IS Curve
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Let’s summarize:
 Equilibrium in the goods market implies that
an increase in the interest rate leads to a
decrease in output.
 Changes in factors that decrease the demand
for goods, given the interest rate shift the IS
curve to the left.

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 Deficit Reduction: Good
or Bad for Investment?
Chapter 5: Goods and Financial
Markets: The IS-LM Model

Investment = Private saving + Public saving

I = S + (T – G)
A fiscal contraction may decrease investment.
Or, looking at the reverse policy, a fiscal
expansion—a decrease in taxes or an increase in
spending—may actually increase investment.

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 Key Terms
Chapter 5: Goods and Financial
Markets: The IS-LM Model

 IS curve,  monetary expansion,

 LM curve,  monetary contraction, tightening,
 fiscal contraction, fiscal cons  monetary-fiscal policy mix, or policy
olidation, mix,
 fiscal expansion,  confidence band,

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