GOODS MARKET EQUILIBRIUM

GOODS MARKET EQUILIBRIUM

Investment
• Investment (I) means addition to physical
stock of capital. It also includes inventories
with firms.
I = I0 - bi
• Where, I0 is the autonomous investment and
‘b’ is the sensitivity (responsiveness) of
investment to interest.
Goods market equilibrium and IS curve

Aggregate demand
• AD= C+I+G+NX
= C0+ c(1-t) Y+cTR0+I0-bi+G0+NX0
AD= A0+c(1-t)Y-bi
Where A0= C0+cTR0+I0+G0+NX0
 Graphical derivation of IS curve

Y=AD
AD
AD2
B AD1 IS curve gives
combination
of income and
A interest at
A0-bi2 A0-bi1
Y which goods
i Y1 Y2 market is in
i1 equilibrium
A B
i2
AD= (A0-bi) + c(1-t)Y
IS
Y1 Y2 Y
 Why is it called IS curve?
• For equilibrium Y=AD
• In a model without govt and external sector,
• Y= C+S, AD=C+I,
• C+S=C+I, Hence I=S
However, in an expanded model with G & NX:
• Y=C+S+(TA-TR), AD= C+I+G+NX
• Therefore, I=S+(TA-G-TR)-NX
Goods market equilibrium and IS curve

For equil: Y=AD

Y= A0+c(1-t)Y-bi
Y-c(1-t)Y= A0-bi
1
Y ( A0  bi ) IS Equation
1  c(1  t )
or Y =  (A0 – bi), where  is the multiplier.
 Goods market equilibrium

Slope of IS curve
• Slope of IS curve captures the impact of a unit
change in interest on income.
Y =  (A0 – bi) (IS equation)
Slope of the IS curve depends on  and b:
• Value of the multiplier, .
_____ the multiplier, flatter (gentler) the IS curve
• Sensitivity of investment to interest rate changes, b.
________‘b’ flatter (gentler) the IS curve.
 Goods market equilibrium
Position of IS curve (shifts in IS curve)
Y=AD
AD
AD2 Increase in
B AD1
A0 shifts IS
to the right
G A
A0-bi Decrease in
Y A0 shifts IS
i Y1 Y2
to the left.
i A B
IS2
IS1
Y1 Y2 Y
 Goods market equilibrium
Positions off the IS curve

Y=AD Points to the left

AD
C AD of the IS curve :
A B
excess demand
AD for goods
A0-bi AD Y (EDG)
Y
Points to the
Y right : excess
i supply of goods
A B C (ESG) (ESG).
(EDG)
IS
Y1 Y0 Y2 Y