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IS-LM analysis: deriving the IS curve

IS-LM analysis: deriving the IS curve. Extension Class Presentation Ruth Tarrant. Consumption functions. 45⁰ line. Income = consumption. Consumption (C). C = a + bY. a = y-intercept = autonomous consumption (i.e. the level of consumption when income is zero).

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IS-LM analysis: deriving the IS curve

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  1. IS-LM analysis: deriving the IS curve Extension Class Presentation Ruth Tarrant

  2. Consumption functions 45⁰ line Income = consumption Consumption (C) C = a + bY a = y-intercept = autonomous consumption (i.e. the level of consumption when income is zero) b = slope of the line = marginal propensity to consume Yo Income (Y) At Yo, we say there is equilibrium, as consumption = income

  3. Transferring this to Aggregate Demand 45⁰ line AD AD 1. At Yo, the goods market in the economy is in equilibrium: AD = Y 2. In equilibrium, injections = withdrawals 3. So, we can assume that Savings = Investment Income Yo

  4. Developing the IS curve • An IS (Investments = Savings) curve shows the different combinations of income (Y) and interest rates (r) at which the goods market is in equilibrium

  5. 45⁰ line Aggregate Demand Assume that the rate of interest in the economy is r0. At this rate of interest, aggregate demand is shown as AD1. So, when the rate of interest is r0, the goods market of the economy is in equilibrium at y0. AD1 Y0 Income Interest Rate r0 We can now plot a point on the bottom diagram, at the intersection of r0 and y0. At this point we know that the goods market in the economy is in equilibrium Y0 Income

  6. 45⁰ line Aggregate Demand Now suppose that interest rates are lowered, to r1. Lower interest rates boost consumer spending and investment, and so AD rises. AD2 AD1 We draw a new AD curve at AD2. At this higher level of AD, the economy’s goods market equilibrium is achieved at Y1. Y1 Y0 Income Interest Rate Now we plot a point at the intersection of Y1 and r1to indicate the point at which the goods market is in equilibrium. r0 r1 Y0 Income Y1

  7. 45⁰ line Aggregate Demand AD2 AD1 We can repeat this process for all interest rates, and then plot all of the relevant points on the bottom diagram. If we join the dots, we create an IS curve. Y1 Y0 Income Interest Rate r0 r1 IS Y0 Income Y1

  8. The slope of the IS curve • Why might the IS curve be steep? Shallow? • The slope of the IS curve depends on the sensitivity of AD to interest rate changes • If changes in interest rates only lead to a small change in AD, the IS curve will be steep • If changes in interest rates lead to a large change in AD, the IS curve will be shallow

  9. Shifts in the IS curve • Remember, the IS curve shows the effect of interest rates in shifting AD and the resultant level of income • If anything else changes, the IS curve will shift

  10. Shifts in the IS curve • What would happen to the IS curve if: • Government spending increased? • Consumer confidence fell? • Business optimism about future profits improved?

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