IS Curve

Definition

The IS curve represents the relationship between interest rates and the level of income that equates the goods market in an economy. It shows all combinations of interest rates and output where total spending (consumption + investment + government spending + net exports) equals total output. The curve slopes downwards, indicating that lower interest rates lead to higher levels of income due to increased investment and consumption.

5 Must Know Facts For Your Next Test

1. The IS curve shifts to the right when there is an increase in government spending or a decrease in taxes, leading to higher income levels at every interest rate.
2. Conversely, a leftward shift occurs when there is a decrease in consumer confidence, resulting in lower levels of investment and consumption.
3. In the context of the Mundell-Fleming model, the IS curve can be used to analyze how exchange rates affect output and interest rates under different capital mobility scenarios.
4. The intersection of the IS curve with the LM curve determines the equilibrium level of income and interest rates in an economy.
5. Changes in monetary policy, such as changes in interest rates by a central bank, affect the position of the IS curve indirectly through their impact on investment and consumption.

Review Questions

• How does a change in fiscal policy affect the position of the IS curve?
  • A change in fiscal policy, such as increased government spending or reduced taxes, directly affects aggregate demand. When fiscal policy is expansionary, it shifts the IS curve to the right because higher government spending leads to increased income levels at any given interest rate. Conversely, contractionary fiscal policy would shift the IS curve to the left as it decreases overall spending in the economy.
• Compare and contrast the roles of the IS and LM curves in determining equilibrium in an economy.
  • The IS curve focuses on the goods market by illustrating the relationship between interest rates and income levels where total spending equals total output. The LM curve, on the other hand, represents the money market by showing combinations of interest rates and income where money supply equals money demand. Together, their intersection determines overall equilibrium for both goods and money markets, affecting output and interest rates simultaneously.
• Evaluate how external factors such as foreign exchange rates can influence the IS curve within the Mundell-Fleming framework.
  • Within the Mundell-Fleming framework, external factors like foreign exchange rates significantly impact the IS curve by altering net exports. A depreciation of a country's currency makes its exports cheaper for foreign buyers while making imports more expensive for domestic consumers, leading to an increase in net exports. This shift can push the IS curve to the right, indicating a higher level of income at each interest rate due to enhanced demand for domestic goods.

Related terms

LM Curve: The LM curve represents the relationship between interest rates and the level of income that equilibrates the money market, showing all combinations where money supply equals money demand.

Aggregate Demand: Aggregate demand is the total demand for goods and services within an economy at a given overall price level and in a given time period.

Fiscal Policy: Fiscal policy refers to government spending and tax policies used to influence economic conditions, particularly aggregate demand and inflation.