Product Market Equilibrium: The IS Schedule

The Keynesian (II): The IS-LM Model

Muhammad Irwan Ariffin

November 4, 2015

Muhammad Irwan Ariffin Product Market Equilibrium: The IS Schedule November 4, 2015 1 / 13
Outline

1 Construction of the IS Schedule

2 IS Curve Slope Determinant

Slope of Investment Schedule
Slope of Saving Schedule (MPS)

3 IS with Government

4 IS Curve Shift Determinants

Changes in Government Spending
Changes in Taxes
Autonomous Changes in Investment

5 Conclusion

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 Construction of the IS Schedule

Product Market Equilibrium: The IS Schedule

Construction of the IS Schedule

Product market equilibrium condition:

Y =C +I +G (1)

Equivalent condition:
I +G=S+T (2)
Use equation (2) to construct the product market equilibrium
schedule: the IS schedule
IS schedule: combinations of income (Y ) and interest rate (r) that
equilibrate the product market

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 Construction of the IS Schedule

Product Market Equilibrium: The IS Schedule

Construction of the IS Schedule

Assume a private, closed economy (no government, no international

trade); hence equation (2) becomes:

I(r) = S(Y ) (3)

Investment depends on interest rate, saving depends on income

Task: find combinations of interest rate and income that make
investment equals saving!
Recall the investment schedule (I vs r) and the saving schedule
(S = a + (1 b)Y , note: why Y and not YD ?)
Collect these different combinations of r and Y as different points on
Y r plane and connect them: IS schedule!
Refer to Figure 6-11 in textbook

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 IS Curve Slope Determinant Slope of Investment Schedule

Product Market Equilibrium: The LM Schedule

IS Curve Slope Determinant

What determine the slope of the IS curve (flatter/steeper)?

Check slopes of investment and saving
Investment: r-elasticity of investment schedule: how sensitive
investment is to changes in interest rate?
Not so sensitive steeper investment schedule steeeper IS schedule
Very sensitive flatter investment schedule flatter IS schedule
To see how r-elasticity of investment schedule affects the slope of IS
schedule: analyze a drop in interest rate for a steep and a flat
investment schedules
Refer to Figure 6-12 in textbook
Extreme case: zero r-elasticity of investment vertical investment
schedule vertical IS

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 IS Curve Slope Determinant Slope of Saving Schedule (MPS)

Product Market Equilibrium: The LM Schedule

IS Curve Slope Determinant

Saving: assume a simple saving (consumption) function, where MPS

determines saving
Higher MPS S increases by a lot more as Y increases as r
declines, I increases for product market equilibrium, S must
increase by similar amount (to increase in I) Y needs to go up by
a smaller amount for a big increase in S to match I IS schedule
steeper
Higher MPS S(Y ) schedule steeper IS schedule steeper
Lower MPS S(Y ) schedule flatter IS schedule flatter

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 IS with Government

Product Market Equilibrium: The IS Schedule

IS with Government

Adding government sector product market equilibrium condition is:

I(r) + G = S(Y T ) + T (4)

Note: S is a function of disposable income, YD = Y T

G and T are assumed to be autonomous (independent of income and
interest rate)
Injection: Adding G will shift the I + G schedule to the right
Leakage: Adding T will shift the S + T schedule to the left
Refer to Figure 6-13 in textbook

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 IS Curve Shift Determinants

Product Market Equilibrium: The IS Schedule

IS Curve Shift Determinants

IS schedule will shift when any or all of the components of

autonomous expenditures change: a, T , (autonomous) I, and G

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 IS Curve Shift Determinants Changes in Government Spending

Changes in Government Spending

IS Curve Shift Determinants

Increase in G I + G schedule shifts to the RIGHT IS curve

shifts to the RIGHT
As G with T is unchanged, so to ensure equilibrium, HH has to S
by the same amount as G (movement along S(Y T ) + T
schedule, NOT shift)
G = S, but needs more Y to ensure this! (Why?)
The required increase in Y to ensure equilbirium is:

G = S = (1 b)Y |r0
1
Y |r0 = G (5)
1b
Refer to Figure 6-14 in textbook

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 IS Curve Shift Determinants Changes in Taxes

Changes in Taxes
IS Curve Shift Determinants

Increase in T HH disposable income is lower by similar amount as

increase in T S by a smaller amount
If T by $1 YD by $1, but S by less than $1 (why?)
An increase in T S + T schedule shifts to the LEFT (higher S + T
since T > S)
To ensure equilibrium, since there is no change in I + G, we need
T = S (exactly offset)

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 IS Curve Shift Determinants Changes in Taxes

Changes in Taxes
IS Curve Shift Determinants

Increase in T must be exactly balanced by a decline in S:

S + T = 0
(1 b)(Y T ) + T = 0
(1 b)Y (1 b)T + T = 0
(1 b)Y T + bT + T = 0
(1 b)Y + bT = 0
(1 b)Y = bT
b
Y |r0 = T (6)
1b
End up with a lower Y !
IS curve shifts to the LEFT
Refer to Figure 6-15 in textbook
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 IS Curve Shift Determinants Autonomous Changes in Investment

Autonomous Changes in Investment

IS Curve Shift Determinants

Investment schedule shifts due to autonomous change in investment

(similar to preference concept for HH)
Example: increase in expectation of future profitability of investment
I + G schedule shifts to the RIGHT
Similar analysis as increase in G

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 Conclusion

Conclusion
Product Market Equilibrium: The IS Schedule

1 IS schedule slopes downward (a negative slope)

2 IS schedule is relatively flat (steep) if the r-elasticity of I is relatively
high (low)
3 IS schedule shifts to the right (left) with an increase (decrease) in G
4 IS schedule shifts to the left (right) with an increase (decrease) in T
5 IS schedule shifts to the right (left) with an autonomous increase
(decrease) in I

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