AGGREGATE DEMAND, PRODUCT MARKET EQUILIBRIUM AND THE IS CURVE

S. M. Ikhtiar Alam
We know that:

AD = C + I + 𝑮̅ . Now, C does not depend on Y; since government takes away taxes from Y and pays back
̅̅̅̅ . That is, C is now a function of disposable income, YD .
some 𝑻𝑹
̅̅̅
YD = Y ̶ TA + 𝑻𝑹 and TA, the total tax income of the government (and is known as tax allowance) is a
𝑻𝑨
fraction of Y = t x Y, where t = average tax rate. Thus, we can write: t = = t x Y = TA.
𝒀
=> C = 𝐂̅ + c [Y ̶ t x Y+̅̅̅̅
𝑻𝑹] = 𝐂 ̅ + c Y ̶ c x t x Y+ c̅̅̅̅̅̅̅
𝑻𝑹.
=> C = 𝐂̅ + c Y ̶ c x t x Y + c̅̅̅̅̅̅̅
𝑻𝑹 = 𝐂 ̅ + Y [c ̶ c x t] + c̅̅̅̅̅̅̅ ̅ + Y [c (1 ̶ t)] + c̅̅̅̅̅̅̅
𝑻𝑹 = 𝐂 𝑻𝑹.
Now we will consider investment, I:

I = 𝐼̅ ̶ bx ί

Where b is the slope of investment demand curve and ί is the interest rate. We can plot the investment
demand curve as follows:

𝐼̅
If ί is zero, then I = 𝐼 ̅ , on the other hand, if I = 0, then ί =𝑏. Now, we can draw the
investment demand:

𝐼̅
Slope = ̶ b
𝑏

0 ̅𝑰 I
̅ . It will not change. It is autonomous. Thus, we get the Aggregate Demand (AD):
Next is our𝑮

̅̅̅̅ + 𝐼 ̅ ̶ b x ί + 𝑮
AD = 𝐂̅ + Y [c (1 ̶ t)] + c𝑻𝑹 ̅

̅̅̅̅ + 𝐼 ̅ +𝑮
Here, 𝐂̅ + c𝑻𝑹 ̅=Ā
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AD = Ā + Y [c (1 ̶ t)] ̶ b x ί
These four components of AD are known as autonomous components and is denoted by Ā.
Now we can draw the AD curve:

AD 450 Line (Slope = 1)

AD1
̅
∆𝑮 AD0

̅ + Ā ̶ bx ί
∆𝑮 a Slope = 𝐜 (𝟏 ̶ 𝑡)

Ā ̶ bx ί ∆𝒀

Ā ̶𝒃𝒙ί
̶ 𝒄 (𝟏 ̶ 𝒕)
0 Y* Y
Ā ̶𝒃𝒙ί
If Y = 0, AD = Ā ̶ b x ί and if AD = 0, Y = ̶
𝒄 (𝟏 ̶ 𝒕)
.
Now, if 𝑮̅ increases by ∆𝑮̅ the AD curve will shift upward in parallel way. That is, the slope
of AD = 𝐜 (𝟏 − 𝑡) will remain unchanged. But the intercept will increase. This increase in
̅ will increase Y more than the increase in 𝑮
𝑮 ̅ . (This is shown with the blue AD curve). Note
that the slope of AD is less than 1 but greater than 0. That is, 0 < 𝐜 (𝟏 − 𝑡) < 1. Here, ∆𝒀
∆𝒀
̅ . Note that,
>∆𝑮 > 1 and it is known as National Income Multiplier” (NIM). NIM =
̅
∆𝑮
𝟏 ∆𝒀 𝟏
. That is, ̅ = > 1. It means that the change in Y due to change
𝟏−𝒄 (𝟏− 𝒕) ∆𝑮 𝟏−𝒄 (𝟏−𝒕)
̅ is equal to ∆𝒀 = 𝟏 ̅ . If 𝐆̅ 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞𝐬 𝐛𝐲 3, Y will increase by 12 to 15 depending on
in 𝑮 ∆𝑮
𝟏−𝒄 (𝟏−𝒕)
the values of 𝒄 and 𝒕.

Now, we will analyze the product market equilibrium and derive the IS equation and IS curve. Each point
on the IS curve represents the product market equilibrium where AD = Y. IS curve shows the inverse
relationship between equilibrium ί and equilibrium Y of the product market. In equilibrium
 Page 3 of 6

Y = AD => Y = Ā + Y [c (1 ̶ t)] ̶ b x ί
By rearranging the terms, we get:

=> Y ̶ Y [c (1 ̶ t)] = Ā ̶ b x ί

=> Y [1 ̶ c (1 ̶ t)] = Ā ̶ b x ί
Ā ̶ 𝒃𝒊
=> Y =
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)

Ā 𝒃
=> Y = − ί. This is the IS Equation.
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡) 𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)

We can rearrange it as follows:

𝟏 𝟏
Y= (Ā − 𝒃)𝒙 ί. Here, is the National
𝟏 −̶ 𝐜 (𝟏−̶ 𝑡 ) 𝟏 −̶ 𝐜 (𝟏 −̶ 𝑡 )
Income Multiplier. Thus, we find that in our IS equation, NIM is built-
in.
Now we can plot this IS equation:

Ā Ā
If Y = 0, ί = , and if ί=o, then Y = .
𝒃 𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)
 Page 4 of 6

ί
Ā
𝒃
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)
Slope = −
𝒃

IS Curve

Ā
0 Y
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)

If t increases, the IS curve will rotate to the left:

ί
Ā
𝒃

t’ > t.

t↑

Ā Ā
0 Y
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡′) 𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡)
 Page 5 of 6

Now, if c or MPC increases, the IS curve will rotate to right:

ί
Ā Ā′
𝒃 𝒃

c’ > c.

c↑

Ā Ā′
0 Y
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡) 𝟏−𝐜′ (𝟏 ̶ 𝑡)

In Ā there is c̅̅̅̅̅
𝑻𝑹. If c increases, then Ā slightly increases. Thus, the IS curve shifts a
bit and then rotate. We generally ignore it for policy implications.

If any component of Ā↑, then IS curve will shift upward and vice versa. But its slope
will not change. So, the shift is always parallel. If, for instance, ̅
𝑮 ↑ then IS curve
will shift upward as shown below.
 Page 6 of 6

ί
Ā′
𝒃

Ā
𝒃

Ā’ > Ā .

Ā↑

Ā Ā′
0
𝟏 ̶ 𝐜 (𝟏 ̶ 𝑡) 𝟏−𝐜′ (𝟏 ̶ 𝑡)
Y