Unformatted text preview: ssumes that I is fixed, however we add the relationship between the interest rate and investment to our model. Planned investment I = I(r). We derive the IS curve from the investment function and the Keynesian cross. An increase in the interest rate r lowers planned investment, which shifts planned expenditure downward, decreasing income Y. Therefore, the downward sloping IS curve plots this negative relationship between the interest rate and real income. The IS curve shows us, for any given interest rate, the level if income that brings the goods market into equilibrium. The IS curve is drawn for a given fiscal policy, i.e. we hold G and T fixed. When fiscal policy changes, the IS curve shifts. A decrease in government purchases or an increase in taxes reduces income; therefore such a change in fiscal policy shifts IS inward. In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce this demand shift IS to the left. The market for loanable funds produces the IS curve. S = I, so Y – C(Y – T) – G = I(r), and Y = C(Y – T) + I(r) + G. This shows that the supply of loanable funds depends on income and fiscal policy, while the right hand side depends on the interest rate. The interest rate adjusts to equilibrate the demand and supply of loans. When income rises, national saving increases, which shifts S right and drives down the interest rate. Thus, the IS curve slopes downward since an increase in Y decrease r. Additionally, fiscal policy affects national saving, which has an effect on the supply of loanable funds as well. The IS curve shifts upward in response to the expansionary change in fiscal policy. Money markets Liquidity preference theory is a simple model of the interest rate, based on Keynes, which says that the interest rate adjusts to equilibrate the supply and demand for real money balances. The theory of liquidity preference is a building block for the LM curve. The theory assumes that there is a fixed supply of real balances. (M/P)S...
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 Fall '10
 Henriques
 Economics, Macroeconomics

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