desired income. It is downward sloping since investment is an inverse function of interest
rate. At higher the interest rates, there is lower investment spending, hence the lower the
aggregate income.
From the above diagram, at E
1
, interest rate is r
1
and corresponding income is Y
1
. As
interest falls to r
2
and then r
3,
aggregate expenditure curve shifts to E
2
and then E
3
while
income increases to Y
2
and then Y
3
.
Shifts of the IS curve
Above the IS curve, Y > E, savings will increase and the IS curve will shift outwards.
Below the IS curve, E >Y, is savings decline and the IS curve shifts inwards.
IS
3
2
1
r
r
r
3
2
1
Y
Y
Y
3
2
1
r
r
r
)
(
)
(
)
(
1
1
2
2
3
3
r
E
r
E
r
E
Y
AE
r
32
Y
On the IS curve, E = Y and hence the goods market is in equilibrium. The IS curve is
defined as the locus of points corresponding to rates of interest and levels of income that
produce equilibrium in the goods/product market.
An outward (inward) shift of the IS curve will be caused by an increase (decrease) in any
of the following:

autonomous investment

autonomous consumption

government expenditure

exports (Net)
Disequilibrium Income
This occurs when I is not equal to S.
S > I implies that AD = C + I < Y and C + S > C + I.
This leads to accumulation of inventory forcing firms to reduce production and induce a
decline in income and employment until S = I.
S < I implies that AD = C + I > Y and C + S < C + I.
This means inventories will be sold and businesses will produce more leading to increase
in supply of goods and income until S = I.
Planned investment and planned savings don’t always equal each other. Changes in
employment, production and income occur causing changes in savings and investment.
The direction of these changes will be towards equality of Savings and Investments (S=I)
If planned investment and planned savings differ, changes in production will force
consumers to change their savings plans or firms to change their investment plans (or
both will occur) until I = S.
It is only at equilibrium that both planned and realized investments and savings will be
equal. However, realized investment and realized savings are always equal.
33
The Multiplier concept
0
0
0
0
0
I
I
34
I
Y
=
1
1
which is the simple investment multiplier.
35
Example
Suppose
Y
0
= 100
ΔI = 25
MPC =
= 0.8,
Change in income (ΔY) will be given by:
ΔY =
8
.
0
1
1
x 25 =
2
.
0
25
= 125
Investment multiplier will be given by:
I
Y
=
1
1
=
2
.
0