Local stability of a steady state would depend on the fact whether K
t+1
is intersecting the 45° line from above or
below. When it intersects the 45° line from above, it is a locally stable equilibrium while when it intersects the 45°
line from below it is a locally unstable equilibrium.
Section B
Q. 3. Interpret the IS and the LM curves. What policy implications do they have?
Ans. Equilibrium in Real Sector–is Curve–
An economy is in equilibrium when aggregate demand is just
equal to aggregate supply. In a two sector economy, AD comprises of consumption and investment. While aggregate
supply comprises of consumption and savings. Therefore, at equilibrium level of output, savings is equal invest-
ment. If for simplicity sake, we take investment as autonomous and therefore, a horizontal line parallel to income
axis, then economy is in equilibrium at point E as shown in the diagram. On the right side of point E, unplanned
investment will be positive and on the left hand side, unplanned investment is negative:
Investment is an inverse function of rate of interest and saving is a positive function of income. Both savings and
investment can be integrated to get equilibrium level of income and interest rate. The IS curve shows the equilibrium
in the real sector of the economy. Let us see how IS curve is derived.
In order to understand how IS curve is derived, let us first understand what are we taking on
y
-axis and
x
-axis. In
first quadrant, we have taken rate of interest on
y
-axis and income on
x
-axis. In second quadrant, we have taken rate
of interest on
y
-axis and investment on
x
-axis. In third quadrant, we have taken saving on
y
-axis and investment on
x
-axis. In fourth quadrant, we have taken savings on
y
-axis and income on
x
-axis.
Second quadrant is showing that there is an inverse relationship between investment and rate of interest. More is
the rate of interest; less is the level of investment and
vice-versa
, other things being constant. In the third quadrant,
we have shown a 45° line to exhibit that on this line at all levels saving is equal to investment. In the fourth quadrant
positive relation between savings and investment has been shown. It is showing the different levels of savings at
different levels of income. Hence, by implication that saving is directly related to income and investment is inversely
related to rate of interest and saving is equal to investment at equilibrium level, it is clear that there is an inverse
relation between rate of interest and income. It is shown by IS curve in I quadrant which is the locus of equilibrium
levels of income. In other words, every point on IS curve represents equilibrium level of income and interest rates.
When there is change in the level of investment, there will be a chain of reactions.

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