Monetary - Macro Economics. Hicks, Hansen analysis

1. THE IS CURVE
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. 2
Keynes’ Equilibrium
• Keynes showed equilibrium in the
commodity market.
• He assumed that Investment is
determined by a) rate of interest, and b)
marginal efficiency of capital.
• So investment is independent of the level
of national income.
• Investment determines NY, but level of NY
does not determine investment.
02/05/2016 Prabha Panth

3. 3
Keynes’ Equilibrium
• Keynes showed that change in money supply
affects Investment, and real output.
• When SM, i , and Investment 
• Increase in investment leads to increase in
output and NY.
• Therefore when there is change in money
market, it affects the commodity or real
economy.
• But Keynes did not discuss how change in real
economy affects the money market, or the rate
of interest.
02/05/2016 Prabha Panth

4. 4
Interaction between Real and
Money markets
• Hicks, Hansen, Lerner and Johnson show that
there is a relationship between real and money
market.
• They show the interrelationship between I, NY, i,
DM, and SM.
• This is given by the IS-LM curves.
• It shows how the level of NY and i are jointly
determined by the simultaneous equilibrium in
the real and the money markets.
02/05/2016 Prabha Panth

5. 5
The IS curve
• The IS curve relates different equilibrium
levels of NY with various rates of i.
• When SM increases, i falls, and planned or
private investment increases.
• When Investment increases, output and
income will also increase.
• At different interest rates, there will be
different impacts on Investment and NY.
02/05/2016 Prabha Panth

6. 6
Derivation of IS curve
0
Planned Investment
Rateof
interest
I
i0
I0 I1
i1
I1
i2
I2
I2
C+I0
C+I1
C+I2
0
I
National Income
Y=C+S
Aggregate
Demand
Y0
E0
I1
I2
Y1
E1
Y
E2
Y2
Y
Panel I
Panel II
A
B
C

7. 7
0
National Income
Y=C+S
Aggregate
Demand
Y0
E0
I1
I2
Y1
E1
Y
E2
Y2
Y
National Income
0
Rateof
interest
Y0
A
i0
i1
Y1
B
i2
Y2
C
IS
Panel II
Panel III
IS curve
derivation
continued

8. 8
The IS curve
• Definition: The IS curve is the locus of those
combinations of i and level of NY at which the
real or commodity economy is at equilibrium.
• When rate of interest fall, private investment
increases.
• This results in higher output and NY.
• So there is an inverse relationship between
rate of interest and NY.
• The IS curve slopes down to the right.
02/05/2016 Prabha Panth

9. 9
The IS curve
• The position of the IS curve depends on
Government expenditure, or Autonomous
Investment and consumption.
• This investment is independent of i, or NY
• The steepness of the IS curve depends
on:
a) Elasticity of investment to i. The more the
responsiveness of I to i, the greater will NY
b) size of the multiplier k, the higher the value
of multiplier, the more NY will increase.
02/05/2016 Prabha Panth