Saturday, May 14, 2011

Part II - Derivation of the IS Curve

Synthesis of Monetary and Income Analysis - Part II

Derivation of the IS-Curve

The derivation is based on the following three propositions.

1. The rate of interest determines the level of investment (Autonomous). 2. The level of investment determines the level of income. 3. Therefore, the rate of interest determines the level of income.

Diagram (a) shows that lower the rate of interest, the higher the volume of investment.
Diagram (b) shows the relationship between income and investment.
We know that change in income = multiplier times change in autonomous investment
Or, ΔY = m(ΔI)
Or, m = ΔY/(ΔI)

If investment changes by a small amount, national income changes by a multiplied amount.

Corresponding to each level of investment there is a particular level of income. Here the rate of interest and the level of income move in opposite directions. Lower the rate of interest, higher is the level of investment and higher the level of national income.

The IS-Curve shows the alternative combinations of the rate of interest and the level of income, which bring about equilibrium in the commodity market. In other words, every point on the IS-Curve is a point of savings-investment equality.

Part II of IV | Part III: Derivation of the LM Curve and equilibrium

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