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3.3.1 The goods market and the IS curve

Equilibrium in the goods market occurs where the aggregate demand for and

aggregate supply of goods are equal. In the orthodox Keynesian model the

level of output and employment is assumed to be determined entirely by

aggregate demand; that is, supply constraints are ignored. In a closed economy

aggregate demand comprises the sum of consumption, government expenditure

and investment. In order to simplify the analysis, consumption expenditure

is held to depend positively on disposable income, government expenditure is

taken as being exogenously determined, while investment is treated as being

inversely related to the rate of interest, a variable determined within the

model by the interaction of the goods and money markets.

The IS curve traces out a locus of combinations of interest rates and

income associated with equilibrium in the goods market. The IS curve

derives its name from the equilibrium condition in the goods market where,

in a closed economy with no government sector, investment (I) equals

savings (S). Given the assumption that investment is inversely related to the

rate of interest, the IS curve is downward-sloping (see Figure 3.2). Ceteris

paribus, as the rate of interest falls, investment increases, resulting in a

higher level of income. The slope of the IS curve depends on the interest

elasticity of investment expenditure and the value of the multiplier (see

Chapter 2, section 2.8). The IS curve will be steeper (flatter) the less (more)

investment responds to a change in the rate of interest and the smaller

(greater) is the value of the multiplier. For example, ceteris paribus, the

less investment increases for a given fall in the rate of interest, the less

income will increase, generating a steeper IS curve. Similarly, the smaller

the value of the multiplier, the less income will increase following a given

increase in investment, and hence the steeper the IS curve will be. In the

limiting (extreme Keynesian) case where investment is perfectly interestinelastic,

the IS curve will be vertical.

Finally, it is important to remember that the IS curve is drawn for a given

level of government expenditure, taxation and expectations, so that expansionary

fiscal policy (that is, an increase in government expenditure and/or a

reduction in taxation, or a more optimistic business outlook) shifts the IS

curve outwards to the right, and vice versa. For example, an increase in

government expenditure will be associated with a higher level of income at

any given level of the rate of interest, the outward shift of the IS curve being

equal to the increase in government expenditure times the value of the multiplier.

We now turn to the money market and the LM curve.