Model Answer
0 min readIntroduction
The IS (Investment-Saving) curve is a fundamental component of the Keynesian IS-LM model, which illustrates the interaction between the goods market and the money market to determine short-run equilibrium interest rates and output. Developed by John Hicks in 1937 as an interpretation of John Maynard Keynes's theories, the IS curve represents all combinations of interest rates and levels of income (or output) at which the goods market is in equilibrium, meaning that planned investment equals planned saving. It essentially maps the equilibrium in the real economy for various interest rate levels, forming a crucial link between monetary and real sectors of the economy.
Interpretation of the Slope of the IS Curve
The slope of the IS curve indicates the sensitivity of the equilibrium level of income to changes in the interest rate. A negatively sloped IS curve signifies an inverse relationship between the interest rate (r) and the equilibrium level of national income (Y). This means that as interest rates fall, the equilibrium level of income tends to rise, and vice versa. The steepness or flatness of the IS curve is crucial for understanding the effectiveness of fiscal and monetary policies. A flatter IS curve implies that a small change in interest rates leads to a large change in equilibrium income, suggesting greater sensitivity of investment to interest rate changes.
Reasons for the Negatively Sloped IS Curve
The IS curve is typically negatively sloped due to the following interconnected economic relationships:
- Inverse Relationship between Interest Rates and Investment: The primary reason for the negative slope is the inverse relationship between the interest rate and investment spending. Businesses typically borrow funds for investment projects (e.g., expanding factories, purchasing new machinery). A higher interest rate increases the cost of borrowing, making investment projects less profitable and thus discouraging investment. Conversely, a lower interest rate reduces borrowing costs, incentivizing businesses to undertake more investment, leading to increased investment demand.
- Impact on Aggregate Demand: Investment is a significant component of aggregate demand (AD = C + I + G + NX). When interest rates fall, investment increases, which directly boosts aggregate demand. This increase in aggregate demand, in turn, stimulates economic activity.
- The Multiplier Effect: The initial increase in investment dueated by a lower interest rate triggers a multiplier effect in the economy. An increase in investment leads to an increase in production and employment, generating higher incomes for individuals. A portion of this increased income is consumed, which further stimulates demand and production, leading to a magnified increase in overall national income or output. Therefore, a small change in the interest rate can lead to a larger change in the equilibrium income level through this multiplier process.
- Consumption of Durable Goods: Lower interest rates can also encourage consumers to borrow more for purchasing durable goods like cars and homes, further contributing to aggregate demand and thus national income.
In essence, the negative slope reflects how changes in the cost of borrowing (interest rates) influence investment decisions, which then propagate through the economy via the multiplier effect to affect the overall level of economic activity and income.
Conclusion
In conclusion, the IS curve, representing equilibrium in the goods market, is fundamentally negatively sloped due to the inverse relationship between interest rates and investment. Lower interest rates reduce borrowing costs, stimulating investment and consumption of durable goods, which subsequently boosts aggregate demand. This initial surge in demand is amplified through the Keynesian multiplier effect, leading to a greater increase in equilibrium national income. Understanding this negative slope is crucial for policymakers to gauge the potential impact of fiscal and monetary interventions on economic output and stability.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.