What cause the IS curve to shift?

What cause the IS curve to shift?

The IS curve shifts when any of the factors which were held constant when drawing the curve changes. These are the autonomous components of expenditure i.e. Co. Io, Go (and if we have a lump sum tax it will include To).

Recall the concept of the paradox of thrift which you learnt in Introduction to Economics. What is the paradox of thrift and how does the fact that people want to save more affect the IS curve?

What determines the slope of the IS curve?

What determines the slope of the IS curve?
There are two factors, namely:

The responsive of investment to a change in interest rate; and The size of the multiplier.

Conclusions:
The more responsive investment is to a change in interest rate, the flatter is the IS curve and vice versa;

The bigger is the multiplier, the flatter is the IS curve, vice
versa.

Steps for drawing the IS curve

Steps for drawing the IS curve:

At the initial interest rate of ro, investment is Io and the planned expenditure line corresponding to this level of interest rate and investment is Eo. With planned expenditure represented by Eo(ro), equilibrium in the goods market is attained at output level Yo. As interest rate falls to r1, investment increases to I1. This in turn increases planned expenditure to E1 resulting in a higher new equilibrium level of output, Y1.

Conclusion:
A decline in interest rate results in a new equilibrium at a higher level of output. Interest rate and output are inversely related, therefore the IS curve which shows the relationship between interest rate and the equilibrium output is negatively sloped.

Drawing of IS curve

To draw the IS curve, we need to first understand the relationship between interest rate and investment. Investment is inversely related to interest rate. This inverse relationship can be expressed as:

I = Io – br

Where: Io = autonomous investment
b = elasticity of investment with respect to interest rate (b>0) It measures the responsiveness of investment to changes in interest rate.

Since the IS curve shows the combinations of interest rate and income that brings about equilibrium in the goods market (i.e. equality between demand and supply), what we will need to do in order to draw the IS curve is to change interest rate and observe the
effect on Y.

What happens when we are not at equilibrium?

What happens when we are not at equilibrium i.e. at Y1 or Y2?

When the economy is at Y1, planned expenditure (at B) is greater than output. Firms are not producing enough and this results in a rundown of inventories. The fall in inventories will induce firms to increase their output. This causes the economy to move toward the equilibrium at Yo.

At Y2, however, planned expenditure (at C) is less than output. Firms are selling less than what they are producing. The increase in inventories induces firms to cut back on production. As output and employment falls the economy moves back to the equilibrium level of output, Yo.