The
IS curve shows those combinations of income and the interest
rate for which aggregate expenditure equals income (or output).
Its name derives from the fact that in an economy with no government
(then TG = 0) and no trade with other countries (then
IMEX = 0) the required balance of leakages out of
and injections into the income circle [(SI) + (TG) + (IMEX)
= 0] obtains if I = S.
In an interest rate/income diagram the IS curve slopes downward.
To show why we may proceed from a Keynesian cross diagram
with the numbers plugged in that we used when discussing aggregate
demand (see figure on the right):
First, suppose that the 400 units of investment occurred
at an interest rate of 5%, due to an investment function that reads
I = 600  40i. We may note this fact that at an interest
rate of 5% equilibrium income is Y_{1} by means of the red
dot in the i/Y diagram below the Keynesian cross.
Next
suppose that the interest rate drops to 2%. According to our investment
function this raises investment to I = 600  40×2 = 520.
This shifts the aggregate demand line up and raises equilibrium
income to Y_{2}. So at the lower interest rate of 2% equilibrium
income is higher. We may note this by means of another red dot,
as shown in the second figure.
We might repeat this exercise numerous times and mark all interest
rate/income combinations that clear the goods market by red dots
in our i/Y diagram. All these dots would lie on the red line that
runs through the two dots we identified so far. This red line is
called the IS curve. It slopes downward to the right, indicating
that higher equilibrium levels of income obtain at lower interest
rates.
The IS curve is drawn with the understanding that other demand categories
(that is G and NX) remain unchanged. If they do change, this amounts
to shifting the IS curve.
