Return to the road map.
macro in a nutshell
IS and the price level

3D IS planeThe downwards sloping IS curve indicates that rising income levels must be accompanied by falling interest rates to maintain a demand side equilibrium in the goods market. When drawing this line, the exchange rate is assumed to be constant. Following the procedure previously applied to the money market, we add a third dimension to the usual IS diagram. The question is what happens to the interest rate that clears the goods market (at unchanged income) as we move into this third dimension.

When we move out the newly added price axis, domestic goods become more expensive compared to foreign goods. This is because world prices are considered fixed and the exchange rate is considered fixed as well. So if the interest rate did not change as we move out along the P axis, the demand for all domestically produced goods would fall and an excess supply of home goods would be generated. To prevent this, the interest rate must fall. It must fall just enough to make rising investment demand fill in for falling net exports.

The bottom line is that the IS plane slopes down as we move out along the price axis.


Copyright 1997-2013, Manfred Gärtner. All rights reserved.