Answer to Question #225382 in Macroeconomics for Tehreem

Question

It is possible that the interest rate might affect consumption spending. An increase in the interest rate could, in principle, lead to increases in saving and therefore a reduction in consumption, given the level of income. Suppose that consumption is, in fact, reduced by an increase in the interest rate. How will the IS curve be affected?

Answer 1

The IS curve shows the goods market equilibrium in an economy. The goods market is in equilibrium when aggregate demand for goods is equal to its supply. Alternatively, the economy is said to be in equilibrium when desired national saving equals desired investment. So the 'I' in the IS curve stands for investment and the 'S' represents saving. The IS curve is thus a downward sloping curve which shows the real interest rate that clears the goods market, for a given level of output or income Y. At every point on this curve desired savings equals desired investment.

If an increase in the interest rate induces people to save more and consume less, then aggregate demand for goods and services will fall. In such a situation if output remains at the original level then this will cause an excess supply of goods and services. So for the goods market to reach equilibrium, total output has to fall. If this happens then we will move to a point on the IS curve with a higher interest rate and lower output. So the IS curve will remain at its original position and there will only be a movement along the curve.