To understand how to derive the IS curve you must remember what it represents. The IS curve represents all combinations of the interest rate and output that are consistent with equilibrium in the goods market. Recall that equilibrium in the goods market can be depicted using the Keynesian Cross diagram as in the top of this active graph. Line ZZ represents the level of demand (comprising consumption expenditures, investment spending, government spending, and net exports) for any given level of output. The equilibrium level of output is determined where the 45° line and the ZZ line cross. The lower panel of this active graph shows all possible combinations of the interest rate and output. What you have to do is to figure out which combinations are consistent with equilibrium in the goods market.

First, notice the handle on the vertical axis of the lower panel marking the current interest rate i1.

  1. What level of output is the equilibrium level of output when the interest rate is equal to i1 ?
  2. Can you determine one of the combinations of the interest rate and the level of output consistent with equilibrium in the goods market ?
  3. What do you expect will happen to the ZZ demand line as the interest rate rises ?

    Shift upward Shift downward No change

  4. What happens to the level of equilibrium output ?

    Increases Decreases No change

  5. What does this imply about the slope of the IS curve ?
  6. Move the interest rate up and down pressing the "Mark" button at various different interest rates. Does the IS curve look as you expected in question 5 ?  Now click on "Fill-in" to see the IS curve.