To understand how changes in fiscal policy affect the position of the IS curve, you should recall how the IS curve is derived. The IS curve (lower panel) represents the combinations for output, Y, and the interest rate, i, consistent with equilibrium in the goods market (upper panel). Move the handle in the lower panel up and down, to graphically simulate changes in the interest rate.

  1. What happens to the equilibrium level of Y as i goes up and down ?

To draw the IS curve, we′ve held constant all fiscal policy variables – taxes, T, and government spending, G. Let's see how changing fiscal policy affects the position of the IS curve.

  1. Suppose the President and Congress agreed on a tax reduction in the next Federal budget. How do you think that reduction will affect the demand for goods and services ?
  2. Is the new combination of i and Y, with the new taxes, a point somewhere on the IS0 curve ?
  3. Move the handle in the lower panel up and down to graphically simulate changes in the interest rate. How does changing the interest rate affect equilibrium output in the goods market ?
  4. What do the series of dots in the lower panel look like ?
  5. What does the IS1 curve represent ?
  6. How do you think a reduction in government expenditures would affect the position of the IS curve ?