Shift in IS curve and its Effect on Equilibrium Income

Changes in fiscal policy are the main reasons for the shift in IS curve. A number of factors can be responsible for the shift in aggregate demand. This shift consequently leads to change in the level of equilibrium output.

According to the Keynesian theory, for a given rate of interest, changes that occur in consumption level, business investment level, government expenditure, and taxes shift the aggregate demand function and bring changes in the level of equilibrium output. Some of these major factors that lead to shift in the IS curve have been explained below:

Changes in Autonomous Consumer Expenditure

Autonomous consumption expenditure rises with the increase in stock of wealth or expected future income, which shifts the aggregate demand upwards leading to a rightward shift in IS curve.

For example, when more gold mines are discovered, the people of that country become more optimistic about the prosperity of the economy, and so their autonomous consumption level rises.

On the contrary, a decline in autonomous consumption expenditure has a reverse effect. For any given interest rate, the aggregate demand shifts downwards, equilibrium level of output falls, and consequently, the IS curve shifts leftwards.

Changes in Investment Expenditure unrelated to Interest Rate

A change in interest rate affects the amount of planned investment and the output level. However, this only causes a movement along the IS curve rather than a shift.

However, an increase in the level of planned investment expenditure (occurs when business companies are optimistic about a new venture) not related to interest rates, causes an upward shift in the aggregate demand (C + I + G). This, further results in the rightward shift of the IS curve, at a given rate in interest.

A fall in investment spending (occurs when business firms are pessimistic due to internal and external conflicts) shifts the demand curve downwards and thus the IS curve shits to the left.

Changes in Taxes

Change in taxes have an indirect effect on aggregate demand function. A decline in taxes increase consumer expenditure, as government’s tax cut policy results in an increased level of individuals’ disposable income. This shifts aggregate demand upwards for any given interest rate, and results in the upward shift of IS curve.

However, the intensity of shift in IS curve due to reduction in taxes is less in comparison to the effect of government expenses. So, change in tax has relatively smaller effect on aggregate demand, and the equivalent change in IS curve also remains relatively small.

Change in Net Export unrelated to Interest Rate

Changes that occur in the net exports as a result of change in interest rate only causes a movement along the same IS curve. However, an autonomous rise in net exports not related to interest rates lead to a shift in IS curve.

For example, if the clothes produced in China are in more demand in the USA than the clothes produced in France, aggregate demand function of China increases and causes the IS curve to shift rightwards.

Conversely, when autonomous net exports fall, aggregate demand function shifts downwards, output level decreases and the IS curve shifts left.

Changes in Government Expenditure

An increasing level of government expenditures leads to an upward shift in the aggregate demand function. As the demand increases, aggregate output level also rises, which results in the rightward shift of the IS curve.

On the other hand, a decline in the government expenses, aggregate demand shifts downwards, the equilibrium output falls, and this causes the IS curve to shift left.