How Fiscal Policy Shifts the IS Curve
The IS curve shows us, for any given interest rate, the level of income that brings the goods market into equilibrium. As we learned from the Keynesian cross, the equilibrium level of income also depends on government spending and taxes . The IS curve is drawn for a given fiscal policy; that is, when we construct the IS curve, we hold and fixed. When fiscal policy changes, the IS curve shifts:
For any given interest rate, the upward shift in planned expenditure of leads to an increase in income of . Therefore, the IS curve shifts to the right by this amount.
We can use the Keynesian cross to see how other changes in fiscal policy shift the IS curve. Because a decrease in taxes also expands expenditure and income, it, too, shifts the IS curve outward. A decrease in government purchases or an increase in taxes reduces income; therefore, such a change in fiscal policy shifts the IS curve inward.
In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left.