Government spending and the IS-LM model

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Government spending and the IS-LM model발음듣기

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Let's think about what happens to an IS curve when government spending goes up.발음듣기

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To think about that, let's first draw our Keynesian cross.발음듣기

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On the vertical axis over here, we have aggregate expenditures.발음듣기

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In the horizontal axis right over here, wee have aggregate income.발음듣기

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These are really just 2 ways of talking about GDP.발음듣기

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We are thinking, we actually want all of the points where the economies and equilibrium where income is equal to expenditures.발음듣기

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That's why we draw that line of slope 1, that's all of the points where income is equal expenditures.발음듣기

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Where is economy is in some type of equilibrium or in equilibrium.발음듣기

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Then we think about planned expenditures.발음듣기

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Planned expenditures, we've done this multiple times, it's equal to aggregate consumer spending which is a function of income minus taxes.발음듣기

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Or it's a function of disposable income.발음듣기

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We're not seeing C x Y - T, we're seeing C is a function of Y - T.발음듣기

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This is one way of talking about consumption function.발음듣기

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We assume it's linear in this video and another but it's doesn't have to be, it could be a curve of some kind.발음듣기

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Then we have our planned investment, plus planned investment which we're assuming that we're sitting at some, that our real interest rates are fixed right now.발음듣기

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Planned investment plus government spending and then we could even throw net exports out there if we assume that we have some type of an open economy.발음듣기

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This curve, our plan investment, this is all a review of the Keynesian cross videos,발음듣기

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it might look something like this and we get to our equilibrium level of GDP.발음듣기

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We can also use this information given that we were sitting here at interest rate r1 to start, to at least plot one point on our IS curve.발음듣기

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Let's draw at least point on our IS curve and hopefully you feel good about the general shape of it and then we could think about how the IS curve might shift.발음듣기

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Here, we have real interest rates.발음듣기

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We're trying to relate real interest rates to aggregate GDP.발음듣기

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We just showed that when real interest rates are sitting at r1, if this is r1 right over here.발음듣기

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If real interest rates are sitting at r1, we know that the aggregate level of output or income is that point right over there.발음듣기

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We could just drop that down and so it is this level right over here.발음듣기

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When real interest rates are r1 this is our output.발음듣기

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That is a point on our IS curve.발음듣기

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We can draw the entire IS curve which might look something like that, that is our entire IS curve.발음듣기

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If we kept changing this, if we kept trying this out for different real interest rates we could plot more and more of these points along the IS curve.발음듣기

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This is really thinking in terms of, if real interest rates go up then this whole expression will go down then this thing will be shifted down and so we would have less GDP.발음듣기

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If this gets shifted down your equilibrium GDP might go over here.발음듣기

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At a higher real interest rate you would have lower aggregate income.발음듣기

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That's how we actually thought about plotting our IS curve.발음듣기

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Now, with all of that out of the way, let's think about what happens when government spending goes up.발음듣기

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Well, if government spending goes up, if this piece right over here goes up, that will shift our planned expenditures up as well.발음듣기

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So your change in government spending, change in G, it would shift this curve up.발음듣기

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Let me draw that a little bit neater.발음듣기

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It would shift this curve up and you would get to a new level of income or equilibrium level of real GDP.발음듣기

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That amount, this delta Y which is this amount right over here.발음듣기

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It's actually going to be equal to the multiplier which is 1 minus the marginal propensity to consume times our change in government spending.발음듣기

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You don't have to worry about this too much for the sake of this video, that's just a little bit of a review.발음듣기

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The whole reason why I'm going this is we're saying, "Look, assuming r1 didn't change "and when we increased government spending "it shifted GDP up by that amount."발음듣기

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When you increase government spending, it shifted at r1, it shifted it by that amount.발음듣기

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Well, that would be true at any of the real interest rates along the IS curve.발음듣기

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In general, if you increase government spending and you're not changing any of this other stuff then the IS curve would shift to the right.발음듣기

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If you decreased government spending the IS curve would shift to the left.발음듣기

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With that in our toolkit now, we can think about how a change in government spending might change our equilibrium point in our IS-LM model.발음듣기

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Let's do that. Once again, real interest rates.발음듣기

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Here we have aggregate income or real GDP and then we have our IS curve.발음듣기

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Our IS curve looks something like that.발음듣기

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Our LM curve, I will do it in magenta.발음듣기

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Our LM curve might look something like that.발음듣기

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So, if we have a increase in government spending, we already saw the IS curve shift to the right.발음듣기

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I want to do that in the same color.발음듣기

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It shift to the right and it might look something like that.발음듣기

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If our old equilibrium real interest rate was sitting here and equilibrium income was sitting here,발음듣기

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we saw that by increasing the government spending our new equilibrium GDP is higher and our new equilibrium interest rate is higher just by the shift to the IS curve.발음듣기

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Now, you might be saying, "Okay Sally, you've been focusing on the IS curve "but does an increase in government spending, "does it affect the LM curve?발음듣기

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A change in physical policy, does that affect the LM curve?"발음듣기

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We're not talking about printing more money, we're talking about the government spending more, increasing its budget.발음듣기

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Remember, the LM curve, it's driven by people's liquidity preferences.발음듣기

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At different levels of GDP, how much do they want to hold money and how much would you have to pay for them in terms of interest for them to depart with it?발음듣기

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How much interest are they willing to pay to get access to money at different levels of GDP?발음듣기

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That's not really impacted by government spending, and it's also impacted by the money supply, by the amount of money that are out there and just general levels of prices.발음듣기

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You could start to think about, "Oh, doesn't government spending "affect the prices in the long run?"발음듣기

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But if we just hold a lot of those things constant especially in the short-term, especially if you hold prices constant, fiscal policy is not going to change the LM curve.발음듣기

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Monetary policy, the money supply part, that could or people's liquidity preferences could.발음듣기

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But just government policy by itself, fiscal policy by itself won't change it.발음듣기

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In this model, just not trying to get too over-complicated.발음듣기

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When government spending goes up, when G goes up, it would shift the IS curve to the right.발음듣기

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Increase in real interest rates, increase in real GDP according to this model.발음듣기

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