Video transcript
Let's think about whathappens to an IS curve when government spending goes up. To think about that, let'sfirst draw our Keynesian cross. On the vertical axis over here, we have aggregate expenditures. In the horizontal axis right over here, wee have aggregate income. These are really just 2 ways of talking about GDP. We are thinking, we actuallywant all of the points where the economies and equilibrium where income is equal to expenditures. That's why we draw that line of slope 1, that's all of the points where income is equal expenditures. Where is economy is insome type of equilibrium or in equilibrium. Then we think about planned expenditures. Planned expenditures, we'vedone this multiple times, it's equal to aggregate consumer spending which is a function of income minus taxes. Or it's a function of disposable income. We're not seeing C x Y - T, we're seeing C is a function of Y - T. This is one way of talkingabout consumption function. We assume it's linear inthis video and another but it's doesn't have to be, it could be a curve of some kind. Then we have our planned investment, plus planned investment which we're assuming thatwe're sitting at some, that our real interestrates are fixed right now. Planned investment plusgovernment spending and then we could eventhrow net exports out there if we assume that we havesome type of an open economy. This curve, our plan investment, this is all a review ofthe Keynesian cross videos, it might look something like this and we get to ourequilibrium level of GDP. We can also use this information given that we were sittinghere at interest rate r1 to start, to at least plotone point on our IS curve. Let's draw at least point on our IS curve and hopefully you feel goodabout the general shape of it and then we could think abouthow the IS curve might shift. Here, we have real interest rates. We're trying to relate real interest rates to aggregate GDP. We just showed thatwhen real interest rates are sitting at r1, if this is r1 right over here. If real interest rates are sitting at r1, we know that the aggregatelevel of output or income is that point right over there. We could just drop that down and so it is this level right over here. When real interest ratesare r1 this is our output. That is a point on our IS curve. We can draw the entire IS curve which might look something like that, that is our entire IS curve. If we kept changing this, if we kept trying this out fordifferent real interest rates we could plot more and more of these points along the IS curve. 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. If this gets shifted down your equilibrium GDP might go over here. At a higher real interest rate you would have lower aggregate income. That's how we actually thoughtabout plotting our IS curve. Now, with all of that out of the way, let's think about what happens when government spending goes up. Well, if government spending goes up, if this piece right over here goes up, that will shift our plannedexpenditures up as well. So your change in governmentspending, change in G, it would shift this curve up. Let me draw that a little bit neater. It would shift this curve up and you would get to a new level of income or equilibrium level of real GDP. That amount, this delta Y which is this amount right over here. It's actually going to beequal to the multiplier which is 1 minus the marginalpropensity to consume times our change in government spending. You don't have to worryabout this too much for the sake of this video, that's just a little bit of a review. The whole reason why I'mgoing this is we're saying, "Look, assuming r1 didn't change "and when we increased government spending "it shifted GDP up by that amount." When you increase government spending, it shifted at r1, itshifted it by that amount. Well, that would be true atany of the real interest rates along the IS curve. In general, if you increasegovernment spending and you're not changingany of this other stuff then the IS curve wouldshift to the right. If you decreased government spending the IS curve would shift to the left. With that in our toolkit now, we can think about how a change in government spending might change our equilibriumpoint in our IS-LM model. Let's do that. Once again, real interest rates. Here we have aggregate income or real GDP and then we have our IS curve. Our IS curve looks something like that. Our LM curve, I will do it in magenta. Our LM curve might looksomething like that. So, if we have a increasein government spending, we already saw the IScurve shift to the right. I want to do that in the same color. It shift to the right and it might look something like that. If our old equilibrium realinterest rate was sitting here and equilibrium income was sitting here, we saw that by increasingthe government spending our new equilibrium GDP is higher and our new equilibriuminterest rate is higher just by the shift to the IS curve. Now, you might be saying, "Okay Sally, you've beenfocusing on the IS curve "but does an increasein government spending, "does it affect the LM curve? "A change in physical policy, "does that affect the LM curve?" We're not talking aboutprinting more money, we're talking about thegovernment spending more, increasing its budget. Remember, the LM curve, it's driven by people'sliquidity preferences. At different levels of GDP, how much do they want to hold money and how much would youhave to pay for them in terms of interest forthem to depart with it? How much interest are they willing to pay to get access to money atdifferent levels of GDP? That's not really impactedby government spending, and it's also impactedby the money supply, by the amount of money that are out there and just general levels of prices. You could start to think about, "Oh, doesn't government spending "affect the prices in the long run?" But if we just hold a lotof those things constant especially in the short-term, especially if you hold prices constant, fiscal policy is not goingto change the LM curve. Monetary policy, the moneysupply part, that could or people's liquidity preferences could. But just government policy by itself, fiscal policy by itself won't change it. In this model, just not tryingto get too over-complicated. When government spendinggoes up, when G goes up, it would shift the IS curve to the right. Increase in real interest rates, increase in real GDPaccording to this model.
