Loanable funds interpretation of IS curve Thinking about how real GDP can drive real interest rates
Loanable funds interpretation of IS curve
- In the last video we began to explore the IS curve
- which, as I think I mentioned, stands for investment savings
- And we really analyzed it from the point of view of investment
- we thought of it as real interest rates driving the level of investment
- which drives the equilibrium level of real output
- High real interest rates - low level of investment
- low level of investment leads to low level of equilibrium output
- So this scenario is closer to that right over there
- If real interest rates are lower then that leads to higher levels of planned investment
- which leads to a higher level of equilibrium output
- so that right over there
- What I want to do in this video
- so that was more from the investment point of view
- What I want to do in this video is explore the exact same relationship
- the exact same curve, but think of it more from savings point of view
- and in this situation we're going to have the exact same thing
- but instead of viewing real interest rates as driving GDP
- we're actually going to view GDP as driving real interest rates
- So let me leave this up here
- Let's just break down the expenditure model of GDP
- So we know that aggregate income, or aggregate GDP, or aggregate output
- however you want to think of it
- Is equal to, and you can break it up into it's component expenditures
- its equal to aggregate consumer spending, which is a function
- of disposable income. Y - T is disposable income - aggregate income minus taxes
- plus investment
- plus government expenditures
- and I could do net exports, but for simplicity for this discussion
- we'll just assume we're in a closed economy
- it makes conceptualizing saving and investment a little bit easier
- Now, what I want to do is solve for investment
- So if I solve for investment, I'm just going to subtract
- this piece and this piece from this equation
- and I get aggregate income minus total aggregate consumer spending
- minus total government spending
- is equal to, on the right hand side I'm just going to be left with investments right over here
- and this thing right over here is interesting
- because this is total income minus...
- Let me make sure that we- I don't want to confuse you
- because that looks like a lower case 'c'
- and if we're talking about aggregate consumption, it's usually and upper case 'c'
- So on the left hand side, we have total aggregate income minus consumer spending
- minus government spending
- so you could really view this as this right over here
- really is aggregate savings
- this over here really is savings
- And as we see when one side of the economy, when people are saving that goes into banks
- and it gets lent out, and then it gets reinvested
- or you could save directly by reinvesting
- And so what we have here, savings is equal to investment
- and that's why it's called an IS curve
- because when you look at the expenditure model, savings and investment are really the same thing
- They could have- they are really just saying,
- look, there's two ways to view this curve
- it's investment driven, or it's savings driven
- and when you think of it this way, you have slightly different view of this curve
- because when you view it from a savings point of view,
- you say "well what's going to happen if GDP goes up?"
- "what happens if he have a high GDP over here?"
- So if we have a high GDP-
- or let's say in particular, if GDP goes up,
- the consumer spending, which is a function of GDP, it will go up
- but it won't go up as much
- it's going to go up by this expression right here
- times <u><u></u>_</u> linear model, times the marginal propensity to consume
- which is less than one, it's between 0 and 1
- So this is going to go up less than that
- and then we can- for the sake of this model we'll assume right now that happens without any changes in government expenditure
- So this, if total aggregate income goes up, then savings are going to go up
- if we assume government expenditure holds constant
- so then we have savings goes up
- and if savings goes up, that means we have more loanable funds
- there is more money to lend
- and if there's more money to lend, what's going to happen to interest rates?
- Well, interest rates are just the price of borrowing money
- the price of money
- So if you have more of something, the price of that thing goes down
- So if savings goes up, then real interest rates go down
- So if you have a high GDP, you're going to end up with low interest rates
- So, once again, looking at it from the point of view of GDP driving interest rates
- we have high savings here, so we're going to have low interest rates
- and you view it the other way around, if you have a lower income
- this thing is going to also decrease
- but it's not going to decrease as much as this did
- because of the marginal propensity to consume is less than one
- we saw that up here, we saw that all the way over here, right over there
- and so, in aggregate, the savings are going to go down
- once again, we hold government spending constant
- So in this situation savings are going to go down
- and if you have fewer loanable funds, there's less savings to lend out
- Then, if you have less of a supply of something, what's going to happen to it's price?
- The price is going to go up, the price of borrowing money is the interest rate
- So in this situation, interest rates would go up
- So that's going in this direction, right over here
- if aggregate income goes down, loanable funds go down, interest rates are going to be higher
- So, once again, same exact curve
- IS curve, but there's two takeaways here
- One is to realize why it's called IS - then investment and savings (when you view it from this point of view)
- really are the same thing
- One person's savings can be another person's investment
- And when we viewed it from the investment point of view, we were viewing r as driving Y
- now we're looking at it the other way around
- Y is driving savings, which is driving r
- but it gives us the exact same relationship for this model
Be specific, and indicate a time in the video:
At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
Have something that's not a question about this content?
This discussion area is not meant for answering homework questions.
Share a tip
When naming a variable, it is okay to use most letters, but some are reserved, like 'e', which represents the value 2.7831...
Thank the author
This is great, I finally understand quadratic functions!
Have something that's not a tip or thanks about this content?
This discussion area is not meant for answering homework questions.
At 2:33, Sal said "single bonds" but meant "covalent bonds."
For general discussions about Khan Academy, visit our Reddit discussion page.
Here are posts to avoid making. If you do encounter them, flag them for attention from our Guardians.
- disrespectful or offensive
- an advertisement
- low quality
- not about the video topic
- soliciting votes or seeking badges
- a homework question
- a duplicate answer
- repeatedly making the same post
- a tip or thanks in Questions
- a question in Tips & Thanks
- an answer that should be its own question