Loanable Funds Interpretation of IS Curve Thinking about how real GDP can drive real interest rates
Loanable Funds Interpretation of IS Curve
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- 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 _____ 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
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