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# Government spending and the IS-LMĀ model

How a change in fiscal policy shifts the IS curve. Created by Sal Khan.

Video transcript

Let's think about what
happens to an IS curve when government spending goes up. To think about that, let's
first 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 actually
want 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 in
some type of equilibrium or in equilibrium. Then we think about planned expenditures. Planned expenditures, we've
done 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 talking
about consumption function. 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. 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. 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. This curve, our plan investment, this is all a review of
the Keynesian cross videos, it might look something like this and we get to our
equilibrium level of GDP. 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. 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. Here, we have real interest rates. We're trying to relate real interest rates to aggregate GDP. We just showed that
when 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 aggregate
level 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 rates
are 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 for
different 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 thought
about 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 planned
expenditures up as well. So your change in government
spending, 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 be
equal to the multiplier which is 1 minus the marginal
propensity to consume times our change in government spending. 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. 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." When you increase government spending, it shifted at r1, it
shifted it by that amount. Well, that would be true at
any of the real interest rates along the IS curve. 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. 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 equilibrium
point 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 look
something like that. So, if we have a increase
in government spending, we already saw the IS
curve 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 real
interest rate was sitting here and equilibrium income was sitting here, 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. 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? "A change in physical policy, "does that affect the LM curve?" We're not talking about
printing more money, we're talking about the
government spending more, increasing its budget. Remember, the LM curve, it's driven by people's
liquidity preferences. 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? How much interest are they willing to pay to get access to money at
different levels of GDP? 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. You could start to think about, "Oh, doesn't government spending "affect the prices in the long run?" 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. Monetary policy, the money
supply 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 trying
to get too over-complicated. When government spending
goes up, when G goes up, it would shift the IS curve to the right. Increase in real interest rates, increase in real GDP
according to this model.