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Government spending and the IS-LM model

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

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  • leaf green style avatar for user Nuno Coelho
    How can we assume that Government Spending can magically go up? Doesn't there have to be a relation between Government Spending and Taxation? If the Government increases its expenditure, it has to be funded either by an increase in taxes or an increase in debt. Shouldn't that be addressed by this model somewhere?
    (12 votes)
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    • leaf green style avatar for user Ryan
      You will see this over and over again in all of economics. The first thing you do is change one variable and assume everything else is equal. Then you see how everything else is affected.

      Sal talks about how the equilibrium real interest rate will increase when government spending increases. So, you could extrapolate that if government spending increases and that spending is funded via borrowing, keeping everything else equal, borrowing costs will increase.
      (10 votes)
  • blobby green style avatar for user jimdetry
    If increased Government spending makes interest rates go up, then Investment should go down. Don't these two effects offset each other?
    (9 votes)
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    • piceratops seedling style avatar for user Jonathan Spilky
      What you're describing is crowding out according to the Classical Theory, where government spending can have no effect on output and will be totally offset by a "crowding out" of private investment, caused by lower interest rates (as a result of higher demand for loanable funds = more government spending). Keynesian Theory, however, believes that changes in G can affect output directly, without changing interest rates at all, as shown by the sloping LM curve (a shift in the IS curve leads to a higher equilibrium output and interest rate).
      (1 vote)
  • male robot donald style avatar for user Jordan Manduki
    If the Government increases spending, that would increase investment and thereby increase GDP. Why though would interest rates go up? Wasn't the connection between investment and real interest rates in the IS/LM model that high investment means low interest rates (or vice versa)?
    (7 votes)
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    • blobby green style avatar for user Gautam Khandelwal
      Interest rates would go up since the Government would be borrowing money to fund the expenditure. That would increase the demand for money and thereby increase interest rates.

      On the second issue, we need to get the causation right. If interest rates come down, then that could lead to higher investment. However, if investments increase (say through higher borrowings from banks), greater demand for money would lead to higher interest rates.
      (8 votes)
  • blobby green style avatar for user Toby Hurst
    Any Idea why an increase in government spending has a larger effect in the ISLM model than in the AD/AS diagram?
    (8 votes)
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    • mr pants teal style avatar for user Wrath Of Academy
      I don't think it necessarily has a larger effect in one model or the other. Keep in mind these silly little models are not drawn to scale. They're almost always drawn without any vertical or horizontal intercepts, because the models break down completely anywhere near the axes.

      You can't take these things too seriously - they're just supposed to help you think about big ideas.
      (3 votes)
  • blobby green style avatar for user adnanrais321
    What will be the effect in the IS-LM curve when increased in govt spending financed by an equal amount of increase in taxes?
    plz give this answer with complete explanation. and as soon as possible.
    (3 votes)
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    • mr pants teal style avatar for user Wrath Of Academy
      The IS-LM curve doesn't really address that question. You would need to think it through logically. When the government steals money from one group and then uses it to buy things, the question is whether that makes the citizenry better off or not. If they're using it to buy tanks to protect the country from an invasion, then maybe. These things aren't easily reflected in GDP numbers though.
      (3 votes)
  • blobby green style avatar for user pasindumuth
    when the government spends more money, that does not mean that the demand for money(the IS curve) should shift. It could simply mean that the quantity demand increases and the real interest rate decrease. can somebody clarify
    (3 votes)
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    • blobby green style avatar for user Zach.Barillaro
      The demand for money is the LM curve, when the government spends more money, it increases the AE curve thus increasing GDP. Therefore the investment/saving curve will shift due to the increases GDP which leads to increased Savings which leads to a lower interest rate.
      (2 votes)
  • blobby green style avatar for user zaclim1
    It seems to me the only way to achieve low interest rates while increasing GDP would be to increase the amount of base money. This will stimulate more investments. However why do we use M0 instead of M1. Surely when you include on-demand deposits and the loans created from fractional reserve banking, there will be more demand than indicated with M0
    (3 votes)
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    • blobby green style avatar for user Gautam Khandelwal
      Increasing base money could lead to higher growth. However, if this increased money starts chasing assets, one could have asset inflation and lead to bubbles popping up say in the stock market or in the real market, etc. So not a very desirable thing to do.

      On the second issue, possibly you are right. In fact, why just M1, we should maybe adopt an even more liberal measure of money supply, say M3.
      (2 votes)
  • male robot johnny style avatar for user Cormac
    At how come an increase in Government spending increases the interest rate?
    (3 votes)
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  • blobby green style avatar for user Andy Caldwell
    If the U.S. government eliminates physical currency and implements a digital currency system, could the general population recognize inflation as easily? I worry about monetary policy, interest rates, and inflation. I heard that in Weimar Germany during hyper inflation that the citizens had to carry their currency around in wheelbarrows just to purchase goods and services. With a digital currency I don't think that the general population would be cognizant enough to foresee inflation and speak out on spending and monetary policy. Is a fully digital currency a good idea?
    (2 votes)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      I suspect digital currency will reduce the negative effects of hyperinflation like they had in Weimar Germany, but it will still be a disaster for the economy. In Weimar Germany the prices got raised multiple times a day. Because of that the people instantly spent any money they had. A full digital currency won't help against that.

      Plus, there are multiple issues with getting rid of all of the paper currency. Many people still like using it and don't want to get rid of it. To show how hard this can be, there are discussions to get rid of the penny, because the copper in the pennies is worth more than the penny itself. It still looks like it will take some time before pennies will no longer be in circulation.
      (4 votes)
  • blobby green style avatar for user Maryam Umar Dahiru
    Explain the effects of simultaneous increase in government expenditure and reduction in money supply on all endogenous macroeconomic variables in the economy in the short-run.
    (2 votes)
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    • leaf green style avatar for user macgregor.d
      It is not possible to answer this question without more data.

      One thing you must understand if you are to grasp economics as a concept, is that all terms are relative. The fact that government expenditure increases is only relevant if it is framed in a relative context - such as government expenditure doubles compared to GDP.

      The other issue which is much more difficult to rectify is that mathematically, what you are trying to determine is not really possible. If both government expenditure and money supply are variable you cannot arrive at a determinant solution. If you want I can explain further but it does require sufficient background in mathematics to understand.
      (2 votes)

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.