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# Loanable funds interpretation of IS curve

Thinking about how real GDP can drive real interest rates. Created by Sal Khan.

## Want to join the conversation?

- At2:42, when Sal labeled Investment as equal to savings I was confused. From a previous video, I was expecting Saving to be complementary with Consumption, his 1-C where C is MPC is called Marginal Propensity to Save. Are the two savings the same thing? If they are the same, does Consumption complement Investment?(8 votes)
- (MPS= 1- MPC)

lets say a person is earning 100 $, his savings will be (MPS * 100) and which will be saved in banks and banks will invest that money and thus savings=investments.

As GDP grows, more people will have more money in hand, which they will put in banks. Due to larger money, banks will lower interest rates and hence the IS curve .(14 votes)

- What would be the effect of change in MPC to IS curve? would it change its slope?(7 votes)
- The change in MPC such that consumers are saving more than they are consuming will increase national saving which in turn will shift the IS curve to the left, this is because the long-term steady state curve will increase. Note this shift is long term.(8 votes)

- I try to relate the I = S concept to the banking system and I don't think all of the savings in the banks will be lent out to be invested since they need to keep some for their reserves, so doesn't it supposed to be S > I ?(5 votes)
- As I understand it, "savings" and "investments" are really just two labels for the money that is leftover after consumers spending and government spending. Not all of this money would actually either be invested growing the economy, or squirreled away. It's not so important what actuall append to this money, it is just a label in this model to denote what is leftover, rather than to summarize what happens to the leftovers(4 votes)

- Will the IS Curve only apply to a closed economy that is NX = 0 ?(1 vote)
- No, the IS relation applies in an open economy, too.(3 votes)

- Does the Interest Rate - Investment - Aggregate Output relationship, to some certain extent, explains what I'd like to call the "Circle of Poverty" which is befalling some Third World Countries at the moment ? Low Income => Low Savings => High Interest Rate => Low Invetment => Low Aggregate Output (Low Income) ?(1 vote)
- No, not at all. Third world countries are at an enormous technological advantage when it comes to growth. They can take advantage of all the centuries of hard work that we put in to invent electricity, radio, TV, cell phones, and immediately they leverage all of that immense investment. Money invested in third world countries can be multiplied extraordinarily by taking advantage of these technological advancements. This means that investment
`I`

is more effective there, driving more growth, increasing GDP in real terms, thus increasing incomes.

The problem in third world countries is that they have tyrannical anti-freedom governments. You can predict the path a country will take thanks to the research collected here: http://www.heritage.org/index/ranking(3 votes)

- Could the conclusions we drew from this video say that a larger market is beneficial to everyone because of the higher GDP the interest rates will naturally be lower.(2 votes)
low interest rates are evidence of a healthy economy and prosperous times. Note however that interest rates are frequently manipulated by heavy-handed government agencies that have their own agenda. When that happens you can't really draw any conclusions.**Naturally**(1 vote)

- Will the slope of the IS curve only be affected by the responsiveness of investment to interest rate, government multiplier and MPC ?(1 vote)
- Depends on the model, in this model yes it will, however in other models where other variables depend on income then the slope will likely depend on those variables as well e.g. if investment depended on income(2 votes)

- Is it correct to say that the IS Curve contains all points of income and respective rate of interest that equilibrium is being attained in the goods market as the equilibrium condition savings = investment is satisfied ?(1 vote)
- I would say output instead of income, but yes that looks good.(2 votes)

- At3:28, Sal assumes that Y goes up. That does not just happen though. It basically happens, because aggregate Demand went up, which means people spent more of their money. If you spend more of your money, that means you put less in banks, you save less, Savings Go Down (If the total amount of money in the economy is constant). So how can lower savings ( = more consumption = higher GDP) lead to more Savings?(1 vote)
- If you spend more money, income (Y) will increase as well (multiplication). So you do not necessarily spend more or save more, relatively speaking, since you also have more money/output. The point is that both savings and consumption rise in absolute terms.(2 votes)

- at5:00.when Y goes down and Saving goes down shouldn't r go down to encourage investment?and therefore output will recover? (or am I confusing real and nominal r ?)(1 vote)
- if it was an ideal economy in which you controlled everything, that may be the sensible thing to do. however, in economic terms, that would be harder to do as r is driven by savings, which in turn is driven by Y. unless the government directly intervenes, in normal competitive markets the r will always go up in response to decreased savings.(1 vote)

## Video transcript

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 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. 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 the savings
point of view. And in this
situation, we're going to have this exact
same thing, but instead of viewing real interest
rates as driving GDP, we're actually going to view GDP
as driving real interest rate. So let me leave this up here. But 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
could break it up into its component
expenditures, it's equal to aggregate
consumer spending, which is a function of
disposable income. y minus 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
are in a closed economy. It makes good
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 both sides
of 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, with
investment right over here. And this thing right
over here is interesting because this is total
income minus what-- and let me make sure that we,
I don't want to confuse you. Because that looks
like a lowercase c. And if we're talking about
aggregate consumption it's usually an uppercase 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 on
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 is
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're really
just saying, look, there's two ways
to view this curve. It's investment driven
or its savings driven. And when you think
of it this way you have a slightly
different view of this curve. Because when you view
it from a savings point you say, well, what's going
to happen if GDP goes up? What happens if we 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, if we
assume a linear model, times the marginal propensity to
consume, which is less than 1, 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 change in
government expenditure. So if total aggregate
income goes up then savings are going
to go up, if we assume government expenditures
holds constant. So then we have savings goes up. And if savings
goes up, that means we have more loanable funds. There's 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
real interest rates. So once again, is looking at
it from a 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 is not going to decrease
as much as this did, because of the
marginal propensity to consume is less than
1, 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 its price? It's 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, the same
exact curve, IS curve. But there's two takeaways here. One is to realize
why it's called IS, that 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.