Help me out on IS curve

CFA Level I
#1

For the IS Curve

(S-I)=(G-T)+(X-M) …How come saving minus investments will be equal to fiscal balance and trade balance?

i dont understand the logic how it is directly proportional?

#2

This arises from two formulations of GDP:

GDP = C + I + G + (X – M)

and

GDP = C + S + T.

Thus,

C + I + G + (X – M) = C + S + T,

I + G + (X – M) = S + T,

S – I = (G – T) + (X – M).

#3

Thank you sir. ya i understand the derivation part.

But lets assume our savings is 100b and Investment is 50b how will you equalize that to fiscal and trade balance?

Forgive me if i am confusing you.

#4

Here the IS and LM model and such formula,

S – I = (G – T) + (X – M). tells you that the aggregate savings - aggregate investment should equal to (government expenditure - Taxes) + ( Total export - Total import).

The whole effect should be balanced.

#5

Thank you so much. so if both the sides are equal then the economy is in equilibrium. correct?

#6

Yes: it’s consuming (or exporting) everything that it’s producing.

#7

How is the economy consuming everything that it is producing? I mean, how is it visible in these equations. Kindly walk me me through this

#8

Expenditures approach to GDP:

GDP = C + I + G + (X – M)

The left side is production, the right side is expenditures.

#9

How are net exports an expenditure? Shouldn’t it be net imports?

#10

You spend money on imports, but that’s not stuff you make here; it’s stuff someone else makes elsewhere, so we subtract it from expenditures to get to expenditures on stuff you make here.

Other folks elsewhere spend money on our exports, so we add that to expenditures to get to the stuff made here.

#11

This is confusing. Why Why wouldn’t I add the money I spend here as expenditure? Why do “others” come in the picture?

#12

Because we’re trying to compute GDP: how much stuff we produce. If you buy stuff that someone else produces (imports), then we didn’t produce it, so we don’t include it in GDP. If someone else buys stuff we do produce (exports), then we did produce it, so we include it in GDP.

It’s similar in philosophy to the indirect method for CFO (from FRA):

  • C is the amount consumers (here) spent buying stuff
  • I is the amount that investors (here) spent investing in (i.e., buying) stuff
  • G is the amount that the government (here) spent buying stuff
  • But M is the amount that consumers (or the government) spent on stuff that wasn’t produced here, so we have to subtract it; it was included in C + I + G, but we didn’t produce it, so we make the adjustment
  • And X is the amount that folks elsewhere spent on stuff we produced; it wasn’t included in C + I + G because our consumers, investors, and government didn’t buy it, but we still produced it, so we make the adjustment
#13

Brilliant! Thank you so much.

#14

Thanks S2000magacian!

#15

My pleasure.

I wrote up a series of articles on IS/LM that may be helpful; at least, they’re colorful:

http://financialexamhelp123.com/islm-deriving-aggregate-demand/

#16

I was breaking my head in studying LM Curve. Let me read in that link. thanks !

#17

In LM Curve , Price level is nothing but the value of the money. Am i correct?

#18

Price level is the inverse (reciprocal) of the value of money: as the value of money increases, price level drops, and as the value of money decreases, price level rises.

#19

so interest rate determines the value of money correct?

#20

Sort of: interest rate determines the cost (value) of money (relative to money). The value of money (relative to other goods) is determined by the price level.