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50:35
Transcript
0:16
okay so let's H let's continue with this
0:19
islm model remember in the previous
0:21
lecture we we set up we set it up we
0:24
cons we built the eslm model I will go
0:27
over that very quickly in this lecture
0:30
because I think it's very important for
0:31
you and then we're going to use it and
0:34
uh eventually we're going to talk a
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0:35
little bit about the policy response the
0:38
mcro macroeconomic policy response
0:41
during the covid-19
0:44
ER shock or recession all of the
0:51
B so the the starting point remember
0:54
with first thing we did we constructed
0:56
the relation and the relation was just
0:59
the same as lecture three but we sort of
1:02
expel out what what is inside that
1:04
investment that we had taken as a
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1:06
constant there we said well far more
1:08
realistic is to make investment itself
1:10
increasing in output because it's
1:12
increasing in
1:13
sales that in one change analysis that
1:17
we had in lecture three all that will do
1:19
is change the slope of the of the
1:21
aggregate demand curve and therefore
1:22
change the multiplier but we could have
1:25
solved everything in terms of lecture
1:27
three what made this a little different
1:29
from lecture three is that we also said
1:31
the
1:32
investment real investment remember this
1:34
has nothing to do with financial
1:35
investment real investment is also a
1:37
decreasing function of the interest rate
1:40
okay and
1:43
so er and and that led to the is
1:47
relationship which essentially says
1:48
these are all the is curve traces all
1:51
the combinations of output and interest
1:53
rate that are consistent with
1:55
equilibrium in the Goods Market that's
1:57
the definition of the now of course
2:00
you know in in in lecture three we were
2:02
able to determine equilibrium output
2:05
here we
2:07
can't why can't
2:17
we yeah we have two unknowns it's output
2:20
and the interest rate and we have only
2:22
one relationship the is LM the curve so
2:27
the reason for the LM curve is that we
2:29
need pin down the second
2:31
variable okay and that's what LM will do
2:34
and it will be sort of very brutal about
2:37
it in the past remember it was some
2:38
upward slope in relationship I said in
2:40
previously no that's not what the
2:42
central banks do today just set the
2:44
interest rate so if the Central Bank
2:46
sets the interest rate then you can use
2:48
lecture three to pin down equilibrium in
2:50
the Goods Market which is what you would
2:52
effectively be doing here if you fix
2:55
this interest rate at whatever level the
2:57
Central Bank wants then now you have one
2:59
curve for one unknown which is output
3:01
and that's exactly what we solve in
3:03
lecture three
3:06
okay
3:08
good um so I said you know lecture three
3:12
now this z z Curve will a little steeper
3:14
because investment also responds
3:17
positively to increases in
3:19
output importantly now we have an
3:21
interest rate which is a shifter of this
3:24
aggregate demand in particular if the
3:26
interest rate goes up what happens to
3:28
that curve
3:34
so if the interest rate goes up what
3:37
happens to the AG demand
3:40
curve I have two candidates here down or
3:46
up down yeah because investment drops so
3:50
you can tell me even more by how much if
3:52
I tell you how much a change in the
3:54
interest rate is and I tell you what is
3:56
a sensitivity of investment to the
3:58
interest rate you know exactly by how
4:00
much this thing will come down it's
4:02
going to be the change in the interest
4:03
rate time the sensitivity of the
4:05
investment function to to the interest
4:09
rate that's not the end of the story as
4:11
you well know that's the horizontal
4:13
shift in a great demand but the final
4:15
decline in output will be larger than
4:18
that initial decline in investment as a
4:20
result of the higher interest rate why
4:22
is
4:25
that
4:27
so someone say the fed raises interest
4:31
rate ER that immediately reduces
4:34
investment because investment is
4:37
negative related to the interest rate
4:39
that immediately decreases aggregate
4:41
demand which immediately increases
4:44
decreases output because in this part of
4:45
the course output is determined by agre
4:48
demand does the adjustment stop
4:52
there no that's what the multiplier was
4:54
about because now with lower income
4:57
there's lower consumption and actually
4:59
lower investment as a result of that and
5:01
we keep going okay so this the final
5:03
Decline and output is a lot larger and
5:06
doing that kind of experiment moving the
5:08
interet around and seeing what happens
5:10
to equilibrium output is that we derive
5:13
we constructed the I curve okay that's
5:18
here is for a cutting the inter no oh
5:22
this is exactly the experiment I just
5:23
describe so if you raise the interest
5:26
rate then aggre demand comes down and
5:29
then output declines buy a lot more than
5:30
the initial decline in investment
5:32
because of the multiplier but eventually
5:34
we get to another equilibrium output
5:36
which is that so now we know that this
5:39
point belongs to the yes curve because
5:40
it's a combination of output y Prime an
5:44
interest rate I prime that is consistent
5:46
with equilibrium in the Goods Market
5:48
that's what lecture three told us that's
5:50
what equilibrium in the goods markets
5:52
look like that's another point of the
5:54
same
5:55
is H because I have higher output here
5:58
lower interest rate straight that's
6:00
another point of the as that's the
6:01
reason this downward sloping look at
6:04
what I just said I said I have another
6:06
point of the same I how do I know it's
6:10
the same
6:11
as and not some other
6:18
I you know all that I told you there is
6:20
I found two points two combinations of
6:23
output and interest rate that are
6:25
consistent with equilibrium in the Goods
6:27
Market but I said a little more I said
6:29
and that's part that's the way we
6:31
construct one
6:36
is exactly because there is a lot of
6:39
other parameters that we're keeping
6:40
constant there you know that's the
6:44
distinction between a movement along and
6:45
is curve which is when the when the only
6:47
thing I move is the interest rate that
6:49
allows me to trace a movement along a
6:52
single is if I move something else like
6:54
taxes go on expenditure or autonomous
6:58
consumption by you know something like
7:00
that then I I will be Shifting the
7:03
agregate demand for any given interest
7:04
rate and I want to get a different level
7:06
of output for any given interest rate
7:08
which means I'm going to be in a
7:09
different I
7:11
okay and that's what we did there no in
7:14
that case there we would said look I can
7:17
fix the interest rate any interest rate
7:18
you want let's pick this one but I could
7:20
have done it other interest rate here
7:22
there whatever and now I say what
7:24
happens if I increase taxes well again
7:27
you know from lecture three exactly what
7:29
happen happens when the interest rate is
7:31
constant because there we didn't even
7:32
talk about the interest rate nothing was
7:34
a function of the interest rate and you
7:37
increase taxes well that will reduce
7:38
disposable income for any level of
7:41
output and H that um will lead to
7:46
contraction our great demand output and
7:47
so on so forth so that means that for
7:50
this interest rate now I found another
7:53
Point another point that is is an
7:56
equilibrium in the Goods Market but it
7:58
belongs to a different is because I move
8:00
one of the parameters which is the taxes
8:02
okay and now for this higher level of
8:04
taxes I can play around with the
8:06
interest rate I can say well what
8:07
happens if I cut interest rate well if I
8:09
cut interest rate I'm going to find
8:10
another equilibrium say here if I cut
8:13
the interest rate from here to here I'm
8:15
going to find another equilibrium LEL of
8:17
output which is consistent with that
8:19
very same is why is that very same is
8:22
well because I haven't moved taxes again
8:25
okay so the reason I'm I'm repeating
8:28
this is because I I it's very important
8:30
to understand what what is a movement
8:31
along the is versus what shift the
8:36
is
8:38
good then we move to the LM relation no
8:42
and the LM relation is just equilibrium
8:44
in the financial Market this is
8:46
combinations of output and interest rate
8:48
that are consistent with equilibrium in
8:49
financial
8:50
markets and we constructed from our
8:54
money supply equal to money demand in
8:56
nominal terms then we divide it by P
8:58
which is not very interest in this part
9:00
of the course because p is constant
9:01
we're assuming that P is not moving
9:03
that's the price of goods and services
9:06
and then we have a this this this
9:08
equilibrium here now stated in real
9:10
terms so real money supply is equal to
9:13
real money demand and as I said had you
9:16
taken this course a few years back or
9:18
perhaps in other places I don't know H
9:21
that would have been an upward slop in
9:23
relationship so the LM would have been
9:25
an upward sloping relationship how do I
9:26
know it's upward sloping well because if
9:29
if I don't don't change money supply and
9:30
I increase output then I need to bring
9:33
Li down and since L Prime is negative
9:37
the way to bring L down is by increasing
9:39
the interest rate so that's what would
9:41
have given you an upward sloping LM
9:45
curve I said we don't do that now
9:47
because really Bank central banks
9:49
abandoned a long time ago in most parts
9:51
of the world not everywhere this idea of
9:53
targeting M what they target directly is
9:56
the interest rate and then they give you
9:58
whatever M they you need they need in
10:01
order for the equilibrium in financial
10:04
markets to be consistent with the
10:05
interest rate the Central Bank wants to
10:07
set okay so I said the modern is curve
10:10
really looks like
10:12
that the FED in the US Central Bank
10:16
anywhere else sets the interest rate
10:19
turkey is a little
10:20
different but sets the interest rate
10:26
ER and and and that's a a l now this
10:31
this particular LM says I you know I
10:33
it's a flat curve it's not a function of
10:35
output the F sets the interest
10:37
rate that's it that's the reason you
10:41
know it's flat it's not upward slope or
10:43
anything so I asked the question what
10:45
shifts the modern
10:48
LM only the central bank because the
10:51
central bank is the one that sets the
10:53
interest
10:54
rate
10:56
certainly well let me not complicate
11:00
sets the interest rate so if the central
11:02
bank doesn't change its mind then the
11:04
interest rate is whatever it is and the
11:06
LM will remain there okay good so we put
11:11
the two things together and now we can
11:13
pin down equilibrium output because
11:15
remember we had when we just look at the
11:17
is we had combinations of interest rate
11:19
and output that were consistent with
11:20
equilibrium in the goods market now we
11:22
have an an interest rate which is
11:24
consistent with equilibrium in financial
11:25
markets that's what the central bank is
11:27
there to ensure and so at that interest
11:30
rate we can look into the yes what is
11:32
the level of output that corresponds to
11:34
that that's what we get here okay so now
11:36
we
11:37
found an equilibrium we found a
11:40
combination of interest and output that
11:41
is consistent with equilibrium in both
11:44
Goods markets and financial markets okay
11:47
and that's what the eslm model is about
11:49
it's about finding those
11:52
combinations
11:53
okay good
12:00
is this very clear yes
12:04
yes okay
12:07
good so now we can begin to play with
12:10
this stuff we can one of the main
12:11
purposes of the islm model is to
12:14
understand policy macroeconomic policies
12:18
what you what you should do in certain
12:20
environments or not well before knowing
12:22
what you should do in certain
12:23
environments you need to understand what
12:25
is that the different macroeconomic
12:26
policies do to equilibrium output and
12:29
interest rate and so on and so that's
12:31
what we began to do and the first
12:33
experiment was was one of fiscal
12:36
policy so that's an example of a
12:38
contractionary fiscal policy that could
12:40
happen as a contractionary fiscal policy
12:42
is essentially increasing taxes like
12:45
like we Illustrated before or a
12:47
reduction in government expenditure
12:49
either of those H will lead to a shift
12:53
in the yes to the left okay remember
12:56
from lecture three if I increase taxes
12:59
or reduce government expenditure
13:01
equilibrium output will fall that's
13:03
lecture three remember H and and and and
13:07
so I can chase using lecture three I can
13:11
I tell you well that yes will shift to
13:12
the left no we just did that but now we
13:16
know more because we know that the
13:18
central bank is also pinning down the
13:20
interest rate and in this particular
13:22
example here the central bank did not go
13:24
along with the treasury Department and
13:26
say okay I'm going to keep the interest
13:27
rate whatever it is you do whatever you
13:29
one with
13:31
the fiscal policy so this is an example
13:34
of a situation where fiscal policy
13:37
contractionary and the Central Bank
13:40
remains H with its previous Target
13:42
interest rate target okay so as a result
13:45
of that a contractionary fiscal policy
13:48
as the word says a then is a
13:50
contractionary aggregate demand policy
13:53
ends up also leading to lower
13:56
equilibrium
13:57
output and then I ask I already told you
14:01
two things T up or G down but what else
14:05
would do something similar to this which
14:07
is not
14:22
policy exactly I want anything that is a
14:25
shock to aggregate demand different from
14:26
interest rate or anything like that so
14:28
for example consumer confidence that
14:31
thing that we put in c0 or wealth
14:33
something that wasn't in the mold but
14:35
clearly is what is behind c0 that would
14:37
lead to a shock like that and it's
14:40
contraction that's the reason you know
14:42
central banks and financial markets are
14:44
all the time looking at sort of the
14:45
releases of surveys of consumer
14:47
confidence and things of that
14:49
kind because these are the implications
14:52
of of shocks to to to consumer
14:55
confidence and so on okay good so
14:59
what is a what is the mechanism here
15:01
well you know it we have discussed it
15:03
multiple
15:04
times H the contraction in fiscal policy
15:08
lowers the aggregate demand down then
15:10
via multiplier you end up lowering
15:11
output a lot
15:13
more and this happens for a given
15:15
interest rate I'm having the same
15:16
interest rate here and there because I'm
15:21
looking at at two points
15:23
along for a fixed LM for a fixed
15:25
interest
15:27
rate good
15:30
so that's a that's a contractionary
15:31
monetary policy needless to say an
15:34
expansionary fiscal policy sorry is just
15:38
a shift in the opposite direction so
15:40
what will an expansionary fiscal policy
15:42
do to equilibrium
15:46
output
15:48
expansionary okay will increase output
15:51
okay this was contraction fiscal policy
15:53
reduce output we'll do the opposite
15:55
obviously will increase output so that's
15:56
expansion in fiscal policy and it's a
15:58
very important tool to move output
16:01
around when the econom is in a recession
16:03
or so on so
16:05
forth the other canonical macroeconomic
16:08
policies monetary policy and that's an
16:10
example of an expansionary monetary
16:12
policy so an expansionary monetary
16:15
policy Cuts interest
16:16
rate why is that expansion well look it
16:20
is expansion you
16:22
know let me take this as I'm going to do
16:25
things in a step
16:26
so claim first an expansion in monetary
16:30
policy is a reduction in the interest
16:32
rate so the the central bank now decides
16:34
to set a lower interest rate than it
16:35
used to as a result of that no if output
16:39
didn't change what would happen in the
16:41
Goods
16:42
Market so suppose that the FED cuts the
16:45
interest rate and output doesn't
16:47
change is that an equilibrium in the
16:49
Goods
16:57
Market is that an equili in the Goods
16:59
Market suppose that the the the the FED
17:01
cuts the interest rate and now I say
17:04
okay well nothing will happen here
17:05
output will stay where it is would have
17:07
a lower interest rate that's
17:09
nice wh why is that's not the final
17:13
outcome of of the monetary policy
17:20
expansion exactly this is an imbalance
17:23
no because aggregate demand now a lower
17:25
interest rate investment will go up this
17:27
physical investment remember purchase of
17:30
goods and services by firms for the
17:31
purpose of building Capital structures
17:33
and like that so a aggre demand went up
17:37
so now we have a dise equilibrium there
17:39
output is less than aggregate demand and
17:40
we know that output is determined by
17:42
aggre demand and then we go on through
17:44
all the mechanism okay so this point is
17:46
not an equilibrium we're going to end up
17:48
with a higher level of output at that
17:50
lower interest rate we have a lower
17:52
level of output therefore it's not
17:54
surprising that we call this an
17:56
expansionary monetary policy so when the
17:58
FED cuts the interest rate that's an
18:00
expansionary monetary policy okay will
18:03
expand aggregate
18:06
demand good so how does the FED
18:09
implement this sorry they can do
18:12
expansionary open market operations yeah
18:14
there you are perfect so what they they
18:17
need to do is do some expansion in
18:20
monetary open market operation no again
18:23
now it's a little more sophisticated
18:25
than that but but let's stick with this
18:28
that is the first thing they'll do is
18:30
they they'll shift money supply okay
18:33
they go out there and start buying bonds
18:35
and and and and giving money to
18:38
injecting money into the system
18:39
particularly through the
18:41
banks so that's initial response that's
18:43
what we'll cut the interest
18:45
rate what happens
18:53
next this this will allow me to
18:55
illustrate sort of the modern I yes
18:58
remember the f the fed's decision was
19:01
not to increase the money supply by you
19:04
know
19:06
35% what the FED communicated to the
19:09
market was that it was going to cut
19:10
interest rate by 50 basis points that's
19:12
the communication so initially the way
19:16
it does that overnight is it goes out
19:19
and does exactly
19:24
that
19:26
so what it did
19:29
is what we have there no we had some
19:31
interest rate I
19:36
zero the FED now wanted to go to
19:43
i1 okay so in order to do that well you
19:46
have to look at this money
19:49
demand and increase money supply to get
19:52
to achieve the lower interest rate the
19:54
question I'm asking you now does it a
19:56
stop there
20:00
so the the FED say okay I did my job you
20:02
know I want to lower the interest rate
20:04
I'm going to increase m i increase M and
20:06
now I manag to bring the interest rate
20:08
down to that point and that they
20:11
intervene in overnight market so that
20:13
happens very
20:14
quickly do you think that the FED now
20:17
can sleep for a
20:21
while why not
20:30
there are many reasons why the F cannot
20:32
sleep for a long time but but but in
20:34
this particular
20:41
case okay yes money demand will
20:46
increase
20:51
why no so the first shock was an increas
20:55
in money
20:56
supply the point that I think you want
20:59
to say is that because now the interest
21:02
rate is lower equilibrium output will go
21:05
up but if equilibrium go output goes up
21:09
then what happens in this diagram well
21:11
the money demand goes up because
21:14
remember one of the parameters in this
21:16
curve was output remember this was
21:19
output times Li that's that that curve
21:22
there when in this manone demand I had
21:25
output fixed at y zero but now
21:28
equilibrium output is higher so this
21:31
Curve will also shift
21:33
out okay now you're going to have y1 l i
21:38
there so what what will the FED
21:42
do see the FED doesn't do anything and
21:45
it stops here then the interest rate
21:47
goes back up not necessarily to the old
21:49
level but will go up so what the FED
21:51
will have to do is keep expanding
21:54
money no sorry ugly diagram but it will
21:57
keep expanding money
21:59
up to so it can preserve the interest
22:01
rate so that's you know in the old
22:03
analysis you would have stopped in the
22:05
first shot but nowadays that's not the
22:07
FED says look I'm going to provide money
22:09
and I know it takes time for output to
22:11
expand and all that so I will
22:13
accommodate all that comes it will not
22:15
come overnight all this extra demand for
22:17
money but I know there will be more
22:19
demand coming along if I'm successful at
22:21
expanding economic activity okay so the
22:25
the Central Bank knows that if this ends
22:28
up happening then that they will have to
22:31
provide more money than than initially
22:34
just to preserve the interest at the
22:35
lower rate again we don't have any
22:38
concept of time in this course and I
22:40
don't think that well we'll do a little
22:42
bit
22:42
later but things happen in reality in
22:45
the financial markets they happen very
22:47
quickly and then they take time the real
22:49
side is much slower I mean this
22:51
expansion in output takes a couple of
22:53
years for example it's slower the
22:56
reaction of interest rate asset price
22:58
and so on happens overnight instantly
23:01
when people do analysis of the impact of
23:03
monetary policy on on financial assets
23:06
prices you look at the small Windows the
23:09
minutes around an announcement or
23:12
something like that to understand what
23:13
is the impact when you look at the
23:15
impact of monetary policies or prices on
23:18
real activity you look over the span of
23:20
quarters that's your unit of and and you
23:23
begin to see effects a quarter later and
23:25
you keep seeing effects you know eight
23:28
quarters later so so different time
23:31
scale in this course we're not worrying
23:32
about that but but everything happens at
23:35
once so so really what will happen in
23:37
this course is that it won't be enough
23:39
to increase money supply to this point
23:42
in order to have an interest rate at the
23:44
final equilibrium level of output at
23:46
this level I'm going to have to expand
23:47
money supply a lot more okay that's what
23:50
I'm saying good
24:01
so again I can always go back to my
24:04
lecture three remember I always I told
24:06
you that that diagram in lecture three
24:08
was going to be very important the
24:10
expansionary effects of an expansionary
24:12
monetary policy can be analyzed in the
24:14
lecture three diagram because there we
24:16
take as given an interest rate and now
24:19
we know that when I have a a higher
24:20
interest rate a lower interest rate
24:22
we'll bring this aggregate demand up and
24:24
then we get them multiplied and blah
24:26
blah blah blah blah okay that's that's
24:29
what so
24:31
this is a movement in the when when
24:34
monetary policy changes that's another
24:36
thing that is very important when you do
24:37
islm analysis whenever you ask a
24:39
question the first thing you need to
24:41
think about is which curve is this
24:43
policy moving or which curve is this
24:46
shock moving okay and what I know is
24:50
that monetary policy fiscal policy will
24:53
always move the is will it move the
24:57
LM no it has nothing to do with things
24:59
that happen in financial Market that
25:01
doesn't mean that the FED may not wish
25:03
wish to respond to the fiscal expansion
25:05
or whatever but but but but that's a
25:08
response that the FED decize is not a
25:10
direct consequence to the fiscal policy
25:12
it's not fiscal policy not bandle with
25:15
with interventions in the financial
25:17
Market contrary to that is monetary
25:20
policy I tell you the FED decides to cut
25:23
interest rate that's a movement of the
25:26
LM has nothing to do with the is
25:29
so anything that happens in the is is
25:31
going to be a movement along the is not
25:33
a shift of the is so that's that's what
25:36
we saw here no when when the FED cut
25:39
interest rate we end up with higher
25:41
output but that was a result of a shift
25:42
along
25:44
the because monetary policy is not an
25:47
policy it's an LM
25:49
policy fiscal policy is an as policy
25:53
that is something that shift the is and
25:56
not the LM so that is very important
25:59
to to understand again what moves
26:03
what okay so let's look at at the anyway
26:07
so let me pause here because if you
26:10
understand sort of what I just
26:11
said it's two third of your quiz so so
26:16
make sure that you understand it okay I
26:19
mean if you really understand it
26:20
obviously we're not going to ask you
26:22
exactly this but there small
26:24
perturbations around what I just said
26:27
okay
26:29
so now we can use this stuff even more
26:31
now we understand what the basic
26:33
monetary policy does we understand what
26:35
basic fiscal policy does to the economy
26:39
H let's look at some
26:42
scenarios this I'm calling all in what
26:46
what what am I representing
26:54
there in that diagram
27:02
so I'm saying all that you see in that
27:04
diagram is a result of policy decision
27:06
macroeconomic policy
27:10
decision exactly that's the reason I'm
27:12
calling it all in you know that's a case
27:14
in which both want to be very
27:16
expansionary okay and so you see that
27:19
the mon the expansionary monetary policy
27:21
already sort of increase equilibrium
27:23
output but then you add to it
27:25
expansionary fiscal policy which moves
27:26
theas to the right and you further
27:28
increase
27:30
output okay so you end up with a big
27:32
increase in output as a result of this
27:35
powerful policy package when do you
27:38
think you may see situations like
27:47
that sometimes you see it out of pure
27:51
responsibility I mean yes people go to
27:53
Argentina this happens all the time for
27:55
the wrong reasons but but if if if if H
27:59
in normal times normal environments when
28:01
do you think that I should have said
28:03
normal times in normal
28:05
environments sort of with sound
28:08
macroeconomic policy when do you think
28:10
you would see something like
28:15
this recessions you know and the biggest
28:18
during recessions you you need to get
28:20
the economy out of the of the whole and
28:22
then you you'll probably you'll first
28:25
try monetary policy because that's the
28:26
most direct and quick I mean that's a
28:28
decision that can be made
28:30
overnight no but often when the rec is
28:33
officially deep that's not enough and
28:36
you need more and that's what you do
28:38
with fiscal policy there other reasons
28:40
there are differen between the two
28:41
policies because we're not looking under
28:43
the hood here but for example in Co it
28:46
was very certain group of people were
28:48
much more affected than others I mean
28:50
people that work in restaurants those
28:51
guys just lost their job there was
28:52
nothing they could do so there was a
28:55
reason to Target the transfers when you
28:57
use rate is very Bland policy to
29:00
everyone when when you use a fiscal
29:03
policy you can also it's not only the
29:05
amount you spend but you can also Target
29:07
the expenditure in certain directions
29:09
and and so there other reasons why you
29:11
may want to use the two tools but the
29:14
main one is the first ordered one is if
29:16
you're in a deep recession you need
29:18
everything to try to lift the economy
29:20
out of that and so that's the kind of
29:22
packages you see in big
29:25
recessions now
29:29
there's a there's a slide that I that I
29:32
think I have pending from from two
29:33
lectures ago and and this is a good
29:35
opportunity to to bring it back remember
29:38
when we look at equilibrium in financial
29:40
markets we we came up with this H
29:43
downward sloping demand money demand
29:46
then we said well you lower the interest
29:48
rate there's more more money demand and
29:50
so on so forth and we said therefore the
29:52
way the FED lowers interest rate or the
29:54
Central Bank lowers the interest rate is
29:56
by increasing money supply
29:58
the point of this picture is that
30:00
there's a limit to
30:02
that and the
30:03
limit is more or less when the interest
30:07
rate reaches
30:08
zero because when the interest rate
30:10
reaches the nominal interest rate
30:12
reaches
30:13
zero then there's no cost in holding
30:16
bonds remember the the in holding money
30:19
sorry the only reason for you not to
30:21
hold all your wealth in the form of
30:23
money because you were giving up some
30:24
opportunity cost of investing in bonds
30:28
which were inconvenient Financial assets
30:30
because you couldn't transact with them
30:32
but they pay you higher interest that's
30:33
the reason you want to go there but once
30:35
you reach zero interest rate then you're
30:37
indifferent and you might as well hold
30:39
if the Central Bank goes out there and
30:40
doesn't man open market operation you
30:43
don't need to be compensated for that
30:44
because you you're totally willing to
30:46
hold your wealth in the form of money
30:49
and so monetary policy is no longer
30:51
effective when you when you reach the
30:54
what is called the zero lower bound and
30:56
that's what we call the liquidity TR
30:59
okay it's called the liquidity trap let
31:01
me not get into why but but essentially
31:04
is is that is said you can inject more
31:07
and more liquidity but you cannot move
31:08
the interest rate so you lost a policy
31:10
tool this was the tragedy of Japan for
31:13
many decades okay they they they were
31:16
stuck against the zero lower bound the
31:18
liquidity trap and so they had to go
31:20
through massive fiscal expansions
31:23
because they didn't have they were in
31:24
recession chronic recessions and they
31:26
didn't have powerful monetary policy
31:29
tool because they were against the zero
31:31
lower B so why did I use this
31:34
opportunity to bring this about because
31:36
that's for the reason I just described
31:39
the case of Japan but
31:41
but I asked the question here what would
31:44
you advise the government to do when I
31:46
already told you the answer if if you
31:47
have an economy is and a recession and
31:50
and this means you use all the monetary
31:52
policy that you had conventional mon
31:55
monetary policy that you have now we
31:57
have UNC conventional monetary but I'll
31:59
tell you a little bit more about that
32:00
later but once you run out of this and
32:04
you're still in a recession what would
32:05
you tell the government to
32:10
do use fiscal policy that's the other
32:13
tool you are so that's a typical
32:15
situation you see when countries are the
32:17
interest rate are already very low they
32:19
tend to use much more actively fiscal
32:21
policy because it's the only policy they
32:22
have left and that has been the case of
32:24
Japan again since the crash of their
32:27
financial bubble in the late 80s early
32:32
90s so look at the covid-19 response
32:36
something happened to my figure here but
32:38
anyways this is zero essentially so this
32:41
is
32:42
covid okay the covid shock happened
32:46
clearly the economy was imploding into
32:48
recession the FED immediately reacted
32:51
and cut interest very very aggressively
32:53
to zero and then we were stack there
32:56
this is effectively zero I mean they're
32:57
Technic things why thing moves a little
33:00
but but this is effectively
33:02
zero so the US was during that period
33:05
against really a a a liquidity against
33:08
the zero lower bound there was no more
33:10
power for the kind of monetary policy
33:13
that we have describe
33:15
here so let
33:17
me so so that tells you that that
33:20
there's going to have to be a lots of
33:22
fiscal policy if you want to get out of
33:23
that and I'll show you that later there
33:25
was a lot of fiscal policy but but
33:28
before getting there I'm going to show
33:29
you something that you don't need to
33:31
really know for the quiz But but so you
33:33
can understand what is going on the
33:36
newspapers a little better the FED that
33:39
was not the only precisely because
33:41
because the situation of
33:43
Japan was so chronic people began to
33:46
develop lots of tools alternative tools
33:49
for central banks to use when you your
33:51
interest rate this the main interest
33:53
rate you use is stuck against zero
33:55
against the zero lower bound and that's
33:57
what you may have heard is called
33:59
sometimes unconventional monetary policy
34:01
QE quantitative easing all those kind of
34:04
things they represent essentially
34:06
policies that are like monetary policy
34:09
but they're not exactly the way we have
34:11
because they don't they're not
34:12
interventions in very shortterm bonds
34:14
there interventions in other assets out
34:16
there in this course we have it very
34:18
simple we have only one interest rate in
34:20
reality there are multiple bonds they
34:22
are risky bonds they are spread somebody
34:24
asked about risky Bonds in a few
34:25
lectures ago there are Express there
34:27
lots of of interest rates floating
34:28
around so in principle a central bank
34:31
could intervene in those other rates as
34:32
well in fact in Japan they have even
34:34
intervened in the stock market that
34:36
tells you how far they can go okay so
34:39
you so in a richer environment with more
34:41
financial Assets in principle the FED
34:43
could go beyond the standard short-term
34:45
bonds that they go for for their open
34:47
market operation and that's
34:50
exactly what they have been doing a way
34:52
of thinking about that is remember when
34:54
when we look at a Monet expansion
34:56
conventional monetary policy we start
34:59
with a balance sheet like that remember
35:00
we said the the central bank has bonds
35:02
and then money if he wants to have an
35:04
expansion in monetary policy goes out
35:06
there it buys more bonds and gives them
35:09
the gives the banks money okay and that
35:13
expands the balance sheet you end up
35:15
with more the balance sheet of the
35:16
Central Bank ends up with more bonds and
35:19
also with more liabilities because it
35:21
gave more money to people out Banks and
35:23
so on so he owes more money so monetary
35:27
policy naturally expansion and monetary
35:29
policy naturally leads to an expansion
35:31
of the balance sheet now for
35:33
years outside of Japan nobody really
35:36
cared too much about that because this
35:39
effect relative to what you saw in the
35:40
interet was very small I mean yeah the
35:42
balance sheet was moving a little bit
35:43
but it was mild no so here we hit the
35:47
zero lower
35:48
bound and essentially the FED went out
35:50
and bought all sort of things first of
35:53
all the when you hear QE quantitative
35:56
easing
35:58
that means mostly that the FED goes out
36:00
there and buys not only shortterm US
36:04
Treasury bonds but long-term BS okay
36:07
because there something called the term
36:09
spread typically interest rates in the
36:10
long run are higher than than interest
36:13
rate in the short right typically
36:16
controlling for a bunch of things and
36:18
that's called the term premium well they
36:21
went and bought those kind of bones they
36:23
also bought bought bones issued by
36:25
frenan f
36:29
what is Freddy ma no Freddy and Fanny H
36:34
mortgage back Securities a bunch of
36:35
stuff even loans in fact they created a
36:38
facility to buy corporate
36:40
bonds and at some point they created a
36:42
facility to buy Fallen Angels Bond
36:45
initially it was only investment great
36:47
bonds all the companies that have the
36:49
best possible rating but that wasn't
36:51
enough so they went out there and and
36:53
created a facility to buy Fallen angin B
36:57
Fallen were essentially companies that
36:59
were Prime companies before covid but
37:02
you know but after covid they didn't
37:04
look so good Airlines you know cruises
37:07
and stuff like that hotels and so on so
37:10
that was a massive expansion of the
37:12
balance sheet so in terms of this this
37:14
guy grew a lot okay but the purpose
37:18
that's like monetary policy that's what
37:20
we call unconvention it's different from
37:21
the standard one but they were doing
37:23
trying to operate very much like
37:26
monetary policy operates here you see
37:28
the balance sheet of the fed you see
37:31
before the the the global financial
37:33
crisis or the Great Recession of 2008
37:36
2009
37:38
ER the balance sheet wasn't an
37:40
interesting thing to look at as the
37:42
central bank because the idea they did
37:43
the regular open market operations and
37:46
you know for for anti-al policy but you
37:49
would see small Wiggles in the size of
37:51
the balance sheet relative to the size
37:52
of the balance sheet in the global
37:54
financial crisis they hit the zero lower
37:56
Bound for the first time the US and so
37:59
there you saw massive expansion of the
38:02
bance this is the number of assets the
38:03
same happen to liabilities they out side
38:05
of it is they're injecting massive
38:07
amount of money into the economy okay so
38:10
there use a big expansion the recovery
38:13
from the global fin was hard because the
38:15
financial sector was very compromised so
38:18
it took them a while they kept doing
38:20
these kind of policies then they began
38:21
to unwind the balance sheet and then Co
38:24
came and that's what I was showing you
38:26
before massive they send the interest
38:29
rate to
38:29
zero that wasn't enough and then they
38:32
went out and bought lots of other
38:34
Financial assets which work very much
38:37
like monetary policy big thing and now
38:40
they're unwinding the thing now we're
38:42
we're in the opposite process we have
38:43
inflation we want to get out of this
38:44
situation they unwinding but you can see
38:46
the size of that is
38:48
huge
38:50
huge I mean this is you know the balance
38:54
sheet that a couple of decades ago had
38:56
was was when the of the order $1
38:58
trillion which is more or less the money
38:59
that is circulating around ER now it's
39:02
$9 trillion massive
39:05
theion and all central banks major
39:08
central banks look like this I mean the
39:09
ACB also looks like
39:12
this the bank of
39:14
Japan H looks like this but actually you
39:17
don't see this blips that much because
39:18
they began to do them here okay so they
39:21
have been accumulating for a long
39:23
time they have been using this kind of
39:25
policy what about
39:28
so coming back now to the course what
39:30
about fiscal policy well I'm showing you
39:33
different countries around the world
39:34
massive fix fiscal expansion during the
39:37
covid episode massive I mean this is you
39:40
know the US the fiscal expansion if you
39:42
combine all the packages so the order of
39:44
20% of
39:46
GDP that's huge for fiscal you don't see
39:49
things like this and this happen almost
39:51
everywhere okay now you don't see things
39:53
like that outside of Wars this was
39:56
really like a war there's no doubt of
39:59
that the kind amount of expansion in
40:01
fiscal policy we saw was comparable to
40:03
what you see in a
40:06
war so there you have it big recession
40:10
huge recession massive policy response
40:12
both monetary of a conventional and
40:15
unconventional kind and fiscal and again
40:19
this was not unique to the US it
40:21
happened essentially everywhere China is
40:23
a little different for reasons I think I
40:26
mentioned uh in the first lecture
40:29
but I may talk more about that
40:32
later
40:34
good okay so another policy mix this is
40:37
different so what do we have
40:39
there that's another policy mix that we
40:42
see fairly
40:45
frequently so what is
40:47
that LM going down that's expansion in
40:50
monetary
40:51
policy I going to the left that's
40:54
contractionary fiscal policy okay so
40:57
when do you think you would do such a
41:03
thing or countries would engage and
41:05
things like this again what if you want
41:07
to like reduce like government spending
41:09
you want to off a recession exactly
41:11
that's that's exactly the the conditions
41:15
when you want to do this it's called
41:17
consolidation of the fiscal deficit
41:19
sometimes you you you know you have a
41:20
large fiscal deficit that's leading to
41:23
accumulation of public debt that doesn't
41:24
look so good so the the the government
41:30
the central the treasur in the case of
41:32
the US may may decide that he wants to
41:37
reduce fiscal policy but he's afraid
41:40
because and doing so is going to cause a
41:42
recession and the purpose and there is
41:44
no problem of output being overheating
41:46
that it's just that the fiscal accounts
41:47
look look they
41:50
weak so if that's a situation that is if
41:54
the economy is not going is not going
41:56
through an overheating period perod and
41:57
so on and you want to reduce the fiscal
42:01
deficit in some places it will be
42:03
explicit in some places implicit but you
42:06
know the central because the central
42:07
bank has a goal to keep prices stable
42:10
and an output close to the potential
42:13
output so even if there's no explicit
42:16
coordination if the if the government
42:18
announce a massive fiscal consolation
42:21
package say reduce going expenditure by
42:23
10% the Central Bank knows that that's
42:26
going to cause a recession and so the
42:28
Central Bank naturally will respond by
42:30
cutting interest rate to that because
42:32
the recession is not needed if if the if
42:35
the US announced today a a fiscal
42:38
contraction of 5% I'm not sure the FED
42:40
would do anything just stay there put
42:42
okay because we have an economy is
42:46
overheating but but so that's what you
42:48
would do in a situation in which you
42:50
want to fix the fiscal account and the
42:53
economy is more or less at the at the
42:55
normal time it's not it's not over here
43:00
heating when would you do the
43:08
opposite or when it's not when would you
43:11
do the opposite is when are you likely
43:13
to see the
43:19
opposite so first of all what is the
43:21
opposite the opposite is a combination
43:24
of a fiscal expansion with a Monet
43:29
contraction okay when do you think you
43:32
would see such a
43:37
thing either maybe when government has a
43:42
budging maybe
43:44
when rates are too
43:47
high
43:50
yeah okay that's
43:53
true but but I'm not sure that's yeah
43:56
but that requires a to concerted
43:58
decision and so on H it's true yeah
44:02
valid question it's not the one I wanted
44:04
I wanted something more interesting but
44:06
more exciting but but those
44:09
are valid
44:15
answers War you know War typically is
44:18
all
44:23
in no okay let me not I know it's a
44:28
strange question but but I know where
44:30
I'm heading a um suppose that the
44:34
government decides to
44:36
spend for whatever
44:38
reason and the Central Bank says Whoa We
44:40
don't need that expenditure now so you
44:43
know we don't need this exp fiscal
44:45
expansion now because we're on the
44:47
margin of overheating and now I'm going
44:49
to get this big fiscal expansion then
44:51
the fed the central bank is likely to
44:53
react to that and high interest rate
44:56
that will will make very upset the
44:58
government it always happens the
45:00
government gets very upset guy say look
45:02
I'm trying to span the economy and
45:03
you're fighting me okay but that's the
45:06
nature of the that's the reason central
45:08
banks are meant to be independent so
45:10
they can they can offset that and the
45:13
reason I wanted to highlight the example
45:14
is I think some of that and somebody
45:16
asked that question I think in the
45:17
previous lecture ER happened to the US
45:21
economy one of the reasons we are in an
45:23
overheating situation right now is
45:26
because the US had a big fiscal
45:28
expansion early in
45:30
2021 and that fiscal expansion was at
45:32
the time in which there wasn't much
45:34
spare capacity in the economy so we were
45:36
very close to Full Employment the supply
45:38
side was very constrained and so on and
45:41
so there may have been good reasons for
45:42
the fiscal package transfers to people
45:44
that you need to transfer and so on but
45:46
the macroeconomic consequence of that
45:48
very naturally was going to lead to
45:50
overheating and and the and the FED did
45:53
not respond to that and I think that's
45:56
one of the reasons people think
45:58
sometimes that the fed well there's no
45:59
doubt exposed that the Fed was behind
46:02
the curve but one of the reasons they
46:04
were behind the curve is
46:06
that they there was this big fiscal
46:09
expansion which naturally was going to
46:11
span output and they did not react to
46:13
it and eventually they reacted but it
46:16
took them a long time and by then we had
46:17
inflation and all that okay so that's a
46:19
situation in which we should have seen a
46:21
picture like the opposite of this but we
46:23
didn't see the picture we didn't see the
46:24
monetary part and that's the reason we
46:26
end up ended up with an economy that is
46:30
overheating okay
46:37
yeah I mean it's always it's a very
46:40
uncertain environment here yeah they
46:42
thought this was going to be very
46:43
transitory that that that there was
46:46
enough inflationary Dynamics
46:48
disinflationary dynamics that that would
46:50
have settled that Expos is obviously it
46:53
was a mistake but it's exposed I mean
46:54
there was a lot of noise and so on then
46:56
it cames the
46:57
the Russian war that sort of increased
47:00
the price of oil dramatically and that
47:03
sort of created lots of bad Dynamic so
47:06
they were
47:07
unlucky that part is a part that I think
47:10
that that again they thought we were
47:13
going through a temporary situation they
47:14
didn't think that it was going to be
47:16
strong enough they thought the supply
47:17
side was going to expand a lot faster
47:19
than it did ER so they may have been
47:23
right in not fighting it but over a
47:25
horizon of three years and they found
47:27
everything very compressing to three
47:28
months and that led to to a
47:31
problem uh so the last thing I want to
47:34
show you is is is is
47:38
um that this mod how this mod Works in
47:40
practice if you if you I mean obviously
47:43
you're not going to estimate exactly the
47:44
model I show you if you have a real
47:47
model we have Dynamics and many more
47:49
things but the the the the more complete
47:51
version of what I just show you the islm
47:54
show you many people have estimated sort
47:57
of you know how do for
48:01
example I've estimated the response of
48:04
of of the economy to monetary shocks or
48:06
to fiscal expansion and so on and they
48:09
trace out different Dynamics different
48:12
variables and and you know and check
48:13
whether that's consistent with the slm
48:15
framework or not and the point of this
48:17
figure is that it's is very consistent
48:19
with that but let me show you a little
48:20
bit all time so this is the effect on
48:22
different variable of a surprise
48:25
increase in the in the federal funds
48:27
rate that's the monetary policy rate
48:29
okay federal funds rate is the is the
48:31
interest rate that the FED sets and what
48:34
you see that in practice what what you
48:36
see is um this is the impact on retail
48:38
sales on sales out really more or less
48:43
and yeah in practice the output doesn't
48:45
respond immediately it takes a while it
48:48
takes several quarters but eventually
48:50
hits you and that's one of the big
48:52
issues with monetary policy today that
48:54
is that clearly inflation is not under
48:56
control but they have done a lot and we
48:59
know that that it takes time for the
49:02
economy to really perceive the full
49:04
impact of a monetary policy and so
49:07
that's a tension now because lots of
49:08
people pushing the FED to do more
49:10
because we still have 6% inflation but
49:12
they have done a lot and they know the
49:14
monetary policy works with lags with
49:16
long and variable lags is a famous
49:18
sentence and so you know it takes about
49:20
six quarters to really see the mess how
49:23
much mess has been cost right now it
49:25
will take a while so I have to see you
49:27
see output well it's more like sales the
49:30
same thing initially declines slowly but
49:32
but it takes a while but it does have a
49:34
very large
49:35
effect this is employment same
49:39
thing something this these diagrams you
49:41
don't you don't well this unemployment
49:44
naturally the other side of it is
49:47
unemployment also will build up slowly
49:49
so unemployment is very low now but we
49:51
don't know when you the economy really
49:53
feels the impact of all the monetary
49:55
policy has been done in the last eight
49:57
months or so where will unemployment end
50:01
and the big problem for the FED today is
50:04
something that you don't need to
50:05
understand until the second part of the
50:07
course is that prices do decline
50:09
eventually but it takes a long time so
50:12
to control inflation with monetary
50:14
policy takes a while a long time let's
50:16
see whether the economy consumers and so
50:19
on have the patience to to hang in
50:21
there
50:25
okay e
— end of transcript —
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