[00:16] okay so let's H let's continue with this
[00:19] islm model remember in the previous
[00:21] lecture we we set up we set it up we
[00:24] cons we built the eslm model I will go
[00:27] over that very quickly in this lecture
[00:30] because I think it's very important for
[00:31] you and then we're going to use it and
[00:34] uh eventually we're going to talk a
[00:35] little bit about the policy response the
[00:38] mcro macroeconomic policy response
[00:41] during the covid-19
[00:44] ER shock or recession all of the
[00:51] B so the the starting point remember
[00:54] with first thing we did we constructed
[00:56] the relation and the relation was just
[00:59] the same as lecture three but we sort of
[01:02] expel out what what is inside that
[01:04] investment that we had taken as a
[01:06] constant there we said well far more
[01:08] realistic is to make investment itself
[01:10] increasing in output because it's
[01:12] increasing in
[01:13] sales that in one change analysis that
[01:17] we had in lecture three all that will do
[01:19] is change the slope of the of the
[01:21] aggregate demand curve and therefore
[01:22] change the multiplier but we could have
[01:25] solved everything in terms of lecture
[01:27] three what made this a little different
[01:29] from lecture three is that we also said
[01:31] the
[01:32] investment real investment remember this
[01:34] has nothing to do with financial
[01:35] investment real investment is also a
[01:37] decreasing function of the interest rate
[01:40] okay and
[01:43] so er and and that led to the is
[01:47] relationship which essentially says
[01:48] these are all the is curve traces all
[01:51] the combinations of output and interest
[01:53] rate that are consistent with
[01:55] equilibrium in the Goods Market that's
[01:57] the definition of the now of course
[02:00] you know in in in lecture three we were
[02:02] able to determine equilibrium output
[02:05] here we
[02:07] can't why can't
[02:17] we yeah we have two unknowns it's output
[02:20] and the interest rate and we have only
[02:22] one relationship the is LM the curve so
[02:27] the reason for the LM curve is that we
[02:29] need pin down the second
[02:31] variable okay and that's what LM will do
[02:34] and it will be sort of very brutal about
[02:37] it in the past remember it was some
[02:38] upward slope in relationship I said in
[02:40] previously no that's not what the
[02:42] central banks do today just set the
[02:44] interest rate so if the Central Bank
[02:46] sets the interest rate then you can use
[02:48] lecture three to pin down equilibrium in
[02:50] the Goods Market which is what you would
[02:52] effectively be doing here if you fix
[02:55] this interest rate at whatever level the
[02:57] Central Bank wants then now you have one
[02:59] curve for one unknown which is output
[03:01] and that's exactly what we solve in
[03:03] lecture three
[03:06] okay
[03:08] good um so I said you know lecture three
[03:12] now this z z Curve will a little steeper
[03:14] because investment also responds
[03:17] positively to increases in
[03:19] output importantly now we have an
[03:21] interest rate which is a shifter of this
[03:24] aggregate demand in particular if the
[03:26] interest rate goes up what happens to
[03:28] that curve
[03:34] so if the interest rate goes up what
[03:37] happens to the AG demand
[03:40] curve I have two candidates here down or
[03:46] up down yeah because investment drops so
[03:50] you can tell me even more by how much if
[03:52] I tell you how much a change in the
[03:54] interest rate is and I tell you what is
[03:56] a sensitivity of investment to the
[03:58] interest rate you know exactly by how
[04:00] much this thing will come down it's
[04:02] going to be the change in the interest
[04:03] rate time the sensitivity of the
[04:05] investment function to to the interest
[04:09] rate that's not the end of the story as
[04:11] you well know that's the horizontal
[04:13] shift in a great demand but the final
[04:15] decline in output will be larger than
[04:18] that initial decline in investment as a
[04:20] result of the higher interest rate why
[04:22] is
[04:25] that
[04:27] so someone say the fed raises interest
[04:31] rate ER that immediately reduces
[04:34] investment because investment is
[04:37] negative related to the interest rate
[04:39] that immediately decreases aggregate
[04:41] demand which immediately increases
[04:44] decreases output because in this part of
[04:45] the course output is determined by agre
[04:48] demand does the adjustment stop
[04:52] there no that's what the multiplier was
[04:54] about because now with lower income
[04:57] there's lower consumption and actually
[04:59] lower investment as a result of that and
[05:01] we keep going okay so this the final
[05:03] Decline and output is a lot larger and
[05:06] doing that kind of experiment moving the
[05:08] interet around and seeing what happens
[05:10] to equilibrium output is that we derive
[05:13] we constructed the I curve okay that's
[05:18] here is for a cutting the inter no oh
[05:22] this is exactly the experiment I just
[05:23] describe so if you raise the interest
[05:26] rate then aggre demand comes down and
[05:29] then output declines buy a lot more than
[05:30] the initial decline in investment
[05:32] because of the multiplier but eventually
[05:34] we get to another equilibrium output
[05:36] which is that so now we know that this
[05:39] point belongs to the yes curve because
[05:40] it's a combination of output y Prime an
[05:44] interest rate I prime that is consistent
[05:46] with equilibrium in the Goods Market
[05:48] that's what lecture three told us that's
[05:50] what equilibrium in the goods markets
[05:52] look like that's another point of the
[05:54] same
[05:55] is H because I have higher output here
[05:58] lower interest rate straight that's
[06:00] another point of the as that's the
[06:01] reason this downward sloping look at
[06:04] what I just said I said I have another
[06:06] point of the same I how do I know it's
[06:10] the same
[06:11] as and not some other
[06:18] I you know all that I told you there is
[06:20] I found two points two combinations of
[06:23] output and interest rate that are
[06:25] consistent with equilibrium in the Goods
[06:27] Market but I said a little more I said
[06:29] and that's part that's the way we
[06:31] construct one
[06:36] is exactly because there is a lot of
[06:39] other parameters that we're keeping
[06:40] constant there you know that's the
[06:44] distinction between a movement along and
[06:45] is curve which is when the when the only
[06:47] thing I move is the interest rate that
[06:49] allows me to trace a movement along a
[06:52] single is if I move something else like
[06:54] taxes go on expenditure or autonomous
[06:58] consumption by you know something like
[07:00] that then I I will be Shifting the
[07:03] agregate demand for any given interest
[07:04] rate and I want to get a different level
[07:06] of output for any given interest rate
[07:08] which means I'm going to be in a
[07:09] different I
[07:11] okay and that's what we did there no in
[07:14] that case there we would said look I can
[07:17] fix the interest rate any interest rate
[07:18] you want let's pick this one but I could
[07:20] have done it other interest rate here
[07:22] there whatever and now I say what
[07:24] happens if I increase taxes well again
[07:27] you know from lecture three exactly what
[07:29] happen happens when the interest rate is
[07:31] constant because there we didn't even
[07:32] talk about the interest rate nothing was
[07:34] a function of the interest rate and you
[07:37] increase taxes well that will reduce
[07:38] disposable income for any level of
[07:41] output and H that um will lead to
[07:46] contraction our great demand output and
[07:47] so on so forth so that means that for
[07:50] this interest rate now I found another
[07:53] Point another point that is is an
[07:56] equilibrium in the Goods Market but it
[07:58] belongs to a different is because I move
[08:00] one of the parameters which is the taxes
[08:02] okay and now for this higher level of
[08:04] taxes I can play around with the
[08:06] interest rate I can say well what
[08:07] happens if I cut interest rate well if I
[08:09] cut interest rate I'm going to find
[08:10] another equilibrium say here if I cut
[08:13] the interest rate from here to here I'm
[08:15] going to find another equilibrium LEL of
[08:17] output which is consistent with that
[08:19] very same is why is that very same is
[08:22] well because I haven't moved taxes again
[08:25] okay so the reason I'm I'm repeating
[08:28] this is because I I it's very important
[08:30] to understand what what is a movement
[08:31] along the is versus what shift the
[08:36] is
[08:38] good then we move to the LM relation no
[08:42] and the LM relation is just equilibrium
[08:44] in the financial Market this is
[08:46] combinations of output and interest rate
[08:48] that are consistent with equilibrium in
[08:49] financial
[08:50] markets and we constructed from our
[08:54] money supply equal to money demand in
[08:56] nominal terms then we divide it by P
[08:58] which is not very interest in this part
[09:00] of the course because p is constant
[09:01] we're assuming that P is not moving
[09:03] that's the price of goods and services
[09:06] and then we have a this this this
[09:08] equilibrium here now stated in real
[09:10] terms so real money supply is equal to
[09:13] real money demand and as I said had you
[09:16] taken this course a few years back or
[09:18] perhaps in other places I don't know H
[09:21] that would have been an upward slop in
[09:23] relationship so the LM would have been
[09:25] an upward sloping relationship how do I
[09:26] know it's upward sloping well because if
[09:29] if I don't don't change money supply and
[09:30] I increase output then I need to bring
[09:33] Li down and since L Prime is negative
[09:37] the way to bring L down is by increasing
[09:39] the interest rate so that's what would
[09:41] have given you an upward sloping LM
[09:45] curve I said we don't do that now
[09:47] because really Bank central banks
[09:49] abandoned a long time ago in most parts
[09:51] of the world not everywhere this idea of
[09:53] targeting M what they target directly is
[09:56] the interest rate and then they give you
[09:58] 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