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