Advertisement
48:33
Transcript
0:16
but before I I I I do that before I get
0:20
into the islm model um let me spend a
0:24
little time telling you what is going on
0:27
uh in the US economy and
0:30
as as this will relate to the kind of
0:32
things I will discuss later in the in
0:34
this lecture so what you see there is is
0:37
the path of net worth so wealth
Advertisement
0:39
essentially of households and nonprofit
0:43
organizations households primarily in
0:46
the US and what you can see is that you
0:49
know there's a more or less steady Trend
0:50
obviously in recessions net wealth tends
0:53
to declin ER and it certainly early on
0:57
in the covid recession it declined very
0:58
dramatically because the price price of
1:00
equity the price of houses everything
1:02
decline with the initial shock but what
Advertisement
1:05
you see after that is a dramatic rise in
1:08
wealth in the US and all around the
1:10
world but particularly in the US and and
1:14
what is behind that well there are two
1:15
things are behind that but the main one
1:18
is asset prices you know you have
1:20
massive rallies in the equity Market the
1:22
price of houses sort of skyrocketed
1:25
everywhere and so on last year 2022 was
1:29
a bad year for for asset values the
1:31
equity Market declined pretty sharply in
1:33
the US but it's still I mean it's a
1:35
small decline relative to the big build
1:38
up on wealth
1:40
now why do I do you think that in this
1:43
course I would be talking about this at
1:45
this
1:46
point what happens what do remember
1:49
we're we're in this part of the course
1:51
we're trying to come up with a model of
1:53
aggregate demand and then how aggre
1:55
demand reacts to policy that's the name
1:57
of the game in this part of the course
1:59
so if I tell you that wealth increase a
2:01
lot why do you think I'm telling you
2:08
that aggregate demand consumers feel
2:10
rich they will tend to consume more that
2:12
will increase aggregate demand so the
2:14
point I'm highlighting to here is that
2:16
there's a big force behind increasing
2:19
aggregate demand which is consumers feel
2:21
richer by the way something similar is
2:24
happening in corporations and investment
2:26
is also pretty high because of that real
2:29
investment the other source of of of of
2:33
increasing wealth which is not as
2:34
dramatic as the previous one but is very
2:37
important especially in lower income
2:39
segments of the population which tend to
2:41
have a higher propensity to consume is
2:44
that ER incomes did not decline a lot
2:49
during during
2:51
covid and in some cases they even
2:53
increased because of the large transfers
2:55
that we saw from the government to
2:57
individual households especially lower
2:59
income households and at the same time
3:02
there wasn't much to spend
3:04
on so that meant that the saving rate
3:07
also went up a lot in the US during the
3:10
covid recession okay so people save a
3:12
lot more that's sort of the average
3:14
saving of household saies you know this
3:17
is by quarter I think no by monthly but
3:20
that's what we saw in the past look at
3:22
during the covid recession people save a
3:24
lot
3:25
more and what you're seeing today is
3:27
obviously they save a lot more that's
3:29
part of the increasing net we worth is
3:32
is due to this it's small relative to
3:34
the amount of wealth we saw increased
3:36
but but this was about this excess
3:39
saving amounted to about 2.7 2.8
3:42
trillion dollar so you get a sense of
3:44
the order of magnitude and what we is
3:46
happening now is that people are
3:47
dissaving so now people are saving less
3:50
than they used to because now they have
3:53
opportunity to spend their stuff on okay
3:56
and so that's you see massive demand for
3:57
travel massive demand for restant hotels
4:00
and stuff like that well that's has a
4:02
lot to do with people had the money to
4:04
do it they hadn't been able to do it for
4:06
a while so now they're doing a lot of
4:08
that why would I be telling you this now
4:12
in the course in it is part of the
4:13
course for the same reason I told you
4:15
that net worth went a lot I mean people
4:17
have the savings and they're really
4:20
willing to spend it that puts lots of
4:21
upward pressure on our great demand
4:25
okay these pictures capture more or less
4:28
the same this is captures very much much
4:29
what I said in the previous slide you
4:31
see the personal saving rate that's the
4:34
average I don't remember over oh seveny
4:38
year average and you see what happened
4:40
during covid big spike in the saving
4:43
rate and now big big decline in the
4:46
saving rate where the saving rate is
4:48
much lower than what normally is and
4:51
remember the saving rate is is your
4:53
income minus your consumption so if
4:55
you're saving less you're consuming more
4:57
relative to your income no that's that's
4:59
the way it
5:00
works obviously there's lots of
5:03
heterogeneity some people made a lot of
5:04
money some people didn't make a lot of
5:06
money during covid H some people Save A
5:08
Lot some people didn't save a lot and
5:11
and and and in fact we do know that that
5:15
sort of on the lower income segments a
5:18
lot of the excess saving is already gone
5:20
I mean accumulated early on but they
5:22
spent it also much
5:24
earlier um so but what you're beginning
5:27
to see in some of those segments is even
5:29
though the don't have excess savings
5:31
they're borrowing a lot so now you see
5:34
credit card borrowing which had declined
5:36
a lot and now has increased quite a bit
5:39
and again what do you borrow for well
5:42
for consumption so that also
5:44
funds additional consumption so for all
5:47
these reasons in this Mo at this moment
5:49
the US economy and many economies around
5:52
the world are so what we call
5:54
overheating there a lot of demand for
5:56
the for the production that capacity of
5:58
the economy and that translates the the
6:01
problem say well what's wrong with that
6:03
well the problem is something you don't
6:05
understand at this part of the course
6:06
you understand but you don't have a
6:07
model for but you will have six Le six
6:11
lectur more or less from now is that
6:13
that leads to high inflation you don't
6:16
know that but intuition tells you that
6:18
is a lot of demand relative to supply
6:20
well prices tend to go up this that
6:23
happens in micro and it also happens in
6:25
macro we'll learn that later but in any
6:28
event as a result of this the US economy
6:30
is overheating and therefore monetary
6:34
policy has been very contractionary the
6:37
FED has been tightening interest rate to
6:40
cool down the economy so how does that
6:43
happen well that's what the kind of
6:45
things that we can answer with the islm
6:47
model okay so the FED is very islm like
6:52
I mean that's the way they think the
6:54
model is richer they have more equations
6:56
and so on but they are thinking in terms
6:58
of the mechanism that we're about to
7:00
sort of summarize in the eslm mod okay
7:04
so if you have an economy that has this
7:06
problem and you are in the Central Bank
7:09
you need to use monetary policy well to
7:11
understand how the thing works you need
7:13
the eslm model that's a starting point
7:16
then you can add bells and whistles but
7:18
your starting point is the model we're
7:21
about to see anyway so so what you see
7:23
is what I was saying is that all that
7:25
wealth all that excess saving all that
7:27
pent up demand if you will led to lots
7:31
of H led to a very an economy it's
7:33
overheating and you can see here what
7:35
happened I disentangle between a
7:38
consumption of goods and consumption of
7:41
services you consumption of servic is
7:43
about two third of consumption remember
7:44
we talk about that and goods is about
7:47
one3 what happens is is in the scales
7:50
are different noce this is for goods
7:52
this that's for for services but what
7:56
you what you see here is that you know
7:58
that was the trend so consumption in
8:00
Services was growing at a steady Pace
8:03
then covid came and collapsed I mean you
8:06
couldn't go to restaurant you couldn't
8:07
travel you couldn't do anything so
8:09
consumption in Services collapsed and
8:12
now has been recovering and and and and
8:14
that recovery pick up pace last year
8:17
actually 2021 already pick up pace and
8:19
by now we're above the trend okay so
8:22
service consumption that collapsed
8:24
during covid now has fully
8:27
recovered while at the same time the
8:29
capacity to produce in the service
8:30
sector hasn't recovered equally but that
8:32
and we'll get that to that after quiz
8:34
one what happens to Goods consumption
8:37
well also initially collaps but then
8:40
well you know people were Bor at home
8:41
they couldn't do anything they bought
8:43
lots of gadgets and and stuff like that
8:45
so Goods consumption went up very
8:47
sharply during covid way above the trend
8:49
you see there's covid collapse and then
8:52
people began to buy all sort of gadgets
8:55
okay and so now it's slowing down but
8:58
still if you look rela to Trend
9:00
consumption of goods is way above what
9:02
would have been in the absence of this
9:03
episode so the sum of the two things
9:05
tells you that you have an economy with
9:07
a lot of consumption and that and that
9:11
at this moment the FED wants to cool
9:12
down okay it's too much for the economy
9:15
to take so the FED wants to cool it down
9:18
and and we're going to see how how you
9:20
do
9:21
that okay so now let's get into into
9:25
this set of lectures and please please
9:27
stop if there's anything that is unclear
9:29
because as I said this is probably if IA
9:32
of the summer you have forgotten
9:33
everything you have learned this course
9:34
but you remember these two lectures well
9:36
I'll be happy okay so so stop it if you
9:42
do in fact I I normally I I I have
9:44
taught this lecture in one I I decided
9:47
to try to slow it down as much as I can
9:49
because again I think it's particularly
9:51
important for this course and for your
9:53
stock of knowledge
9:55
so so one of the thing the main things
9:57
we're going to be able to do with this
9:58
small been saying is we're going to be
10:00
able to discuss the main macroeconomic
10:03
policy tools which are monetary policy
10:05
monetary policies is the main antic
10:07
cyclical pool tool but we're also going
10:09
to be able to understand fiscal policy
10:11
and fiscal policy is not exactly
10:14
equivalent to monetary policy it works
10:16
through different mechanisms allows you
10:17
to do things that are more targeted
10:19
transfer resources to a specific group
10:20
of people and so on ER and sometimes
10:24
monetary policy is just not enough and
10:26
the covid-19 initial recession was
10:28
clearly a case of that and you had to go
10:31
all in and and and we'll see what what
10:33
what we did there it was pretty dramatic
10:36
as an intervention I think that's the
10:38
covid-19 recession LED probably to what
10:41
no not probably surely to the largest
10:44
combined packaging history of policy
10:46
support okay in terms of monetary policy
10:49
and uh and fiscal
10:53
policy
10:54
so so that's what so what we're want to
10:57
so we're going to after these two
11:00
lectures you're going to get to
11:01
understand essentially uh The Joint
11:03
determination of output and interest
11:05
rate H and we're going to be able to
11:07
study as I said before the impact of
11:09
monetary and fiscal policy and this
11:12
framework that we're going to use to
11:14
develop to to study this is what hick
11:17
and Hansen initially called the
11:21
islm
11:23
model I already sort of hinted that that
11:26
this was coming but why do you think the
11:29
name
11:36
I not the that I separate that is se you
11:40
will separate is from LM remember what
11:42
we're trying to do here we're trying to
11:44
look at the Joint determination of
11:46
output and interest rate that is we're
11:48
trying to determine at at the Joint
11:50
equilibrium of goods markets and
11:52
financial
11:56
markets when we describe the equilibrium
11:58
in the goods Market we said there is an
12:00
alternative way of describing remember I
12:02
said it as investment equal to savings I
12:06
equal to
12:07
S okay so the is part of the name comes
12:10
from the part that has to do with
12:12
equilibrium in the Goods Market is
12:14
investment equal to savings and the LM
12:17
part has to do remember L was that
12:20
component of aggregate demand we we had
12:23
in the financial markets we look at
12:25
equilibrium as aggregate demand demand
12:28
for money equal to supply of money
12:30
supply of money was M demand for money
12:32
was y * L of I and there therefore the
12:36
LM part okay that's the reason that's a
12:38
nemonic for why this model is called the
12:41
is LM the is stands for the part that
12:43
has to do with equilibrium in the Goods
12:45
Market the L has to do with the part has
12:47
to do with equilibrium Financial Market
12:49
this model is a model that combines
12:51
those two equilibrium okay so we're
12:53
going to be interest interesting points
12:56
in which both markets are in equilibrium
13:00
that's the name of the game
13:03
here so let's first develop the is
13:06
relation and the yes relation is really
13:09
going back to lecture three we're going
13:12
to go back to lecture three use the same
13:15
model we use in lecture three with one
13:19
change and that change is a remember in
13:22
in in lecture three we work a lot on a
13:24
consumption the only endogenous the only
13:26
function we had was a consumption
13:28
function remember remember and then all
13:30
the rest we took as sort of given
13:31
government expenditure was given
13:33
investment was given all that was given
13:35
well we're going to relax one of those
13:37
here and we're going to we're going to
13:39
flesh out a little more of this
13:40
investment here make get make it closer
13:44
to what what a a realistic function it's
13:46
not a constant obviously it's not to
13:48
exogenous to equilibrium output and so
13:50
on in fact we do know that real
13:53
investment this is physical investment
13:55
remember this is what is this ey is
13:57
investment this is purchase of goods and
13:59
services by firms for the purpose of
14:01
building Capital Equipment structures
14:03
and stuff like that I saw in PIAA very
14:05
quickly I'm not into that but I see more
14:07
or less the
14:08
flow that somebody asked should bonds be
14:11
included in
14:13
investment what is the
14:15
answer in that investment
14:24
I should purchase of bonds be included
14:28
in that investment
14:33
no this is purchase of goods and
14:36
services by firms no Capital machines
14:39
stuff like that the other thing is a
14:41
financial investment it's nothing to do
14:42
with the Goods Market something that has
14:44
to do with the financial Market not with
14:46
a Goods Market a so that investment is
14:49
real investment again purchase of
14:51
capital buildings for the purpose of
14:54
production and stuff like
14:55
that okay and and this this in
14:59
investment is is is a function of two
15:01
things at least the first one is
15:04
activity when output is high sales are
15:07
high companies tend to invest more they
15:10
buy more equipment they buy more
15:11
buildings they expand okay so investment
15:15
is an increasing function of output very
15:18
much like consumption remember was an
15:19
increasing function of output because
15:22
income is increasing in output so was an
15:24
increasing function out so this we
15:27
already had SE functions that look like
15:29
that and we already know what it does to
15:31
aggregate demand no it makes that curve
15:33
steeper remember and if the multiplier
15:36
is behind that well investment gives you
15:38
something similar there but there is a
15:40
second component which is also present
15:42
in consumption but it's not as important
15:44
as if for investment which is the
15:46
interest
15:47
rate in particular when the interest
15:49
rate goes up for any given level of
15:51
income or output then investment goes
15:55
down why do you think that's the case
16:02
yes most of investment is funded with
16:04
borrowing and borrowing becomes more
16:06
expensive so so so you don't do it even
16:09
if you don't need to borrow There's an
16:11
opportunity cost of those funds you can
16:13
use it to build machines to produce or
16:15
you can do something else like like have
16:16
an investment Financial investment so it
16:20
whether you borrow or not still if the
16:22
interest rate is
16:24
higher the opportunity cost of building
16:27
factories is higher High okay and and so
16:31
that's a reason investment is decreasing
16:33
with respect to the interest
16:35
rate so now we go back to H our
16:39
equilibrium in the Goods Market which we
16:40
said production is whatever aggregate
16:42
demand wants so output is going to be
16:44
equal to aggregate demand aggregate
16:46
demand is the same old aggregate demand
16:49
we had except that now we flesh out what
16:51
is inside that investment function there
16:53
which we have another function is
16:56
increasing in output like consumption
16:57
was and
16:59
but we also have something that is
17:00
decreasing in the interest rate and so
17:02
this is what we call the is relation and
17:05
the the is relation
17:07
therefore has all the combinations of
17:10
output and interest rate that are
17:12
consistent with equilibrium in the Goods
17:16
Market listen at what I said I said the
17:19
I relation or I curve has all the
17:22
combinations of output and interest rate
17:25
combinations of output and interest rate
17:27
that are consistent with equilibrium in
17:30
the Goods
17:31
Market what about lecture
17:36
three we already had that but interest
17:40
Play No role so we found one point there
17:44
there's one level of output which is
17:46
consistent with equilibrium in the Goods
17:47
Market that's what we found now since we
17:49
have an interest rate there we have two
17:51
variables for one curve so we can trace
17:53
a curve which not only one
17:55
point okay
17:59
you can trace a
18:02
curve
18:03
and good and that's what we call the as
18:07
relation
18:08
so I remember I told you when we look at
18:11
the Goods Market equ remember this
18:13
diagram because you're going to come
18:14
back to it many
18:15
times there you are so remember when we
18:18
look at equilibrium in the Goods Market
18:20
we had something like that I'm I'm just
18:22
making it curve rather than linear
18:24
simply because I haven't specified the
18:26
functional form of investment but
18:27
doesn't matter really make it linear
18:29
okay but remember we had that's the way
18:31
we found equilibrium in the Goods Market
18:33
we have an aggregate demand and it was
18:35
increased the slope was positive because
18:37
we had a margin of PR to consume that's
18:39
the reason we had this was not flat but
18:41
upward sloping no and we found
18:43
equilibrium output that way okay so
18:46
that's this is lecture three we're back
18:49
in lecture three
18:50
here with two things two differences the
18:54
first one is that this ZZ curve relative
18:58
to the one had in lecture three is a
18:59
little steeper why is
19:12
that why is it a little steeper than by
19:16
steeper I mean if income goes up then
19:19
aggregate demand goes up by more than
19:21
than it used to go
19:25
up exactly because what made it is
19:29
upward sloping before was the margin of
19:31
to consume but now there is also a
19:33
margin of to invest which is also
19:36
positive and that's the reason it's a
19:37
little steeper more interesting for this
19:40
part of the lecture though for the
19:42
construction of the curve is that is a
19:46
parameter that we have there in ZZ what
19:48
are the parameters we had before in that
19:50
curve we had things like going
19:52
expenditure taxes the the autonomous
19:55
consumption that's the kind of stuff
19:57
that we had as parameters of that ZZ
20:00
curve by parameters I mean if we change
20:02
those parameter we shift that
20:04
curve now for this particular ZZ we have
20:07
an extra parameter which is very
20:10
interesting what is that it's there I
20:14
think it's the interest
20:17
rate no that curve holds for some given
20:21
interest
20:22
rate if I move the interest I'm going to
20:24
move this curve
20:26
around that's very important
20:32
one of the parameters there the star
20:34
parameter I would say for this for this
20:36
minute of the lecture at least for this
20:38
moment in the lecture is the interest
20:40
rate I can find an equilibrium because I
20:43
couldn't find an equilibrium in the
20:45
Goods Market if you don't tell me what
20:47
the interest rate is because you know
20:48
it's a curve remember I told you it's a
20:50
relationship a curve so if I tell you I
20:52
tell you what the interest rate is then
20:54
you can find the equilibrium in the
20:55
Goods Market because you can fix this
20:58
curve
21:00
okay that's for one given interest
21:04
rate
21:06
okay do do you understand that that's
21:08
important
21:10
yes those of you that are awake do you
21:13
understand it or not not everyone is in
21:16
the same page here okay
21:18
good ER so let's now with that what
21:23
we're going to do next is construct the
21:25
is
21:26
curve and and and how going remember
21:29
what what I want to try to do is Con
21:31
constructing the space of interest rate
21:33
and output a curve which we're going to
21:35
call the as
21:36
curve at this point here we have a point
21:39
in that curve because for one level of
21:41
interest rate I found the equilibrium
21:43
output so to construct the curve what I
21:46
need to do is start moving the interest
21:47
rate and see how the equilibrium output
21:50
changes and that will trace a curve okay
21:53
and that's going to be my
21:54
is curve or relationship so let's do
21:58
that
21:59
that's a construction of the
22:01
curve
22:03
so in the previous chart we found point
22:06
a so point a there is that point okay
22:11
there we are we had some interest
22:14
rate this interest rate I mean believe
22:17
me that was a parameter of the ZZ curve
22:19
I showed you before gave us equilibrium
22:23
output
22:25
a so that's a point in the yes because
22:27
that's a combination of interest rate
22:29
and output which is consistent with
22:31
equilibrium in the Goods Market that's a
22:33
point in the is that's a definition of
22:36
is so now what I'm going to do to
22:38
construct my is is okay let me move the
22:40
interest rate let me raise interest rate
22:42
from I to I prime okay that's an
22:45
increase in the interest rate and now
22:48
let me find what is a new equilibrium in
22:50
the goods market for a given interest
22:52
rate Which is higher than the one I used
22:54
to have well that amounts to Shifting
22:56
the ZZ curve down
23:00
why does it increasing the interest rate
23:02
shift the ZZ curve down the aggregate
23:04
demand
23:07
down it makes investment decline exactly
23:10
B is for investment declines okay so
23:14
that means for any given level of output
23:16
now aggregate demand is lower because
23:19
investment is lower and then you get the
23:21
multiplier to do it stck no and
23:23
therefore you tend end up with a
23:24
declining output which is even larger
23:26
than the declining invest the initial
23:27
declining invest M as a result of
23:30
increase in the interest rate that's
23:31
what a multiplier does no so say
23:34
interest rate increased by 100 100 basis
23:37
points that reduce investment by a say10
23:42
billion and equilibrium output ends up
23:45
falling by $15 billion because of the
23:47
multiplier and so on okay but the point
23:50
is after I do all my convergence to this
23:52
new lower equilibrium level of output I
23:55
have a second point in my as curve
23:57
because that's a combination of a new
23:59
interest rate I prime an output that is
24:02
consistent with equilibrium in the Goods
24:04
Market how do I know that it's
24:06
consistent with equili in the Goods
24:07
Market because I'm there I'm crossing 45
24:10
degree line that means output equal to
24:12
aggregate demand that's equilibrium in
24:13
the Goods
24:15
Market okay
24:19
so and of course you can keep going no
24:22
and trace an entire curve and all that
24:25
you'll do is you'll change the interest
24:26
rate that will shift this curve then you
24:28
do the multiplier and endend up with a
24:30
new
24:31
equilibrium and that's another point for
24:33
your curve
24:35
okay so is it clear how we constructed
24:38
that
24:41
curve very important okay
24:45
good it's also very important to
24:47
understand well so why is it downward
24:49
sloping yeah that's a
24:55
question why is it downward sloping
25:02
what does it mean that it's downward
25:04
slope that means that combination of
25:07
output and interest rate that are
25:08
consistent with equilibrium output are
25:11
negatively correlated meaning you know I
25:13
have a combination of high output and
25:16
low interest rate is consistent
25:20
or low high interest rate and low output
25:24
that's what I find
25:26
here but why is that why what is the
25:28
logic of that behind that or the
25:32
mechanism well the way to think about
25:35
that is exactly the way I I did this
25:38
experiment is okay let me think what
25:41
happens if I increase the interest rate
25:44
and I keep the level of output where it
25:46
was so what happens if I increase the
25:49
interest rate and I I keep the level of
25:51
output at the level it
25:53
was my claim is that that's not an
25:56
equilibrium in the Goods Market what
25:58
what is
26:02
it so I'm saying suppose I increase the
26:05
interest rate but I keep the output
26:06
constant so output is here higher
26:10
interest rate aggregate demand is
26:12
there so what what is the problem I'm
26:15
saying my claim is that's not an
26:16
equilibrium in the Goods Market we're
26:18
going to need a lower level of output to
26:19
have an equilibrium in the Goods Market
26:21
that's the reason it's downward sloping
26:22
but why is that not an equilibrium in
26:24
the Goods
26:25
Market or what is the nature of the dise
26:27
equilibrium in the Market there what do
26:29
we have an excess demand excess
26:32
Supply excess Supply meaning there isn't
26:35
enough demand to support that
26:37
Supply so supply has to fall in order to
26:41
restore equilibrium in that market in
26:43
the Goods Market okay and since one
26:47
drags the other one it has to Fall by a
26:49
lot that that has to do with the slope
26:51
of this
26:53
curve that's the reason it's negatively
26:56
so that's first thing you have to
26:58
understand understand when you construct
26:59
this curve I know I'm going slowly but
27:02
it's important when you con please try
27:05
to
27:08
understand why is that another way of
27:11
saying
27:12
it when I when I find the when I change
27:15
the equilibrium output along this S
27:18
curve by moving the inid around what I'm
27:21
doing is I'm moving along an is curve
27:25
okay so if I if the only reason why
27:27
equilibrium out with is changing is
27:30
because I'm moving the interest rate
27:32
that's a movement along the S
27:35
curve okay so I'm I'm tracing points of
27:37
the as curve good and I want to draw a
27:41
contrast between these movements along
27:43
the is curve versus things that shift
27:47
the
27:49
curve okay for
27:52
example
27:54
that so suppose I increase taxes
28:00
increase taxes the government increases
28:02
taxes my claim is that the is shift to
28:05
the
28:07
left that is for any given level of
28:11
interest rate pick any interest you
28:13
want say this one you're going to have a
28:17
lower equilibrium output consistent with
28:19
that interest rate if you have a lower
28:22
equilibrium consistent with the same
28:23
interest rate that has shifted the
28:26
is has to be a different is
28:30
okay and and think that I can do that
28:32
for any given level of in I pick this
28:33
one but I could have pick that one would
28:35
have been the same I'm saying you
28:37
increase
28:38
taxes that's going to lead to lower
28:40
equilibrium
28:41
output so that means that for this
28:45
higher level of taxes I will have to
28:47
trace a different test
28:49
curve I can start moving the interest
28:51
rate around but I'm going to have a
28:53
lower level of output for any given
28:54
level of interest rate because I have
28:57
higher taxes
28:59
so how do I know that an increas in
29:02
taxes will do this Which diagram would
29:05
you go to to try to understand
29:14
this so or let me ask it
29:17
differently how do I know that this
29:19
stuff shift to the left so I give you
29:21
more open space how do I know that this
29:23
increasing taxes will shift this is
29:25
curve to the left how would you go about
29:27
thinking
29:36
not going to spend as much money less
29:38
outcome there will be less aggregate
29:40
demand and less aggregate demand leads
29:41
to less output because output is
29:43
aggregate demand deter exactly that's
29:45
what equilibrium in the Goods Market so
29:47
you can go back to this diagram this
29:50
goes in the I could say ignore these
29:52
labels here and say look for any given
29:55
level of interest rate pick any if I
29:57
increase tax I'm going to shift the Z ZZ
30:00
curve
30:01
down okay so ignore the this charar
30:04
suppose that I fix the interest rate but
30:07
I now change taxes increase taxes well
30:08
I'm going to do exactly the same here
30:10
I'm going to move this down and it's
30:11
going to be a different is curve though
30:13
because I shouldn't have used this
30:14
diagram let me keep your answer I should
30:17
have put a new diagram but it's it's
30:20
lecture three in lecture three we did
30:23
see that that an increase in tax would
30:25
lead to lower equilibrium output
30:28
in fact we know exactly by how much if
30:31
if taxes increase by 100 then you know
30:33
that equilibrium output would decline by
30:36
C1 times 1 / minus
30:39
C1 changing taxes here would be a little
30:42
different because there is also remember
30:44
investment also has a propensity to to
30:47
to to spend as a function of output so
30:50
so it would be a little different but
30:52
that's the kind of
30:53
calculation okay what else would shift
30:57
the the is this
31:04
way decrease in governance friend would
31:06
do that what
31:07
else this this another thing I want you
31:09
to think of any everything because for
31:12
sure you're going to face that in the
31:13
quiz that anything that would shift the
31:16
curve what else would shift the
31:23
curve yeah that's true but but but
31:25
that's not for this part of the course
31:28
remember we're in a close economy so
31:30
here we assume xal to m equal to zero I
31:33
equal to
31:35
zero that comes from after quiz one what
31:43
else things that were captur remember
31:46
when I began this lecture I show you
31:48
wealth what had happened and so on well
31:49
there's nowhere wealth in this model
31:51
here it's just output but wealth affects
31:55
how much consumers consume so autonomous
31:58
consumption there were lots of stuff
31:59
hidden in that c0 that constant c0
32:02
remember c0 plus C1 one well c0 captures
32:05
things like how confident were consumers
32:08
how wealthy they felt and stuff like
32:10
that so anything that shift C down
32:13
consumer sentiment declines wealth
32:15
declines something like that will also
32:17
shift yes to the left okay so that's
32:23
important good so now so we're done with
32:28
is for
32:29
now now with the is alone I cannot find
32:32
what I want I want to find equili
32:34
combinations of interest rate and output
32:38
that are consistent with equilibrium in
32:40
the goods and financial markets this
32:42
doesn't do it because it gives you only
32:44
combinations that are consistent with
32:46
equilibrium in the Goods Market
32:50
okay and in fact okay so I now need to
32:54
look at Financial Market which is the
32:56
other side the LM relation ship and
32:58
remember what we had is we had
33:01
equilibrium in the in the financial
33:03
Market we had two instruments that we
33:05
could use remember we had only two
33:06
assets money and bonds so we could look
33:10
at the equilibrium in in in the in money
33:13
or equilibrium in bonds is the
33:16
same but we we did it all in in terms of
33:20
money it's the same because given wealth
33:22
if one is in equilibrium the other one
33:23
has to be in equilibrium as well so I I
33:26
only need to look at one and we're
33:28
looking at money okay so money is equal
33:32
to money
33:33
demand I'm going to divide both sides by
33:35
P this is not going to be very important
33:37
now but later we will be and so we're
33:39
going to have that this is is
33:41
equilibrium in in in financial Market
33:43
means that real real H money supply
33:47
equals real money demand okay that's
33:50
what we have
33:52
here so this you already see it traces
33:56
combinations of out put an interest rate
33:58
which are consistent with equilibrium in
34:00
financial
34:01
markets
34:03
okay in the past that's the way the LM
34:07
would be
34:08
described we would fix M and say well
34:11
this will give you an upward sloping
34:14
curve no because this is downward
34:18
sloping so if this guy goes up I need to
34:21
if this is constant this guy goes up
34:22
well this guy needs to come down what
34:24
does that what does bring L down well I
34:27
go up because L Prime is negative so
34:30
that's the way LM used to be described
34:32
your life is a lot simpler today it's a
34:35
lot simpler because central banks don't
34:38
Target monetary aggates they don't
34:39
Target M they target the interest rate
34:41
directly so they tell you the answer
34:43
already they
34:44
said what Central Bank when it does
34:47
policy says look I tell you what I will
34:50
be then if output moves around whatever
34:53
that's that's problem it's a problem for
34:54
M we'll provide the M that the market
34:56
needs in order to have interest rate
34:58
equal to the one we want okay so so it's
35:02
it's it it is true that it captures all
35:04
the combinations of output and interest
35:06
that are consistent with equilibrium in
35:07
the financial markets but it's very
35:09
simple because the the the what the FED
35:13
does in the US other central banks do is
35:17
they say okay this is the interest rate
35:18
we want and now you can put any amount
35:21
of output you want as long as we remain
35:23
committed to this interest rate it will
35:26
be consistent with equilibrium in the in
35:27
the financial markets because we will do
35:30
it so and the way we will do it so is
35:32
we'll provide as much M as the market
35:35
needs so that that combination of output
35:37
and interest rate is an equilibrium in
35:38
the financial Market that is that's a
35:41
very long way of saying that the FED
35:43
sets I and then m is whatever this is
35:49
needed for this equation to be in
35:52
equilibrium so if output Rises and The
35:54
Fed doesn't want to change the interest
35:55
rate that means you need to change m
35:58
okay so suppose that the FED says I want
36:01
this interest rate to be fixed at this
36:04
level call it I zero and now output
36:07
turns out to be
36:10
higher what will the FED do in order to
36:13
ensure that I remains at i z what if the
36:16
FED doesn't do
36:18
anything so the FED says I want I equals
36:21
z and and the FED is calculated that
36:23
output will be about certain level and
36:26
it turns out that output is higher
36:29
what happens if the FED doesn't
36:32
react and keeps the interest rate at I
36:35
zero and output T to be higher than what
36:38
they thought when they provided the M
36:42
that they thought the market needed to
36:44
be in equilibrium of that interest rate
36:47
what will
36:51
happen well the interest rate will go up
36:54
because money demand will exceed money
36:56
supply well the only way to restory
36:57
equilibrium is for interest rate to go
36:59
up but the FED doesn't want that so what
37:02
the FED will do is when it feels that it
37:04
feels the interest rat are going up they
37:06
will provide more money so so they can
37:09
restore equilibrium in the financial
37:10
Market at that level of interest rate
37:13
despite the fact that output end up
37:15
being higher than they thought so all
37:17
this is a long winded way to say that
37:19
the LM is the modern LM is
37:24
horizontal a few years ago that curve
37:27
would have been upward sloping but given
37:30
the way monetary policy is conducted
37:32
nowadays your life is a lot simpler the
37:35
L is a horizontal curve okay the FED
37:38
tells you the Central Bank tells you H
37:41
what the interest rate has to be and
37:43
then it will give whatever M will
37:45
provide whatever m is needed so that's
37:47
the equilibrium
37:53
industry so what shift the modern LM
37:59
and by modern I only mean the book
38:02
doesn't use the terminology but by
38:04
modern I mean that the FED decides what
38:07
the interest it
38:09
is exactly the only thing that will
38:12
shift into to your life is very simple
38:13
the only thing that will shift the mod
38:16
LM is that the FED changes its
38:21
mind a few years back it would have been
38:23
more
38:24
complicated a change in money demand
38:28
a a change in money supply all those
38:29
things will be Shifting the LM around
38:32
now in this setup is very simple no it
38:35
will change only if the feds changes his
38:37
mind now obviously the FED is not just a
38:41
moody institution it will change the
38:43
mind and sometimes is forced to change
38:45
its
38:46
mind I mean they're not happy with the
38:48
interest rate they're setting
38:50
nowadays they' been forced into that
38:53
were very reluctant to go into very high
38:55
interest rate but you know what is
38:57
happening around with very high
38:59
consumption and the impact that it's
39:01
having on inflation they have been
39:02
forced into moving interest rate not
39:05
only very high but also very fast and
39:07
and and and uh that was very risky we
39:11
have been lucky that that nothing has
39:13
really broken when normally when central
39:15
banks raise interest so fast they break
39:18
something along the way somebody's very
39:20
lever out there some bank or something
39:22
like that and you can you can blow up
39:24
the UK we had a little scare with some
39:26
insurance companies but
39:29
but but was for a different reason
39:33
but but it's it's scary to move policy
39:36
very fast because this is a very
39:37
important price for financial markets
39:40
everything in financial Market gets
39:42
priced off that's a starting any pricing
39:44
model for stocks for anything will start
39:47
from that policy rate then everything
39:49
builds from there so if this has to move
39:51
fast you can have lots of
39:53
dislocation so my goal for today is to
39:56
just to give you the instr and then
39:57
we're going to all talk about
39:58
combinations things that we did in
40:00
certain episodes and and things of that
40:02
kind okay good so again this part of the
40:06
course is this part of the of the ISL
40:08
mod is very easy and it's a lot easier
40:10
now than it was a few years back okay so
40:13
what does the eslm mo the slm M me
40:17
simply mean puts the two curves together
40:20
now we have two Curves in the space of
40:22
output and interest rate and two
40:25
unknowns which is output and interest
40:27
rate
40:29
so we have one combination only a that
40:33
is consistent with both equilibrium in
40:36
the Goods Market and equilibrium in
40:39
financial Market that's the point
40:42
a
40:45
okay what happens to points to the right
40:48
suppose I I I what happen What Happens
40:51
here if I show you this point in this
40:56
space what what's wrong with that
41:05
point so point to the a point along the
41:08
lamp but to the right what's wrong
41:15
there well if it is along the LM I know
41:19
that I'm okay with financial Market that
41:21
those points are consistent with
41:23
equilibrium in financial
41:25
Market but it's not my equilibrium and
41:27
it has to be in consistent with the
41:28
other one it's not consistent with
41:30
equilibrium in the Goods Market in fact
41:33
you know more than that what's wrong
41:35
with Goods Market there's an imbalance
41:37
there but in which
41:40
direction that point
41:47
here what do you mean by excess of
41:52
goods no demand is exactly insufficient
41:55
demand there's too much output for that
41:57
demand so that's the reason it's not
41:59
consistent with equilibrium in the Goods
42:01
Market okay to the left is the opposite
42:05
no to the left we have insufficient
42:08
output for the demand we have so it's
42:10
not consistent with equilibrium in the
42:12
the Goods Market so the only point that
42:14
is consistent oh well you can think what
42:17
happens with a point here for
42:20
example that point because it's in the
42:22
curve is consistent with equilibrium in
42:24
the Goods Market but it's not consistent
42:26
with equilibrium in Financial Market
42:29
okay what do we have there supposed
42:31
having in that point the interest rate
42:34
is too high so that means the money
42:36
demand is low so too much money demand
42:38
for money supply okay that's that's what
42:40
you have so those are not so so that's
42:43
at the end of the day you know this is
42:44
the only equilibrium point we have and
42:46
and all the experiments I want to do
42:48
next have to do with moving one curve or
42:51
the other and see what happens to trace
42:53
new equilibrium points okay but try to
42:57
understand
42:57
very well these diagrams of what
43:00
happens when I move up horizontally and
43:03
so on and convince yourself that this is
43:05
the only combination it's pretty easy to
43:07
convince yourself it's the only
43:08
combination but think a little try to
43:11
get away from point A and see what
43:13
happens I guess the best way to do that
43:15
is just to do experiment meaning move
43:17
parameters of these curves and see how
43:19
equilibrium output changes and so
43:24
on so let's do the first
43:28
experiment and yeah
43:33
maybe so let's let's let's play with
43:35
this so now you have you have your model
43:38
and now we can start asking interesting
43:40
questions the first thing you can ask is
43:42
well fiscal policy how does it
43:45
work
43:47
well
43:49
sorry so here this this is a contraction
43:52
in fiscal policy so the same as we did
43:53
before remember we increase taxes or we
43:56
could have reduced go expenditure
43:57
whatever that would have shifted the we
44:00
we did that when when we look at the we
44:03
did exactly that we shift the to to to
44:06
the left and what happens here is well
44:09
if you shift the to the left there's a
44:12
new combination of output and interest
44:14
rate that is that is consistent with
44:15
equilibrium both markets that's a lower
44:19
output okay so if the FED doesn't do
44:22
anything that means it keeps the LM
44:23
there and there's a contractionary
44:26
fiscal policy well that will lead to
44:28
contraction in output as well that's the
44:30
reason we call it contraction not only
44:32
because fiscal not not only because
44:34
govern expenditure decline but it's if
44:37
taxes increase that's contractionary
44:39
because it reduces aggregate demand and
44:42
the equilibrium that will reduce output
44:47
okay so that's canonical contractionary
44:51
fiscal policy you move output to the
44:54
left interest rate doesn't move because
44:56
that's controlled by the FED but but
44:59
output declines okay so if somebody ask
45:03
you what happens if if if there's a
45:05
fiscal contraction you were asking a bit
45:08
the the opposite side you know that
45:11
people may have spent we have perhaps a
45:13
fiscal expansion that was very large but
45:15
what happens with a fiscal contraction
45:17
well that will lead to lower equilibrium
45:20
output I keep pring the lower equ what
45:23
happens if you have a very large fiscal
45:25
expansion what what happens if you have
45:27
a very large fysical
45:29
expansion what moves Ah that's something
45:32
that's you should that's a question you
45:34
should always ask yourself when when
45:36
there is any question
45:38
islm of islm you should ask which curve
45:42
moves start from that always okay so if
45:46
if we ask you any question about that is
45:48
obvious about aslm the first thing you
45:50
should ask is which Curve will
45:53
move
45:55
so suppose I tell you
45:58
um due to covid the covid shock there
46:01
was a massive ER transfer
46:05
income transfer to lowincome individuals
46:09
that is we had a very expansionary
46:11
fiscal
46:12
policy first thing you should ask is
46:14
okay which curve moves the LM or the is
46:17
if I do
46:19
that is the is shift to the right does
46:23
the LM move no has nothing to do with
46:25
monetary policy
46:27
okay so that's the first thing you need
46:29
to do which curve is
46:31
moving okay if it is fiscal that's a
46:33
Goods Market thing that means it's going
46:36
to move the yes not the
46:43
LM what is the mechanism here what
46:48
happened
46:49
well remember what we have is I told you
46:53
go always back to this diagram if you
46:55
increase taxes and you keep keep the
46:57
interest rate constant and you start
46:58
from there so so the interest rate
46:59
doesn't move then that will do what what
47:03
increasing taxes did in lecture three
47:05
will reduce aggregate demand and then
47:06
the multiplier will take us to a larger
47:10
decline that the initial fiscal
47:12
contraction okay and that's a decline in
47:14
equilibrium output so that y1 there is
47:19
exactly a this one
47:22
here that y Prime okay I haven't moved
47:26
the interest rate I kept it at the same
47:27
level I had a fysical
47:30
contraction that's what we describe with
47:32
that diagram well that's my new is I
47:36
have a new
47:37
is because for any for the same interest
47:40
rate I have a lower equilibrium output
47:44
and it happens that the FED DM change
47:46
the interest rate so that's going to be
47:48
my equilibrium output the whole curve
47:49
moved to the left that would could tell
47:51
three slides ago but now I know more I
47:54
also know that since the FED hasn't
47:56
reacted I I know exactly what is the new
47:57
equilibrium output which is this I don't
48:01
before we could only tell that the curve
48:02
has shift to the left now since the fan
48:04
react to that fiscal contraction I also
48:07
know the equilibrium output will end up
48:09
at White Prim okay good so I'm want to
48:14
stop here and and and in the next
48:15
lecture we'll
48:17
continue with this
— end of transcript —
Advertisement
