[00:16] but before I I I I do that before I get
[00:20] into the islm model um let me spend a
[00:24] little time telling you what is going on
[00:27] uh in the US economy and
[00:30] as as this will relate to the kind of
[00:32] things I will discuss later in the in
[00:34] this lecture so what you see there is is
[00:37] the path of net worth so wealth
[00:39] essentially of households and nonprofit
[00:43] organizations households primarily in
[00:46] the US and what you can see is that you
[00:49] know there's a more or less steady Trend
[00:50] obviously in recessions net wealth tends
[00:53] to declin ER and it certainly early on
[00:57] in the covid recession it declined very
[00:58] dramatically because the price price of
[01:00] equity the price of houses everything
[01:02] decline with the initial shock but what
[01:05] you see after that is a dramatic rise in
[01:08] wealth in the US and all around the
[01:10] world but particularly in the US and and
[01:14] what is behind that well there are two
[01:15] things are behind that but the main one
[01:18] is asset prices you know you have
[01:20] massive rallies in the equity Market the
[01:22] price of houses sort of skyrocketed
[01:25] everywhere and so on last year 2022 was
[01:29] a bad year for for asset values the
[01:31] equity Market declined pretty sharply in
[01:33] the US but it's still I mean it's a
[01:35] small decline relative to the big build
[01:38] up on wealth
[01:40] now why do I do you think that in this
[01:43] course I would be talking about this at
[01:45] this
[01:46] point what happens what do remember
[01:49] we're we're in this part of the course
[01:51] we're trying to come up with a model of
[01:53] aggregate demand and then how aggre
[01:55] demand reacts to policy that's the name
[01:57] of the game in this part of the course
[01:59] so if I tell you that wealth increase a
[02:01] lot why do you think I'm telling you
[02:08] that aggregate demand consumers feel
[02:10] rich they will tend to consume more that
[02:12] will increase aggregate demand so the
[02:14] point I'm highlighting to here is that
[02:16] there's a big force behind increasing
[02:19] aggregate demand which is consumers feel
[02:21] richer by the way something similar is
[02:24] happening in corporations and investment
[02:26] is also pretty high because of that real
[02:29] investment the other source of of of of
[02:33] increasing wealth which is not as
[02:34] dramatic as the previous one but is very
[02:37] important especially in lower income
[02:39] segments of the population which tend to
[02:41] have a higher propensity to consume is
[02:44] that ER incomes did not decline a lot
[02:49] during during
[02:51] covid and in some cases they even
[02:53] increased because of the large transfers
[02:55] that we saw from the government to
[02:57] individual households especially lower
[02:59] income households and at the same time
[03:02] there wasn't much to spend
[03:04] on so that meant that the saving rate
[03:07] also went up a lot in the US during the
[03:10] covid recession okay so people save a
[03:12] lot more that's sort of the average
[03:14] saving of household saies you know this
[03:17] is by quarter I think no by monthly but
[03:20] that's what we saw in the past look at
[03:22] during the covid recession people save a
[03:24] lot
[03:25] more and what you're seeing today is
[03:27] obviously they save a lot more that's
[03:29] part of the increasing net we worth is
[03:32] is due to this it's small relative to
[03:34] the amount of wealth we saw increased
[03:36] but but this was about this excess
[03:39] saving amounted to about 2.7 2.8
[03:42] trillion dollar so you get a sense of
[03:44] the order of magnitude and what we is
[03:46] happening now is that people are
[03:47] dissaving so now people are saving less
[03:50] than they used to because now they have
[03:53] opportunity to spend their stuff on okay
[03:56] and so that's you see massive demand for
[03:57] travel massive demand for restant hotels
[04:00] and stuff like that well that's has a
[04:02] lot to do with people had the money to
[04:04] do it they hadn't been able to do it for
[04:06] a while so now they're doing a lot of
[04:08] that why would I be telling you this now
[04:12] in the course in it is part of the
[04:13] course for the same reason I told you
[04:15] that net worth went a lot I mean people
[04:17] have the savings and they're really
[04:20] willing to spend it that puts lots of
[04:21] upward pressure on our great demand
[04:25] okay these pictures capture more or less
[04:28] the same this is captures very much much
[04:29] what I said in the previous slide you
[04:31] see the personal saving rate that's the
[04:34] average I don't remember over oh seveny
[04:38] year average and you see what happened
[04:40] during covid big spike in the saving
[04:43] rate and now big big decline in the
[04:46] saving rate where the saving rate is
[04:48] much lower than what normally is and
[04:51] remember the saving rate is is your
[04:53] income minus your consumption so if
[04:55] you're saving less you're consuming more
[04:57] relative to your income no that's that's
[04:59] the way it
[05:00] works obviously there's lots of
[05:03] heterogeneity some people made a lot of
[05:04] money some people didn't make a lot of
[05:06] money during covid H some people Save A
[05:08] Lot some people didn't save a lot and
[05:11] and and and in fact we do know that that
[05:15] sort of on the lower income segments a
[05:18] lot of the excess saving is already gone
[05:20] I mean accumulated early on but they
[05:22] spent it also much
[05:24] earlier um so but what you're beginning
[05:27] to see in some of those segments is even
[05:29] though the don't have excess savings
[05:31] they're borrowing a lot so now you see
[05:34] credit card borrowing which had declined
[05:36] a lot and now has increased quite a bit
[05:39] and again what do you borrow for well
[05:42] for consumption so that also
[05:44] funds additional consumption so for all
[05:47] these reasons in this Mo at this moment
[05:49] the US economy and many economies around
[05:52] the world are so what we call
[05:54] overheating there a lot of demand for
[05:56] the for the production that capacity of
[05:58] the economy and that translates the the
[06:01] problem say well what's wrong with that
[06:03] well the problem is something you don't
[06:05] understand at this part of the course
[06:06] you understand but you don't have a
[06:07] model for but you will have six Le six
[06:11] lectur more or less from now is that
[06:13] that leads to high inflation you don't
[06:16] know that but intuition tells you that
[06:18] is a lot of demand relative to supply
[06:20] well prices tend to go up this that
[06:23] happens in micro and it also happens in
[06:25] macro we'll learn that later but in any
[06:28] event as a result of this the US economy
[06:30] is overheating and therefore monetary
[06:34] policy has been very contractionary the
[06:37] FED has been tightening interest rate to
[06:40] cool down the economy so how does that
[06:43] happen well that's what the kind of
[06:45] things that we can answer with the islm
[06:47] model okay so the FED is very islm like
[06:52] I mean that's the way they think the
[06:54] model is richer they have more equations
[06:56] and so on but they are thinking in terms
[06:58] of the mechanism that we're about to
[07:00] sort of summarize in the eslm mod okay
[07:04] so if you have an economy that has this
[07:06] problem and you are in the Central Bank
[07:09] you need to use monetary policy well to
[07:11] understand how the thing works you need
[07:13] the eslm model that's a starting point
[07:16] then you can add bells and whistles but
[07:18] your starting point is the model we're
[07:21] about to see anyway so so what you see
[07:23] is what I was saying is that all that
[07:25] wealth all that excess saving all that
[07:27] pent up demand if you will led to lots
[07:31] of H led to a very an economy it's
[07:33] overheating and you can see here what
[07:35] happened I disentangle between a
[07:38] consumption of goods and consumption of
[07:41] services you consumption of servic is
[07:43] about two third of consumption remember
[07:44] we talk about that and goods is about
[07:47] one3 what happens is is in the scales
[07:50] are different noce this is for goods
[07:52] this that's for for services but what
[07:56] you what you see here is that you know
[07:58] that was the trend so consumption in
[08:00] Services was growing at a steady Pace
[08:03] then covid came and collapsed I mean you
[08:06] couldn't go to restaurant you couldn't
[08:07] travel you couldn't do anything so
[08:09] consumption in Services collapsed and
[08:12] now has been recovering and and and and
[08:14] that recovery pick up pace last year
[08:17] actually 2021 already pick up pace and
[08:19] by now we're above the trend okay so
[08:22] service consumption that collapsed
[08:24] during covid now has fully
[08:27] recovered while at the same time the
[08:29] capacity to produce in the service
[08:30] sector hasn't recovered equally but that
[08:32] and we'll get that to that after quiz
[08:34] one what happens to Goods consumption
[08:37] well also initially collaps but then
[08:40] well you know people were Bor at home
[08:41] they couldn't do anything they bought
[08:43] lots of gadgets and and stuff like that
[08:45] so Goods consumption went up very
[08:47] sharply during covid way above the trend
[08:49] you see there's covid collapse and then
[08:52] people began to buy all sort of gadgets
[08:55] okay and so now it's slowing down but
[08:58] still if you look rela to Trend
[09:00] consumption of goods is way above what
[09:02] would have been in the absence of this
[09:03] episode so the sum of the two things
[09:05] tells you that you have an economy with
[09:07] a lot of consumption and that and that
[09:11] at this moment the FED wants to cool
[09:12] down okay it's too much for the economy
[09:15] to take so the FED wants to cool it down
[09:18] and and we're going to see how how you
[09:20] do
[09:21] that okay so now let's get into into
[09:25] this set of lectures and please please
[09:27] stop if there's anything that is unclear
[09:29] because as I said this is probably if IA
[09:32] of the summer you have forgotten
[09:33] everything you have learned this course
[09:34] but you remember these two lectures well
[09:36] I'll be happy okay so so stop it if you
[09:42] do in fact I I normally I I I have
[09:44] taught this lecture in one I I decided
[09:47] to try to slow it down as much as I can
[09:49] because again I think it's particularly
[09:51] important for this course and for your
[09:53] stock of knowledge
[09:55] so so one of the thing the main things
[09:57] we're going to be able to do with this
[09:58] 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