WEBVTT

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but before I I I I do that before I get

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into the islm model um let me spend a

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little time telling you what is going on

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uh in the US economy and

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as as this will relate to the kind of

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things I will discuss later in the in

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this lecture so what you see there is is

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the path of net worth so wealth

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essentially of households and nonprofit

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organizations households primarily in

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the US and what you can see is that you

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know there's a more or less steady Trend

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obviously in recessions net wealth tends

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to declin ER and it certainly early on

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in the covid recession it declined very

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dramatically because the price price of

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equity the price of houses everything

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decline with the initial shock but what

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you see after that is a dramatic rise in

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wealth in the US and all around the

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world but particularly in the US and and

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what is behind that well there are two

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things are behind that but the main one

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is asset prices you know you have

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massive rallies in the equity Market the

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price of houses sort of skyrocketed

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everywhere and so on last year 2022 was

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a bad year for for asset values the

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equity Market declined pretty sharply in

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the US but it's still I mean it's a

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small decline relative to the big build

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up on wealth

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now why do I do you think that in this

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course I would be talking about this at

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this

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point what happens what do remember

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we're we're in this part of the course

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we're trying to come up with a model of

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aggregate demand and then how aggre

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demand reacts to policy that's the name

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of the game in this part of the course

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so if I tell you that wealth increase a

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lot why do you think I'm telling you

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that aggregate demand consumers feel

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rich they will tend to consume more that

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will increase aggregate demand so the

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point I'm highlighting to here is that

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there's a big force behind increasing

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aggregate demand which is consumers feel

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richer by the way something similar is

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happening in corporations and investment

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is also pretty high because of that real

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investment the other source of of of of

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increasing wealth which is not as

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dramatic as the previous one but is very

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important especially in lower income

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segments of the population which tend to

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have a higher propensity to consume is

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that ER incomes did not decline a lot

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during during

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covid and in some cases they even

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increased because of the large transfers

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that we saw from the government to

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individual households especially lower

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income households and at the same time

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there wasn't much to spend

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on so that meant that the saving rate

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also went up a lot in the US during the

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covid recession okay so people save a

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lot more that's sort of the average

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saving of household saies you know this

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is by quarter I think no by monthly but

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that's what we saw in the past look at

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during the covid recession people save a

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lot

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more and what you're seeing today is

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obviously they save a lot more that's

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part of the increasing net we worth is

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is due to this it's small relative to

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the amount of wealth we saw increased

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but but this was about this excess

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saving amounted to about 2.7 2.8

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trillion dollar so you get a sense of

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the order of magnitude and what we is

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happening now is that people are

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dissaving so now people are saving less

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than they used to because now they have

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opportunity to spend their stuff on okay

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and so that's you see massive demand for

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travel massive demand for restant hotels

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and stuff like that well that's has a

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lot to do with people had the money to

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do it they hadn't been able to do it for

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a while so now they're doing a lot of

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that why would I be telling you this now

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in the course in it is part of the

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course for the same reason I told you

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that net worth went a lot I mean people

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have the savings and they're really

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willing to spend it that puts lots of

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upward pressure on our great demand

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okay these pictures capture more or less

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the same this is captures very much much

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what I said in the previous slide you

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see the personal saving rate that's the

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average I don't remember over oh seveny

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year average and you see what happened

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during covid big spike in the saving

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rate and now big big decline in the

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saving rate where the saving rate is

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much lower than what normally is and

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remember the saving rate is is your

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income minus your consumption so if

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you're saving less you're consuming more

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relative to your income no that's that's

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the way it

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works obviously there's lots of

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heterogeneity some people made a lot of

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money some people didn't make a lot of

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money during covid H some people Save A

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Lot some people didn't save a lot and

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and and and in fact we do know that that

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sort of on the lower income segments a

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lot of the excess saving is already gone

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I mean accumulated early on but they

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spent it also much

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earlier um so but what you're beginning

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to see in some of those segments is even

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though the don't have excess savings

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they're borrowing a lot so now you see

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credit card borrowing which had declined

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a lot and now has increased quite a bit

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and again what do you borrow for well

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for consumption so that also

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funds additional consumption so for all

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these reasons in this Mo at this moment

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the US economy and many economies around

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the world are so what we call

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overheating there a lot of demand for

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the for the production that capacity of

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the economy and that translates the the

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problem say well what's wrong with that

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well the problem is something you don't

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understand at this part of the course

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you understand but you don't have a

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model for but you will have six Le six

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lectur more or less from now is that

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that leads to high inflation you don't

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know that but intuition tells you that

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is a lot of demand relative to supply

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well prices tend to go up this that

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happens in micro and it also happens in

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macro we'll learn that later but in any

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event as a result of this the US economy

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is overheating and therefore monetary

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policy has been very contractionary the

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FED has been tightening interest rate to

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cool down the economy so how does that

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happen well that's what the kind of

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things that we can answer with the islm

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model okay so the FED is very islm like

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I mean that's the way they think the

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model is richer they have more equations

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and so on but they are thinking in terms

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of the mechanism that we're about to

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sort of summarize in the eslm mod okay

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so if you have an economy that has this

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problem and you are in the Central Bank

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you need to use monetary policy well to

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understand how the thing works you need

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the eslm model that's a starting point

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then you can add bells and whistles but

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your starting point is the model we're

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about to see anyway so so what you see

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is what I was saying is that all that

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wealth all that excess saving all that

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pent up demand if you will led to lots

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of H led to a very an economy it's

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overheating and you can see here what

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happened I disentangle between a

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consumption of goods and consumption of

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services you consumption of servic is

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about two third of consumption remember

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we talk about that and goods is about

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one3 what happens is is in the scales

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are different noce this is for goods

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this that's for for services but what

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you what you see here is that you know

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that was the trend so consumption in

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Services was growing at a steady Pace

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then covid came and collapsed I mean you

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couldn't go to restaurant you couldn't

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travel you couldn't do anything so

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consumption in Services collapsed and

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now has been recovering and and and and

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that recovery pick up pace last year

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actually 2021 already pick up pace and

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by now we're above the trend okay so

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service consumption that collapsed

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during covid now has fully

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recovered while at the same time the

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capacity to produce in the service

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sector hasn't recovered equally but that

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and we'll get that to that after quiz

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one what happens to Goods consumption

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well also initially collaps but then

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well you know people were Bor at home

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they couldn't do anything they bought

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lots of gadgets and and stuff like that

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so Goods consumption went up very

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sharply during covid way above the trend

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you see there's covid collapse and then

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people began to buy all sort of gadgets

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okay and so now it's slowing down but

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still if you look rela to Trend

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consumption of goods is way above what

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would have been in the absence of this

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episode so the sum of the two things

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tells you that you have an economy with

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a lot of consumption and that and that

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at this moment the FED wants to cool

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down okay it's too much for the economy

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to take so the FED wants to cool it down

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and and we're going to see how how you

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do

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that okay so now let's get into into

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this set of lectures and please please

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stop if there's anything that is unclear

00:09:29.399 --> 00:09:33.360
because as I said this is probably if IA

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of the summer you have forgotten

00:09:33.360 --> 00:09:36.759
everything you have learned this course

00:09:34.559 --> 00:09:42.199
but you remember these two lectures well

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I'll be happy okay so so stop it if you

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do in fact I I normally I I I have

00:09:44.839 --> 00:09:49.040
taught this lecture in one I I decided

00:09:47.278 --> 00:09:51.720
to try to slow it down as much as I can

00:09:49.039 --> 00:09:53.879
because again I think it's particularly

00:09:51.720 --> 00:09:55.440
important for this course and for your

00:09:53.879 --> 00:09:57.799
stock of knowledge

00:09:55.440 --> 00:09:58.920
so so one of the thing the main things

00:09:57.799 --> 00:10:00.838
we're going to be able to do with this

00:09:58.919 --> 00:10:03.199
small been saying is we're going to be

00:10:00.839 --> 00:10:05.240
able to discuss the main macroeconomic

00:10:03.200 --> 00:10:07.120
policy tools which are monetary policy

00:10:05.240 --> 00:10:09.799
monetary policies is the main antic

00:10:07.120 --> 00:10:11.600
cyclical pool tool but we're also going

00:10:09.799 --> 00:10:14.120
to be able to understand fiscal policy

00:10:11.600 --> 00:10:16.200
and fiscal policy is not exactly

00:10:14.120 --> 00:10:17.679
equivalent to monetary policy it works

00:10:16.200 --> 00:10:19.200
through different mechanisms allows you

00:10:17.679 --> 00:10:20.838
to do things that are more targeted

00:10:19.200 --> 00:10:24.200
transfer resources to a specific group

00:10:20.839 --> 00:10:26.560
of people and so on ER and sometimes

00:10:24.200 --> 00:10:28.640
monetary policy is just not enough and

00:10:26.559 --> 00:10:31.319
the covid-19 initial recession was

00:10:28.639 --> 00:10:33.958
clearly a case of that and you had to go

00:10:31.320 --> 00:10:36.440
all in and and and we'll see what what

00:10:33.958 --> 00:10:38.399
what we did there it was pretty dramatic

00:10:36.440 --> 00:10:41.000
as an intervention I think that's the

00:10:38.399 --> 00:10:44.320
covid-19 recession LED probably to what

00:10:41.000 --> 00:10:46.320
no not probably surely to the largest

00:10:44.320 --> 00:10:49.278
combined packaging history of policy

00:10:46.320 --> 00:10:53.040
support okay in terms of monetary policy

00:10:49.278 --> 00:10:54.759
and uh and fiscal

00:10:53.039 --> 00:10:57.838
policy

00:10:54.759 --> 00:11:00.000
so so that's what so what we're want to

00:10:57.839 --> 00:11:01.320
so we're going to after these two

00:11:00.000 --> 00:11:03.559
lectures you're going to get to

00:11:01.320 --> 00:11:05.278
understand essentially uh The Joint

00:11:03.559 --> 00:11:07.638
determination of output and interest

00:11:05.278 --> 00:11:09.958
rate H and we're going to be able to

00:11:07.639 --> 00:11:12.480
study as I said before the impact of

00:11:09.958 --> 00:11:14.479
monetary and fiscal policy and this

00:11:12.480 --> 00:11:17.759
framework that we're going to use to

00:11:14.480 --> 00:11:21.800
develop to to study this is what hick

00:11:17.759 --> 00:11:23.799
and Hansen initially called the

00:11:21.799 --> 00:11:26.958
islm

00:11:23.799 --> 00:11:29.039
model I already sort of hinted that that

00:11:26.958 --> 00:11:31.239
this was coming but why do you think the

00:11:29.039 --> 00:11:31.240
name

00:11:36.919 --> 00:11:42.879
I not the that I separate that is se you

00:11:40.000 --> 00:11:44.399
will separate is from LM remember what

00:11:42.879 --> 00:11:46.559
we're trying to do here we're trying to

00:11:44.399 --> 00:11:48.000
look at the Joint determination of

00:11:46.559 --> 00:11:50.039
output and interest rate that is we're

00:11:48.000 --> 00:11:52.958
trying to determine at at the Joint

00:11:50.039 --> 00:11:55.559
equilibrium of goods markets and

00:11:52.958 --> 00:11:55.559
financial

00:11:56.278 --> 00:12:00.559
markets when we describe the equilibrium

00:11:58.799 --> 00:12:02.240
in the goods Market we said there is an

00:12:00.559 --> 00:12:06.518
alternative way of describing remember I

00:12:02.240 --> 00:12:07.480
said it as investment equal to savings I

00:12:06.519 --> 00:12:10.759
equal to

00:12:07.480 --> 00:12:12.200
S okay so the is part of the name comes

00:12:10.759 --> 00:12:14.519
from the part that has to do with

00:12:12.200 --> 00:12:17.879
equilibrium in the Goods Market is

00:12:14.519 --> 00:12:20.198
investment equal to savings and the LM

00:12:17.879 --> 00:12:23.679
part has to do remember L was that

00:12:20.198 --> 00:12:25.198
component of aggregate demand we we had

00:12:23.679 --> 00:12:28.159
in the financial markets we look at

00:12:25.198 --> 00:12:30.399
equilibrium as aggregate demand demand

00:12:28.159 --> 00:12:32.919
for money equal to supply of money

00:12:30.399 --> 00:12:36.360
supply of money was M demand for money

00:12:32.919 --> 00:12:38.679
was y * L of I and there therefore the

00:12:36.360 --> 00:12:41.240
LM part okay that's the reason that's a

00:12:38.679 --> 00:12:43.799
nemonic for why this model is called the

00:12:41.240 --> 00:12:45.159
is LM the is stands for the part that

00:12:43.799 --> 00:12:47.519
has to do with equilibrium in the Goods

00:12:45.159 --> 00:12:49.799
Market the L has to do with the part has

00:12:47.519 --> 00:12:51.560
to do with equilibrium Financial Market

00:12:49.799 --> 00:12:53.759
this model is a model that combines

00:12:51.559 --> 00:12:56.719
those two equilibrium okay so we're

00:12:53.759 --> 00:13:00.600
going to be interest interesting points

00:12:56.720 --> 00:13:03.160
in which both markets are in equilibrium

00:13:00.600 --> 00:13:06.440
that's the name of the game

00:13:03.159 --> 00:13:09.639
here so let's first develop the is

00:13:06.440 --> 00:13:12.120
relation and the yes relation is really

00:13:09.639 --> 00:13:15.399
going back to lecture three we're going

00:13:12.120 --> 00:13:19.078
to go back to lecture three use the same

00:13:15.399 --> 00:13:22.240
model we use in lecture three with one

00:13:19.078 --> 00:13:24.159
change and that change is a remember in

00:13:22.240 --> 00:13:26.519
in in lecture three we work a lot on a

00:13:24.159 --> 00:13:28.120
consumption the only endogenous the only

00:13:26.519 --> 00:13:30.440
function we had was a consumption

00:13:28.120 --> 00:13:31.879
function remember remember and then all

00:13:30.440 --> 00:13:33.279
the rest we took as sort of given

00:13:31.879 --> 00:13:35.679
government expenditure was given

00:13:33.278 --> 00:13:37.198
investment was given all that was given

00:13:35.679 --> 00:13:39.159
well we're going to relax one of those

00:13:37.198 --> 00:13:40.559
here and we're going to we're going to

00:13:39.159 --> 00:13:44.078
flesh out a little more of this

00:13:40.559 --> 00:13:46.838
investment here make get make it closer

00:13:44.078 --> 00:13:48.559
to what what a a realistic function it's

00:13:46.839 --> 00:13:50.639
not a constant obviously it's not to

00:13:48.559 --> 00:13:53.879
exogenous to equilibrium output and so

00:13:50.639 --> 00:13:55.639
on in fact we do know that real

00:13:53.879 --> 00:13:57.759
investment this is physical investment

00:13:55.639 --> 00:13:59.959
remember this is what is this ey is

00:13:57.759 --> 00:14:01.440
investment this is purchase of goods and

00:13:59.958 --> 00:14:03.239
services by firms for the purpose of

00:14:01.440 --> 00:14:05.600
building Capital Equipment structures

00:14:03.240 --> 00:14:07.639
and stuff like that I saw in PIAA very

00:14:05.600 --> 00:14:08.920
quickly I'm not into that but I see more

00:14:07.639 --> 00:14:11.799
or less the

00:14:08.919 --> 00:14:13.399
flow that somebody asked should bonds be

00:14:11.799 --> 00:14:15.958
included in

00:14:13.399 --> 00:14:20.559
investment what is the

00:14:15.958 --> 00:14:20.559
answer in that investment

00:14:24.399 --> 00:14:31.039
I should purchase of bonds be included

00:14:28.000 --> 00:14:31.039
in that investment

00:14:33.759 --> 00:14:39.759
no this is purchase of goods and

00:14:36.159 --> 00:14:41.360
services by firms no Capital machines

00:14:39.759 --> 00:14:42.759
stuff like that the other thing is a

00:14:41.360 --> 00:14:44.320
financial investment it's nothing to do

00:14:42.759 --> 00:14:46.519
with the Goods Market something that has

00:14:44.320 --> 00:14:49.600
to do with the financial Market not with

00:14:46.519 --> 00:14:51.440
a Goods Market a so that investment is

00:14:49.600 --> 00:14:54.159
real investment again purchase of

00:14:51.440 --> 00:14:55.880
capital buildings for the purpose of

00:14:54.159 --> 00:14:59.159
production and stuff like

00:14:55.879 --> 00:15:01.879
that okay and and this this in

00:14:59.159 --> 00:15:04.399
investment is is is a function of two

00:15:01.879 --> 00:15:07.439
things at least the first one is

00:15:04.399 --> 00:15:10.039
activity when output is high sales are

00:15:07.440 --> 00:15:11.920
high companies tend to invest more they

00:15:10.039 --> 00:15:15.879
buy more equipment they buy more

00:15:11.919 --> 00:15:18.240
buildings they expand okay so investment

00:15:15.879 --> 00:15:19.879
is an increasing function of output very

00:15:18.240 --> 00:15:22.039
much like consumption remember was an

00:15:19.879 --> 00:15:24.720
increasing function of output because

00:15:22.039 --> 00:15:27.559
income is increasing in output so was an

00:15:24.720 --> 00:15:29.319
increasing function out so this we

00:15:27.559 --> 00:15:31.198
already had SE functions that look like

00:15:29.318 --> 00:15:33.599
that and we already know what it does to

00:15:31.198 --> 00:15:36.359
aggregate demand no it makes that curve

00:15:33.600 --> 00:15:38.278
steeper remember and if the multiplier

00:15:36.360 --> 00:15:40.399
is behind that well investment gives you

00:15:38.278 --> 00:15:42.278
something similar there but there is a

00:15:40.399 --> 00:15:44.360
second component which is also present

00:15:42.278 --> 00:15:46.000
in consumption but it's not as important

00:15:44.360 --> 00:15:47.000
as if for investment which is the

00:15:46.000 --> 00:15:49.198
interest

00:15:47.000 --> 00:15:51.799
rate in particular when the interest

00:15:49.198 --> 00:15:55.359
rate goes up for any given level of

00:15:51.799 --> 00:15:59.679
income or output then investment goes

00:15:55.360 --> 00:15:59.680
down why do you think that's the case

00:16:02.198 --> 00:16:06.359
yes most of investment is funded with

00:16:04.399 --> 00:16:09.198
borrowing and borrowing becomes more

00:16:06.360 --> 00:16:11.240
expensive so so so you don't do it even

00:16:09.198 --> 00:16:13.240
if you don't need to borrow There's an

00:16:11.240 --> 00:16:15.399
opportunity cost of those funds you can

00:16:13.240 --> 00:16:16.879
use it to build machines to produce or

00:16:15.399 --> 00:16:20.318
you can do something else like like have

00:16:16.879 --> 00:16:22.759
an investment Financial investment so it

00:16:20.318 --> 00:16:24.479
whether you borrow or not still if the

00:16:22.759 --> 00:16:27.759
interest rate is

00:16:24.480 --> 00:16:31.399
higher the opportunity cost of building

00:16:27.759 --> 00:16:33.720
factories is higher High okay and and so

00:16:31.399 --> 00:16:35.759
that's a reason investment is decreasing

00:16:33.720 --> 00:16:39.040
with respect to the interest

00:16:35.759 --> 00:16:40.639
rate so now we go back to H our

00:16:39.039 --> 00:16:42.159
equilibrium in the Goods Market which we

00:16:40.639 --> 00:16:44.278
said production is whatever aggregate

00:16:42.159 --> 00:16:46.399
demand wants so output is going to be

00:16:44.278 --> 00:16:49.159
equal to aggregate demand aggregate

00:16:46.399 --> 00:16:51.600
demand is the same old aggregate demand

00:16:49.159 --> 00:16:53.958
we had except that now we flesh out what

00:16:51.600 --> 00:16:56.000
is inside that investment function there

00:16:53.958 --> 00:16:57.638
which we have another function is

00:16:56.000 --> 00:16:59.440
increasing in output like consumption

00:16:57.639 --> 00:17:00.680
was and

00:16:59.440 --> 00:17:02.920
but we also have something that is

00:17:00.679 --> 00:17:05.918
decreasing in the interest rate and so

00:17:02.919 --> 00:17:07.959
this is what we call the is relation and

00:17:05.919 --> 00:17:10.520
the the is relation

00:17:07.959 --> 00:17:12.640
therefore has all the combinations of

00:17:10.519 --> 00:17:16.599
output and interest rate that are

00:17:12.640 --> 00:17:19.799
consistent with equilibrium in the Goods

00:17:16.599 --> 00:17:22.918
Market listen at what I said I said the

00:17:19.798 --> 00:17:25.279
I relation or I curve has all the

00:17:22.919 --> 00:17:27.799
combinations of output and interest rate

00:17:25.279 --> 00:17:30.079
combinations of output and interest rate

00:17:27.798 --> 00:17:31.720
that are consistent with equilibrium in

00:17:30.079 --> 00:17:35.480
the Goods

00:17:31.720 --> 00:17:35.480
Market what about lecture

00:17:36.519 --> 00:17:44.639
three we already had that but interest

00:17:40.679 --> 00:17:46.200
Play No role so we found one point there

00:17:44.640 --> 00:17:47.440
there's one level of output which is

00:17:46.200 --> 00:17:49.840
consistent with equilibrium in the Goods

00:17:47.440 --> 00:17:51.759
Market that's what we found now since we

00:17:49.839 --> 00:17:53.678
have an interest rate there we have two

00:17:51.759 --> 00:17:55.960
variables for one curve so we can trace

00:17:53.679 --> 00:17:59.000
a curve which not only one

00:17:55.960 --> 00:18:01.640
point okay

00:17:59.000 --> 00:18:01.640
you can trace a

00:18:02.000 --> 00:18:07.200
curve

00:18:03.558 --> 00:18:08.918
and good and that's what we call the as

00:18:07.200 --> 00:18:11.279
relation

00:18:08.919 --> 00:18:13.080
so I remember I told you when we look at

00:18:11.279 --> 00:18:14.319
the Goods Market equ remember this

00:18:13.079 --> 00:18:15.639
diagram because you're going to come

00:18:14.319 --> 00:18:18.960
back to it many

00:18:15.640 --> 00:18:20.480
times there you are so remember when we

00:18:18.960 --> 00:18:22.798
look at equilibrium in the Goods Market

00:18:20.480 --> 00:18:24.279
we had something like that I'm I'm just

00:18:22.798 --> 00:18:26.119
making it curve rather than linear

00:18:24.279 --> 00:18:27.639
simply because I haven't specified the

00:18:26.119 --> 00:18:29.918
functional form of investment but

00:18:27.640 --> 00:18:31.640
doesn't matter really make it linear

00:18:29.919 --> 00:18:33.200
okay but remember we had that's the way

00:18:31.640 --> 00:18:35.200
we found equilibrium in the Goods Market

00:18:33.200 --> 00:18:37.360
we have an aggregate demand and it was

00:18:35.200 --> 00:18:39.240
increased the slope was positive because

00:18:37.359 --> 00:18:41.319
we had a margin of PR to consume that's

00:18:39.240 --> 00:18:43.359
the reason we had this was not flat but

00:18:41.319 --> 00:18:46.759
upward sloping no and we found

00:18:43.359 --> 00:18:49.519
equilibrium output that way okay so

00:18:46.759 --> 00:18:50.919
that's this is lecture three we're back

00:18:49.519 --> 00:18:54.558
in lecture three

00:18:50.919 --> 00:18:58.038
here with two things two differences the

00:18:54.558 --> 00:18:59.720
first one is that this ZZ curve relative

00:18:58.038 --> 00:19:03.599
to the one had in lecture three is a

00:18:59.720 --> 00:19:03.600
little steeper why is

00:19:12.839 --> 00:19:19.319
that why is it a little steeper than by

00:19:16.640 --> 00:19:21.759
steeper I mean if income goes up then

00:19:19.319 --> 00:19:24.519
aggregate demand goes up by more than

00:19:21.759 --> 00:19:24.519
than it used to go

00:19:25.919 --> 00:19:31.559
up exactly because what made it is

00:19:29.319 --> 00:19:33.158
upward sloping before was the margin of

00:19:31.558 --> 00:19:36.240
to consume but now there is also a

00:19:33.159 --> 00:19:37.880
margin of to invest which is also

00:19:36.240 --> 00:19:40.679
positive and that's the reason it's a

00:19:37.880 --> 00:19:42.799
little steeper more interesting for this

00:19:40.679 --> 00:19:46.038
part of the lecture though for the

00:19:42.798 --> 00:19:48.319
construction of the curve is that is a

00:19:46.038 --> 00:19:50.599
parameter that we have there in ZZ what

00:19:48.319 --> 00:19:52.279
are the parameters we had before in that

00:19:50.599 --> 00:19:55.719
curve we had things like going

00:19:52.279 --> 00:19:57.359
expenditure taxes the the autonomous

00:19:55.720 --> 00:20:00.079
consumption that's the kind of stuff

00:19:57.359 --> 00:20:02.519
that we had as parameters of that ZZ

00:20:00.079 --> 00:20:04.359
curve by parameters I mean if we change

00:20:02.519 --> 00:20:07.798
those parameter we shift that

00:20:04.359 --> 00:20:10.000
curve now for this particular ZZ we have

00:20:07.798 --> 00:20:14.119
an extra parameter which is very

00:20:10.000 --> 00:20:17.159
interesting what is that it's there I

00:20:14.119 --> 00:20:21.519
think it's the interest

00:20:17.159 --> 00:20:22.600
rate no that curve holds for some given

00:20:21.519 --> 00:20:24.918
interest

00:20:22.599 --> 00:20:26.599
rate if I move the interest I'm going to

00:20:24.919 --> 00:20:30.640
move this curve

00:20:26.599 --> 00:20:30.639
around that's very important

00:20:32.400 --> 00:20:36.840
one of the parameters there the star

00:20:34.440 --> 00:20:38.279
parameter I would say for this for this

00:20:36.839 --> 00:20:40.798
minute of the lecture at least for this

00:20:38.279 --> 00:20:43.678
moment in the lecture is the interest

00:20:40.798 --> 00:20:45.798
rate I can find an equilibrium because I

00:20:43.679 --> 00:20:47.400
couldn't find an equilibrium in the

00:20:45.798 --> 00:20:48.960
Goods Market if you don't tell me what

00:20:47.400 --> 00:20:50.360
the interest rate is because you know

00:20:48.960 --> 00:20:52.759
it's a curve remember I told you it's a

00:20:50.359 --> 00:20:54.399
relationship a curve so if I tell you I

00:20:52.759 --> 00:20:55.519
tell you what the interest rate is then

00:20:54.400 --> 00:20:58.080
you can find the equilibrium in the

00:20:55.519 --> 00:21:00.480
Goods Market because you can fix this

00:20:58.079 --> 00:21:04.480
curve

00:21:00.480 --> 00:21:04.480
okay that's for one given interest

00:21:04.679 --> 00:21:08.880
rate

00:21:06.240 --> 00:21:10.599
okay do do you understand that that's

00:21:08.880 --> 00:21:13.520
important

00:21:10.599 --> 00:21:16.000
yes those of you that are awake do you

00:21:13.519 --> 00:21:18.558
understand it or not not everyone is in

00:21:16.000 --> 00:21:23.359
the same page here okay

00:21:18.558 --> 00:21:25.278
good ER so let's now with that what

00:21:23.359 --> 00:21:26.240
we're going to do next is construct the

00:21:25.278 --> 00:21:29.599
is

00:21:26.240 --> 00:21:31.440
curve and and and how going remember

00:21:29.599 --> 00:21:33.240
what what I want to try to do is Con

00:21:31.440 --> 00:21:35.400
constructing the space of interest rate

00:21:33.240 --> 00:21:36.640
and output a curve which we're going to

00:21:35.400 --> 00:21:39.519
call the as

00:21:36.640 --> 00:21:41.799
curve at this point here we have a point

00:21:39.519 --> 00:21:43.319
in that curve because for one level of

00:21:41.798 --> 00:21:46.200
interest rate I found the equilibrium

00:21:43.319 --> 00:21:47.720
output so to construct the curve what I

00:21:46.200 --> 00:21:50.120
need to do is start moving the interest

00:21:47.720 --> 00:21:53.278
rate and see how the equilibrium output

00:21:50.119 --> 00:21:54.719
changes and that will trace a curve okay

00:21:53.278 --> 00:21:58.079
and that's going to be my

00:21:54.720 --> 00:21:59.159
is curve or relationship so let's do

00:21:58.079 --> 00:22:01.678
that

00:21:59.159 --> 00:22:03.278
that's a construction of the

00:22:01.679 --> 00:22:06.440
curve

00:22:03.278 --> 00:22:11.480
so in the previous chart we found point

00:22:06.440 --> 00:22:14.400
a so point a there is that point okay

00:22:11.480 --> 00:22:17.880
there we are we had some interest

00:22:14.400 --> 00:22:19.798
rate this interest rate I mean believe

00:22:17.880 --> 00:22:23.159
me that was a parameter of the ZZ curve

00:22:19.798 --> 00:22:25.038
I showed you before gave us equilibrium

00:22:23.159 --> 00:22:27.480
output

00:22:25.038 --> 00:22:29.079
a so that's a point in the yes because

00:22:27.480 --> 00:22:31.759
that's a combination of interest rate

00:22:29.079 --> 00:22:33.798
and output which is consistent with

00:22:31.759 --> 00:22:36.200
equilibrium in the Goods Market that's a

00:22:33.798 --> 00:22:38.319
point in the is that's a definition of

00:22:36.200 --> 00:22:40.640
is so now what I'm going to do to

00:22:38.319 --> 00:22:42.399
construct my is is okay let me move the

00:22:40.640 --> 00:22:45.640
interest rate let me raise interest rate

00:22:42.400 --> 00:22:48.320
from I to I prime okay that's an

00:22:45.640 --> 00:22:50.360
increase in the interest rate and now

00:22:48.319 --> 00:22:52.720
let me find what is a new equilibrium in

00:22:50.359 --> 00:22:54.119
the goods market for a given interest

00:22:52.720 --> 00:22:56.720
rate Which is higher than the one I used

00:22:54.119 --> 00:23:00.359
to have well that amounts to Shifting

00:22:56.720 --> 00:23:02.120
the ZZ curve down

00:23:00.359 --> 00:23:04.719
why does it increasing the interest rate

00:23:02.119 --> 00:23:07.119
shift the ZZ curve down the aggregate

00:23:04.720 --> 00:23:07.120
demand

00:23:07.798 --> 00:23:14.000
down it makes investment decline exactly

00:23:10.880 --> 00:23:16.880
B is for investment declines okay so

00:23:14.000 --> 00:23:19.278
that means for any given level of output

00:23:16.880 --> 00:23:21.360
now aggregate demand is lower because

00:23:19.278 --> 00:23:23.359
investment is lower and then you get the

00:23:21.359 --> 00:23:24.479
multiplier to do it stck no and

00:23:23.359 --> 00:23:26.119
therefore you tend end up with a

00:23:24.480 --> 00:23:27.679
declining output which is even larger

00:23:26.119 --> 00:23:30.119
than the declining invest the initial

00:23:27.679 --> 00:23:31.278
declining invest M as a result of

00:23:30.119 --> 00:23:34.678
increase in the interest rate that's

00:23:31.278 --> 00:23:37.079
what a multiplier does no so say

00:23:34.679 --> 00:23:42.038
interest rate increased by 100 100 basis

00:23:37.079 --> 00:23:45.319
points that reduce investment by a say10

00:23:42.038 --> 00:23:47.558
billion and equilibrium output ends up

00:23:45.319 --> 00:23:50.079
falling by $15 billion because of the

00:23:47.558 --> 00:23:52.158
multiplier and so on okay but the point

00:23:50.079 --> 00:23:55.119
is after I do all my convergence to this

00:23:52.159 --> 00:23:57.960
new lower equilibrium level of output I

00:23:55.119 --> 00:23:59.839
have a second point in my as curve

00:23:57.960 --> 00:24:02.798
because that's a combination of a new

00:23:59.839 --> 00:24:04.359
interest rate I prime an output that is

00:24:02.798 --> 00:24:06.119
consistent with equilibrium in the Goods

00:24:04.359 --> 00:24:07.240
Market how do I know that it's

00:24:06.119 --> 00:24:10.079
consistent with equili in the Goods

00:24:07.240 --> 00:24:12.319
Market because I'm there I'm crossing 45

00:24:10.079 --> 00:24:13.960
degree line that means output equal to

00:24:12.319 --> 00:24:15.798
aggregate demand that's equilibrium in

00:24:13.960 --> 00:24:19.000
the Goods

00:24:15.798 --> 00:24:22.400
Market okay

00:24:19.000 --> 00:24:25.319
so and of course you can keep going no

00:24:22.400 --> 00:24:26.759
and trace an entire curve and all that

00:24:25.319 --> 00:24:28.398
you'll do is you'll change the interest

00:24:26.759 --> 00:24:30.798
rate that will shift this curve then you

00:24:28.398 --> 00:24:31.519
do the multiplier and endend up with a

00:24:30.798 --> 00:24:33.480
new

00:24:31.519 --> 00:24:35.720
equilibrium and that's another point for

00:24:33.480 --> 00:24:38.240
your curve

00:24:35.720 --> 00:24:40.440
okay so is it clear how we constructed

00:24:38.240 --> 00:24:40.440
that

00:24:41.000 --> 00:24:47.480
curve very important okay

00:24:45.119 --> 00:24:49.678
good it's also very important to

00:24:47.480 --> 00:24:52.798
understand well so why is it downward

00:24:49.679 --> 00:24:52.798
sloping yeah that's a

00:24:55.440 --> 00:25:00.120
question why is it downward sloping

00:25:02.919 --> 00:25:07.000
what does it mean that it's downward

00:25:04.440 --> 00:25:08.759
slope that means that combination of

00:25:07.000 --> 00:25:11.079
output and interest rate that are

00:25:08.759 --> 00:25:13.919
consistent with equilibrium output are

00:25:11.079 --> 00:25:16.918
negatively correlated meaning you know I

00:25:13.919 --> 00:25:20.399
have a combination of high output and

00:25:16.919 --> 00:25:24.120
low interest rate is consistent

00:25:20.398 --> 00:25:26.000
or low high interest rate and low output

00:25:24.119 --> 00:25:28.759
that's what I find

00:25:26.000 --> 00:25:32.519
here but why is that why what is the

00:25:28.759 --> 00:25:35.038
logic of that behind that or the

00:25:32.519 --> 00:25:38.398
mechanism well the way to think about

00:25:35.038 --> 00:25:41.960
that is exactly the way I I did this

00:25:38.398 --> 00:25:44.959
experiment is okay let me think what

00:25:41.960 --> 00:25:46.880
happens if I increase the interest rate

00:25:44.960 --> 00:25:49.120
and I keep the level of output where it

00:25:46.880 --> 00:25:51.559
was so what happens if I increase the

00:25:49.119 --> 00:25:53.599
interest rate and I I keep the level of

00:25:51.558 --> 00:25:56.000
output at the level it

00:25:53.599 --> 00:25:58.359
was my claim is that that's not an

00:25:56.000 --> 00:26:00.640
equilibrium in the Goods Market what

00:25:58.359 --> 00:26:00.639
what is

00:26:02.839 --> 00:26:06.959
it so I'm saying suppose I increase the

00:26:05.519 --> 00:26:10.200
interest rate but I keep the output

00:26:06.960 --> 00:26:12.919
constant so output is here higher

00:26:10.200 --> 00:26:15.519
interest rate aggregate demand is

00:26:12.919 --> 00:26:16.960
there so what what is the problem I'm

00:26:15.519 --> 00:26:18.158
saying my claim is that's not an

00:26:16.960 --> 00:26:19.880
equilibrium in the Goods Market we're

00:26:18.159 --> 00:26:21.080
going to need a lower level of output to

00:26:19.880 --> 00:26:22.799
have an equilibrium in the Goods Market

00:26:21.079 --> 00:26:24.278
that's the reason it's downward sloping

00:26:22.798 --> 00:26:25.158
but why is that not an equilibrium in

00:26:24.278 --> 00:26:27.599
the Goods

00:26:25.159 --> 00:26:29.360
Market or what is the nature of the dise

00:26:27.599 --> 00:26:32.359
equilibrium in the Market there what do

00:26:29.359 --> 00:26:35.599
we have an excess demand excess

00:26:32.359 --> 00:26:37.639
Supply excess Supply meaning there isn't

00:26:35.599 --> 00:26:41.278
enough demand to support that

00:26:37.640 --> 00:26:43.960
Supply so supply has to fall in order to

00:26:41.278 --> 00:26:47.119
restore equilibrium in that market in

00:26:43.960 --> 00:26:49.480
the Goods Market okay and since one

00:26:47.119 --> 00:26:51.839
drags the other one it has to Fall by a

00:26:49.480 --> 00:26:53.960
lot that that has to do with the slope

00:26:51.839 --> 00:26:56.678
of this

00:26:53.960 --> 00:26:58.120
curve that's the reason it's negatively

00:26:56.679 --> 00:26:59.120
so that's first thing you have to

00:26:58.119 --> 00:27:02.398
understand understand when you construct

00:26:59.119 --> 00:27:05.759
this curve I know I'm going slowly but

00:27:02.398 --> 00:27:08.000
it's important when you con please try

00:27:05.759 --> 00:27:11.278
to

00:27:08.000 --> 00:27:12.519
understand why is that another way of

00:27:11.278 --> 00:27:15.480
saying

00:27:12.519 --> 00:27:18.038
it when I when I find the when I change

00:27:15.480 --> 00:27:21.720
the equilibrium output along this S

00:27:18.038 --> 00:27:25.158
curve by moving the inid around what I'm

00:27:21.720 --> 00:27:27.399
doing is I'm moving along an is curve

00:27:25.159 --> 00:27:30.480
okay so if I if the only reason why

00:27:27.398 --> 00:27:32.439
equilibrium out with is changing is

00:27:30.480 --> 00:27:35.079
because I'm moving the interest rate

00:27:32.440 --> 00:27:37.880
that's a movement along the S

00:27:35.079 --> 00:27:41.599
curve okay so I'm I'm tracing points of

00:27:37.880 --> 00:27:43.799
the as curve good and I want to draw a

00:27:41.599 --> 00:27:47.719
contrast between these movements along

00:27:43.798 --> 00:27:49.558
the is curve versus things that shift

00:27:47.720 --> 00:27:52.919
the

00:27:49.558 --> 00:27:54.879
curve okay for

00:27:52.919 --> 00:28:00.120
example

00:27:54.880 --> 00:28:00.120
that so suppose I increase taxes

00:28:00.398 --> 00:28:05.798
increase taxes the government increases

00:28:02.519 --> 00:28:07.480
taxes my claim is that the is shift to

00:28:05.798 --> 00:28:11.200
the

00:28:07.480 --> 00:28:13.880
left that is for any given level of

00:28:11.200 --> 00:28:17.440
interest rate pick any interest you

00:28:13.880 --> 00:28:19.760
want say this one you're going to have a

00:28:17.440 --> 00:28:22.038
lower equilibrium output consistent with

00:28:19.759 --> 00:28:23.839
that interest rate if you have a lower

00:28:22.038 --> 00:28:26.200
equilibrium consistent with the same

00:28:23.839 --> 00:28:30.038
interest rate that has shifted the

00:28:26.200 --> 00:28:32.200
is has to be a different is

00:28:30.038 --> 00:28:33.759
okay and and think that I can do that

00:28:32.200 --> 00:28:35.558
for any given level of in I pick this

00:28:33.759 --> 00:28:37.000
one but I could have pick that one would

00:28:35.558 --> 00:28:38.480
have been the same I'm saying you

00:28:37.000 --> 00:28:40.440
increase

00:28:38.480 --> 00:28:41.839
taxes that's going to lead to lower

00:28:40.440 --> 00:28:45.720
equilibrium

00:28:41.839 --> 00:28:47.519
output so that means that for this

00:28:45.720 --> 00:28:49.679
higher level of taxes I will have to

00:28:47.519 --> 00:28:51.759
trace a different test

00:28:49.679 --> 00:28:53.440
curve I can start moving the interest

00:28:51.759 --> 00:28:54.919
rate around but I'm going to have a

00:28:53.440 --> 00:28:57.200
lower level of output for any given

00:28:54.919 --> 00:28:59.440
level of interest rate because I have

00:28:57.200 --> 00:29:02.038
higher taxes

00:28:59.440 --> 00:29:05.120
so how do I know that an increas in

00:29:02.038 --> 00:29:09.759
taxes will do this Which diagram would

00:29:05.119 --> 00:29:09.759
you go to to try to understand

00:29:14.519 --> 00:29:19.599
this so or let me ask it

00:29:17.679 --> 00:29:21.159
differently how do I know that this

00:29:19.599 --> 00:29:23.759
stuff shift to the left so I give you

00:29:21.159 --> 00:29:25.559
more open space how do I know that this

00:29:23.759 --> 00:29:27.839
increasing taxes will shift this is

00:29:25.558 --> 00:29:30.038
curve to the left how would you go about

00:29:27.839 --> 00:29:30.038
thinking

00:29:36.079 --> 00:29:40.278
not going to spend as much money less

00:29:38.440 --> 00:29:41.840
outcome there will be less aggregate

00:29:40.278 --> 00:29:43.240
demand and less aggregate demand leads

00:29:41.839 --> 00:29:45.319
to less output because output is

00:29:43.240 --> 00:29:47.880
aggregate demand deter exactly that's

00:29:45.319 --> 00:29:50.038
what equilibrium in the Goods Market so

00:29:47.880 --> 00:29:52.960
you can go back to this diagram this

00:29:50.038 --> 00:29:55.240
goes in the I could say ignore these

00:29:52.960 --> 00:29:57.558
labels here and say look for any given

00:29:55.240 --> 00:30:00.399
level of interest rate pick any if I

00:29:57.558 --> 00:30:01.278
increase tax I'm going to shift the Z ZZ

00:30:00.398 --> 00:30:04.439
curve

00:30:01.278 --> 00:30:07.000
down okay so ignore the this charar

00:30:04.440 --> 00:30:08.880
suppose that I fix the interest rate but

00:30:07.000 --> 00:30:10.000
I now change taxes increase taxes well

00:30:08.880 --> 00:30:11.559
I'm going to do exactly the same here

00:30:10.000 --> 00:30:13.159
I'm going to move this down and it's

00:30:11.558 --> 00:30:14.678
going to be a different is curve though

00:30:13.159 --> 00:30:17.120
because I shouldn't have used this

00:30:14.679 --> 00:30:20.159
diagram let me keep your answer I should

00:30:17.119 --> 00:30:23.319
have put a new diagram but it's it's

00:30:20.159 --> 00:30:25.919
lecture three in lecture three we did

00:30:23.319 --> 00:30:28.599
see that that an increase in tax would

00:30:25.919 --> 00:30:31.159
lead to lower equilibrium output

00:30:28.599 --> 00:30:33.759
in fact we know exactly by how much if

00:30:31.159 --> 00:30:36.159
if taxes increase by 100 then you know

00:30:33.759 --> 00:30:39.359
that equilibrium output would decline by

00:30:36.159 --> 00:30:42.200
C1 times 1 / minus

00:30:39.359 --> 00:30:44.278
C1 changing taxes here would be a little

00:30:42.200 --> 00:30:47.319
different because there is also remember

00:30:44.278 --> 00:30:50.599
investment also has a propensity to to

00:30:47.319 --> 00:30:52.079
to to spend as a function of output so

00:30:50.599 --> 00:30:53.319
so it would be a little different but

00:30:52.079 --> 00:30:57.000
that's the kind of

00:30:53.319 --> 00:30:59.918
calculation okay what else would shift

00:30:57.000 --> 00:30:59.919
the the is this

00:31:04.119 --> 00:31:07.678
way decrease in governance friend would

00:31:06.440 --> 00:31:09.840
do that what

00:31:07.679 --> 00:31:12.399
else this this another thing I want you

00:31:09.839 --> 00:31:13.720
to think of any everything because for

00:31:12.398 --> 00:31:16.359
sure you're going to face that in the

00:31:13.720 --> 00:31:20.480
quiz that anything that would shift the

00:31:16.359 --> 00:31:20.479
curve what else would shift the

00:31:23.000 --> 00:31:28.038
curve yeah that's true but but but

00:31:25.919 --> 00:31:30.519
that's not for this part of the course

00:31:28.038 --> 00:31:33.919
remember we're in a close economy so

00:31:30.519 --> 00:31:35.278
here we assume xal to m equal to zero I

00:31:33.919 --> 00:31:40.440
equal to

00:31:35.278 --> 00:31:40.440
zero that comes from after quiz one what

00:31:43.839 --> 00:31:48.000
else things that were captur remember

00:31:46.200 --> 00:31:49.919
when I began this lecture I show you

00:31:48.000 --> 00:31:51.720
wealth what had happened and so on well

00:31:49.919 --> 00:31:55.038
there's nowhere wealth in this model

00:31:51.720 --> 00:31:58.000
here it's just output but wealth affects

00:31:55.038 --> 00:31:59.519
how much consumers consume so autonomous

00:31:58.000 --> 00:32:02.038
consumption there were lots of stuff

00:31:59.519 --> 00:32:05.519
hidden in that c0 that constant c0

00:32:02.038 --> 00:32:08.839
remember c0 plus C1 one well c0 captures

00:32:05.519 --> 00:32:10.720
things like how confident were consumers

00:32:08.839 --> 00:32:13.519
how wealthy they felt and stuff like

00:32:10.720 --> 00:32:15.839
that so anything that shift C down

00:32:13.519 --> 00:32:17.720
consumer sentiment declines wealth

00:32:15.839 --> 00:32:23.759
declines something like that will also

00:32:17.720 --> 00:32:23.759
shift yes to the left okay so that's

00:32:23.880 --> 00:32:29.159
important good so now so we're done with

00:32:28.000 --> 00:32:32.558
is for

00:32:29.159 --> 00:32:34.960
now now with the is alone I cannot find

00:32:32.558 --> 00:32:38.359
what I want I want to find equili

00:32:34.960 --> 00:32:40.319
combinations of interest rate and output

00:32:38.359 --> 00:32:42.959
that are consistent with equilibrium in

00:32:40.319 --> 00:32:44.678
the goods and financial markets this

00:32:42.960 --> 00:32:46.519
doesn't do it because it gives you only

00:32:44.679 --> 00:32:50.320
combinations that are consistent with

00:32:46.519 --> 00:32:54.839
equilibrium in the Goods Market

00:32:50.319 --> 00:32:56.398
okay and in fact okay so I now need to

00:32:54.839 --> 00:32:58.918
look at Financial Market which is the

00:32:56.398 --> 00:33:01.638
other side the LM relation ship and

00:32:58.919 --> 00:33:03.679
remember what we had is we had

00:33:01.638 --> 00:33:05.359
equilibrium in the in the financial

00:33:03.679 --> 00:33:06.720
Market we had two instruments that we

00:33:05.359 --> 00:33:10.000
could use remember we had only two

00:33:06.720 --> 00:33:13.120
assets money and bonds so we could look

00:33:10.000 --> 00:33:16.638
at the equilibrium in in in the in money

00:33:13.119 --> 00:33:20.158
or equilibrium in bonds is the

00:33:16.638 --> 00:33:22.240
same but we we did it all in in terms of

00:33:20.159 --> 00:33:23.600
money it's the same because given wealth

00:33:22.240 --> 00:33:26.000
if one is in equilibrium the other one

00:33:23.599 --> 00:33:28.519
has to be in equilibrium as well so I I

00:33:26.000 --> 00:33:32.240
only need to look at one and we're

00:33:28.519 --> 00:33:33.319
looking at money okay so money is equal

00:33:32.240 --> 00:33:35.960
to money

00:33:33.319 --> 00:33:37.480
demand I'm going to divide both sides by

00:33:35.960 --> 00:33:39.600
P this is not going to be very important

00:33:37.480 --> 00:33:41.720
now but later we will be and so we're

00:33:39.599 --> 00:33:43.959
going to have that this is is

00:33:41.720 --> 00:33:47.480
equilibrium in in in financial Market

00:33:43.960 --> 00:33:50.519
means that real real H money supply

00:33:47.480 --> 00:33:52.798
equals real money demand okay that's

00:33:50.519 --> 00:33:56.720
what we have

00:33:52.798 --> 00:33:58.720
here so this you already see it traces

00:33:56.720 --> 00:34:00.880
combinations of out put an interest rate

00:33:58.720 --> 00:34:01.960
which are consistent with equilibrium in

00:34:00.880 --> 00:34:03.880
financial

00:34:01.960 --> 00:34:07.000
markets

00:34:03.880 --> 00:34:08.320
okay in the past that's the way the LM

00:34:07.000 --> 00:34:11.760
would be

00:34:08.320 --> 00:34:14.399
described we would fix M and say well

00:34:11.760 --> 00:34:18.000
this will give you an upward sloping

00:34:14.398 --> 00:34:21.078
curve no because this is downward

00:34:18.000 --> 00:34:22.838
sloping so if this guy goes up I need to

00:34:21.079 --> 00:34:24.399
if this is constant this guy goes up

00:34:22.838 --> 00:34:27.440
well this guy needs to come down what

00:34:24.398 --> 00:34:30.000
does that what does bring L down well I

00:34:27.440 --> 00:34:32.679
go up because L Prime is negative so

00:34:30.000 --> 00:34:35.239
that's the way LM used to be described

00:34:32.679 --> 00:34:38.079
your life is a lot simpler today it's a

00:34:35.239 --> 00:34:39.719
lot simpler because central banks don't

00:34:38.079 --> 00:34:41.440
Target monetary aggates they don't

00:34:39.719 --> 00:34:43.158
Target M they target the interest rate

00:34:41.440 --> 00:34:44.480
directly so they tell you the answer

00:34:43.159 --> 00:34:47.320
already they

00:34:44.480 --> 00:34:50.039
said what Central Bank when it does

00:34:47.320 --> 00:34:53.079
policy says look I tell you what I will

00:34:50.039 --> 00:34:54.679
be then if output moves around whatever

00:34:53.079 --> 00:34:56.639
that's that's problem it's a problem for

00:34:54.679 --> 00:34:58.599
M we'll provide the M that the market

00:34:56.639 --> 00:35:02.280
needs in order to have interest rate

00:34:58.599 --> 00:35:04.838
equal to the one we want okay so so it's

00:35:02.280 --> 00:35:06.480
it's it it is true that it captures all

00:35:04.838 --> 00:35:07.639
the combinations of output and interest

00:35:06.480 --> 00:35:09.400
that are consistent with equilibrium in

00:35:07.639 --> 00:35:13.799
the financial markets but it's very

00:35:09.400 --> 00:35:17.000
simple because the the the what the FED

00:35:13.800 --> 00:35:18.560
does in the US other central banks do is

00:35:17.000 --> 00:35:21.480
they say okay this is the interest rate

00:35:18.559 --> 00:35:23.960
we want and now you can put any amount

00:35:21.480 --> 00:35:26.400
of output you want as long as we remain

00:35:23.960 --> 00:35:27.920
committed to this interest rate it will

00:35:26.400 --> 00:35:30.440
be consistent with equilibrium in the in

00:35:27.920 --> 00:35:32.800
the financial markets because we will do

00:35:30.440 --> 00:35:35.240
it so and the way we will do it so is

00:35:32.800 --> 00:35:37.519
we'll provide as much M as the market

00:35:35.239 --> 00:35:38.719
needs so that that combination of output

00:35:37.519 --> 00:35:41.039
and interest rate is an equilibrium in

00:35:38.719 --> 00:35:43.719
the financial Market that is that's a

00:35:41.039 --> 00:35:49.400
very long way of saying that the FED

00:35:43.719 --> 00:35:52.078
sets I and then m is whatever this is

00:35:49.400 --> 00:35:54.400
needed for this equation to be in

00:35:52.079 --> 00:35:55.839
equilibrium so if output Rises and The

00:35:54.400 --> 00:35:58.639
Fed doesn't want to change the interest

00:35:55.838 --> 00:36:01.199
rate that means you need to change m

00:35:58.639 --> 00:36:04.000
okay so suppose that the FED says I want

00:36:01.199 --> 00:36:07.919
this interest rate to be fixed at this

00:36:04.000 --> 00:36:10.639
level call it I zero and now output

00:36:07.920 --> 00:36:10.639
turns out to be

00:36:10.760 --> 00:36:16.920
higher what will the FED do in order to

00:36:13.400 --> 00:36:18.880
ensure that I remains at i z what if the

00:36:16.920 --> 00:36:21.480
FED doesn't do

00:36:18.880 --> 00:36:23.318
anything so the FED says I want I equals

00:36:21.480 --> 00:36:26.000
z and and the FED is calculated that

00:36:23.318 --> 00:36:29.279
output will be about certain level and

00:36:26.000 --> 00:36:32.480
it turns out that output is higher

00:36:29.280 --> 00:36:32.480
what happens if the FED doesn't

00:36:32.559 --> 00:36:38.960
react and keeps the interest rate at I

00:36:35.480 --> 00:36:42.519
zero and output T to be higher than what

00:36:38.960 --> 00:36:44.559
they thought when they provided the M

00:36:42.519 --> 00:36:47.239
that they thought the market needed to

00:36:44.559 --> 00:36:49.599
be in equilibrium of that interest rate

00:36:47.239 --> 00:36:49.598
what will

00:36:51.159 --> 00:36:56.358
happen well the interest rate will go up

00:36:54.280 --> 00:36:57.960
because money demand will exceed money

00:36:56.358 --> 00:36:59.440
supply well the only way to restory

00:36:57.960 --> 00:37:02.639
equilibrium is for interest rate to go

00:36:59.440 --> 00:37:04.519
up but the FED doesn't want that so what

00:37:02.639 --> 00:37:06.679
the FED will do is when it feels that it

00:37:04.519 --> 00:37:09.039
feels the interest rat are going up they

00:37:06.679 --> 00:37:10.559
will provide more money so so they can

00:37:09.039 --> 00:37:13.559
restore equilibrium in the financial

00:37:10.559 --> 00:37:15.159
Market at that level of interest rate

00:37:13.559 --> 00:37:17.318
despite the fact that output end up

00:37:15.159 --> 00:37:19.279
being higher than they thought so all

00:37:17.318 --> 00:37:23.880
this is a long winded way to say that

00:37:19.280 --> 00:37:23.880
the LM is the modern LM is

00:37:24.838 --> 00:37:30.559
horizontal a few years ago that curve

00:37:27.760 --> 00:37:32.160
would have been upward sloping but given

00:37:30.559 --> 00:37:35.480
the way monetary policy is conducted

00:37:32.159 --> 00:37:38.519
nowadays your life is a lot simpler the

00:37:35.480 --> 00:37:41.679
L is a horizontal curve okay the FED

00:37:38.519 --> 00:37:43.318
tells you the Central Bank tells you H

00:37:41.679 --> 00:37:45.199
what the interest rate has to be and

00:37:43.318 --> 00:37:47.239
then it will give whatever M will

00:37:45.199 --> 00:37:50.199
provide whatever m is needed so that's

00:37:47.239 --> 00:37:50.199
the equilibrium

00:37:53.440 --> 00:37:59.318
industry so what shift the modern LM

00:37:59.760 --> 00:38:04.160
and by modern I only mean the book

00:38:02.159 --> 00:38:07.440
doesn't use the terminology but by

00:38:04.159 --> 00:38:09.759
modern I mean that the FED decides what

00:38:07.440 --> 00:38:12.000
the interest it

00:38:09.760 --> 00:38:13.359
is exactly the only thing that will

00:38:12.000 --> 00:38:16.559
shift into to your life is very simple

00:38:13.358 --> 00:38:21.480
the only thing that will shift the mod

00:38:16.559 --> 00:38:23.759
LM is that the FED changes its

00:38:21.480 --> 00:38:24.960
mind a few years back it would have been

00:38:23.760 --> 00:38:28.119
more

00:38:24.960 --> 00:38:29.838
complicated a change in money demand

00:38:28.119 --> 00:38:32.640
a a change in money supply all those

00:38:29.838 --> 00:38:35.679
things will be Shifting the LM around

00:38:32.639 --> 00:38:37.719
now in this setup is very simple no it

00:38:35.679 --> 00:38:41.358
will change only if the feds changes his

00:38:37.719 --> 00:38:43.519
mind now obviously the FED is not just a

00:38:41.358 --> 00:38:45.960
moody institution it will change the

00:38:43.519 --> 00:38:46.838
mind and sometimes is forced to change

00:38:45.960 --> 00:38:48.880
its

00:38:46.838 --> 00:38:50.480
mind I mean they're not happy with the

00:38:48.880 --> 00:38:53.079
interest rate they're setting

00:38:50.480 --> 00:38:55.079
nowadays they' been forced into that

00:38:53.079 --> 00:38:57.119
were very reluctant to go into very high

00:38:55.079 --> 00:38:59.599
interest rate but you know what is

00:38:57.119 --> 00:39:01.000
happening around with very high

00:38:59.599 --> 00:39:02.760
consumption and the impact that it's

00:39:01.000 --> 00:39:05.599
having on inflation they have been

00:39:02.760 --> 00:39:07.800
forced into moving interest rate not

00:39:05.599 --> 00:39:11.119
only very high but also very fast and

00:39:07.800 --> 00:39:13.440
and and and uh that was very risky we

00:39:11.119 --> 00:39:15.880
have been lucky that that nothing has

00:39:13.440 --> 00:39:18.880
really broken when normally when central

00:39:15.880 --> 00:39:20.519
banks raise interest so fast they break

00:39:18.880 --> 00:39:22.240
something along the way somebody's very

00:39:20.519 --> 00:39:24.559
lever out there some bank or something

00:39:22.239 --> 00:39:26.959
like that and you can you can blow up

00:39:24.559 --> 00:39:29.599
the UK we had a little scare with some

00:39:26.960 --> 00:39:33.199
insurance companies but

00:39:29.599 --> 00:39:36.039
but but was for a different reason

00:39:33.199 --> 00:39:37.919
but but it's it's scary to move policy

00:39:36.039 --> 00:39:40.318
very fast because this is a very

00:39:37.920 --> 00:39:42.400
important price for financial markets

00:39:40.318 --> 00:39:44.719
everything in financial Market gets

00:39:42.400 --> 00:39:47.519
priced off that's a starting any pricing

00:39:44.719 --> 00:39:49.159
model for stocks for anything will start

00:39:47.519 --> 00:39:51.000
from that policy rate then everything

00:39:49.159 --> 00:39:53.318
builds from there so if this has to move

00:39:51.000 --> 00:39:56.079
fast you can have lots of

00:39:53.318 --> 00:39:57.800
dislocation so my goal for today is to

00:39:56.079 --> 00:39:58.839
just to give you the instr and then

00:39:57.800 --> 00:40:00.160
we're going to all talk about

00:39:58.838 --> 00:40:02.440
combinations things that we did in

00:40:00.159 --> 00:40:06.239
certain episodes and and things of that

00:40:02.440 --> 00:40:08.240
kind okay good so again this part of the

00:40:06.239 --> 00:40:10.519
course is this part of the of the ISL

00:40:08.239 --> 00:40:13.679
mod is very easy and it's a lot easier

00:40:10.519 --> 00:40:17.639
now than it was a few years back okay so

00:40:13.679 --> 00:40:20.719
what does the eslm mo the slm M me

00:40:17.639 --> 00:40:22.838
simply mean puts the two curves together

00:40:20.719 --> 00:40:25.078
now we have two Curves in the space of

00:40:22.838 --> 00:40:27.000
output and interest rate and two

00:40:25.079 --> 00:40:29.318
unknowns which is output and interest

00:40:27.000 --> 00:40:29.318
rate

00:40:29.519 --> 00:40:36.559
so we have one combination only a that

00:40:33.679 --> 00:40:39.559
is consistent with both equilibrium in

00:40:36.559 --> 00:40:42.880
the Goods Market and equilibrium in

00:40:39.559 --> 00:40:45.199
financial Market that's the point

00:40:42.880 --> 00:40:48.318
a

00:40:45.199 --> 00:40:51.159
okay what happens to points to the right

00:40:48.318 --> 00:40:55.599
suppose I I I what happen What Happens

00:40:51.159 --> 00:40:55.598
here if I show you this point in this

00:40:56.000 --> 00:41:00.280
space what what's wrong with that

00:41:05.318 --> 00:41:12.239
point so point to the a point along the

00:41:08.119 --> 00:41:12.240
lamp but to the right what's wrong

00:41:15.358 --> 00:41:21.960
there well if it is along the LM I know

00:41:19.639 --> 00:41:23.279
that I'm okay with financial Market that

00:41:21.960 --> 00:41:25.519
those points are consistent with

00:41:23.280 --> 00:41:27.800
equilibrium in financial

00:41:25.519 --> 00:41:28.880
Market but it's not my equilibrium and

00:41:27.800 --> 00:41:30.079
it has to be in consistent with the

00:41:28.880 --> 00:41:33.160
other one it's not consistent with

00:41:30.079 --> 00:41:35.280
equilibrium in the Goods Market in fact

00:41:33.159 --> 00:41:37.118
you know more than that what's wrong

00:41:35.280 --> 00:41:39.920
with Goods Market there's an imbalance

00:41:37.119 --> 00:41:39.920
there but in which

00:41:40.960 --> 00:41:44.480
direction that point

00:41:47.838 --> 00:41:51.838
here what do you mean by excess of

00:41:52.480 --> 00:41:57.960
goods no demand is exactly insufficient

00:41:55.119 --> 00:41:59.280
demand there's too much output for that

00:41:57.960 --> 00:42:01.240
demand so that's the reason it's not

00:41:59.280 --> 00:42:05.680
consistent with equilibrium in the Goods

00:42:01.239 --> 00:42:08.559
Market okay to the left is the opposite

00:42:05.679 --> 00:42:10.559
no to the left we have insufficient

00:42:08.559 --> 00:42:12.159
output for the demand we have so it's

00:42:10.559 --> 00:42:14.480
not consistent with equilibrium in the

00:42:12.159 --> 00:42:17.078
the Goods Market so the only point that

00:42:14.480 --> 00:42:20.318
is consistent oh well you can think what

00:42:17.079 --> 00:42:22.960
happens with a point here for

00:42:20.318 --> 00:42:24.400
example that point because it's in the

00:42:22.960 --> 00:42:26.480
curve is consistent with equilibrium in

00:42:24.400 --> 00:42:29.639
the Goods Market but it's not consistent

00:42:26.480 --> 00:42:31.960
with equilibrium in Financial Market

00:42:29.639 --> 00:42:34.519
okay what do we have there supposed

00:42:31.960 --> 00:42:36.000
having in that point the interest rate

00:42:34.519 --> 00:42:38.280
is too high so that means the money

00:42:36.000 --> 00:42:40.159
demand is low so too much money demand

00:42:38.280 --> 00:42:43.160
for money supply okay that's that's what

00:42:40.159 --> 00:42:44.719
you have so those are not so so that's

00:42:43.159 --> 00:42:46.960
at the end of the day you know this is

00:42:44.719 --> 00:42:48.598
the only equilibrium point we have and

00:42:46.960 --> 00:42:51.440
and all the experiments I want to do

00:42:48.599 --> 00:42:53.760
next have to do with moving one curve or

00:42:51.440 --> 00:42:57.000
the other and see what happens to trace

00:42:53.760 --> 00:42:57.760
new equilibrium points okay but try to

00:42:57.000 --> 00:43:00.480
understand

00:42:57.760 --> 00:43:03.640
very well these diagrams of what

00:43:00.480 --> 00:43:05.440
happens when I move up horizontally and

00:43:03.639 --> 00:43:07.400
so on and convince yourself that this is

00:43:05.440 --> 00:43:08.400
the only combination it's pretty easy to

00:43:07.400 --> 00:43:11.039
convince yourself it's the only

00:43:08.400 --> 00:43:13.318
combination but think a little try to

00:43:11.039 --> 00:43:15.400
get away from point A and see what

00:43:13.318 --> 00:43:17.960
happens I guess the best way to do that

00:43:15.400 --> 00:43:19.559
is just to do experiment meaning move

00:43:17.960 --> 00:43:23.079
parameters of these curves and see how

00:43:19.559 --> 00:43:23.079
equilibrium output changes and so

00:43:24.760 --> 00:43:33.200
on so let's do the first

00:43:28.480 --> 00:43:35.960
experiment and yeah

00:43:33.199 --> 00:43:38.558
maybe so let's let's let's play with

00:43:35.960 --> 00:43:40.599
this so now you have you have your model

00:43:38.559 --> 00:43:42.720
and now we can start asking interesting

00:43:40.599 --> 00:43:45.559
questions the first thing you can ask is

00:43:42.719 --> 00:43:47.399
well fiscal policy how does it

00:43:45.559 --> 00:43:49.480
work

00:43:47.400 --> 00:43:52.200
well

00:43:49.480 --> 00:43:53.838
sorry so here this this is a contraction

00:43:52.199 --> 00:43:56.279
in fiscal policy so the same as we did

00:43:53.838 --> 00:43:57.759
before remember we increase taxes or we

00:43:56.280 --> 00:44:00.960
could have reduced go expenditure

00:43:57.760 --> 00:44:03.079
whatever that would have shifted the we

00:44:00.960 --> 00:44:06.079
we did that when when we look at the we

00:44:03.079 --> 00:44:09.960
did exactly that we shift the to to to

00:44:06.079 --> 00:44:12.160
the left and what happens here is well

00:44:09.960 --> 00:44:14.400
if you shift the to the left there's a

00:44:12.159 --> 00:44:15.879
new combination of output and interest

00:44:14.400 --> 00:44:19.400
rate that is that is consistent with

00:44:15.880 --> 00:44:22.318
equilibrium both markets that's a lower

00:44:19.400 --> 00:44:23.920
output okay so if the FED doesn't do

00:44:22.318 --> 00:44:26.039
anything that means it keeps the LM

00:44:23.920 --> 00:44:28.280
there and there's a contractionary

00:44:26.039 --> 00:44:30.558
fiscal policy well that will lead to

00:44:28.280 --> 00:44:32.519
contraction in output as well that's the

00:44:30.559 --> 00:44:34.640
reason we call it contraction not only

00:44:32.519 --> 00:44:37.920
because fiscal not not only because

00:44:34.639 --> 00:44:39.719
govern expenditure decline but it's if

00:44:37.920 --> 00:44:42.318
taxes increase that's contractionary

00:44:39.719 --> 00:44:46.558
because it reduces aggregate demand and

00:44:42.318 --> 00:44:46.558
the equilibrium that will reduce output

00:44:47.960 --> 00:44:54.440
okay so that's canonical contractionary

00:44:51.760 --> 00:44:56.359
fiscal policy you move output to the

00:44:54.440 --> 00:44:59.559
left interest rate doesn't move because

00:44:56.358 --> 00:45:03.719
that's controlled by the FED but but

00:44:59.559 --> 00:45:05.800
output declines okay so if somebody ask

00:45:03.719 --> 00:45:08.598
you what happens if if if there's a

00:45:05.800 --> 00:45:11.039
fiscal contraction you were asking a bit

00:45:08.599 --> 00:45:13.440
the the opposite side you know that

00:45:11.039 --> 00:45:15.679
people may have spent we have perhaps a

00:45:13.440 --> 00:45:17.960
fiscal expansion that was very large but

00:45:15.679 --> 00:45:20.000
what happens with a fiscal contraction

00:45:17.960 --> 00:45:23.039
well that will lead to lower equilibrium

00:45:20.000 --> 00:45:25.719
output I keep pring the lower equ what

00:45:23.039 --> 00:45:27.759
happens if you have a very large fiscal

00:45:25.719 --> 00:45:29.279
expansion what what happens if you have

00:45:27.760 --> 00:45:32.319
a very large fysical

00:45:29.280 --> 00:45:34.240
expansion what moves Ah that's something

00:45:32.318 --> 00:45:36.558
that's you should that's a question you

00:45:34.239 --> 00:45:38.078
should always ask yourself when when

00:45:36.559 --> 00:45:42.160
there is any question

00:45:38.079 --> 00:45:46.318
islm of islm you should ask which curve

00:45:42.159 --> 00:45:48.920
moves start from that always okay so if

00:45:46.318 --> 00:45:50.800
if we ask you any question about that is

00:45:48.920 --> 00:45:53.159
obvious about aslm the first thing you

00:45:50.800 --> 00:45:55.200
should ask is which Curve will

00:45:53.159 --> 00:45:58.759
move

00:45:55.199 --> 00:46:01.759
so suppose I tell you

00:45:58.760 --> 00:46:05.599
um due to covid the covid shock there

00:46:01.760 --> 00:46:09.800
was a massive ER transfer

00:46:05.599 --> 00:46:11.280
income transfer to lowincome individuals

00:46:09.800 --> 00:46:12.318
that is we had a very expansionary

00:46:11.280 --> 00:46:14.640
fiscal

00:46:12.318 --> 00:46:17.199
policy first thing you should ask is

00:46:14.639 --> 00:46:19.239
okay which curve moves the LM or the is

00:46:17.199 --> 00:46:23.558
if I do

00:46:19.239 --> 00:46:25.679
that is the is shift to the right does

00:46:23.559 --> 00:46:27.760
the LM move no has nothing to do with

00:46:25.679 --> 00:46:29.358
monetary policy

00:46:27.760 --> 00:46:31.400
okay so that's the first thing you need

00:46:29.358 --> 00:46:33.920
to do which curve is

00:46:31.400 --> 00:46:36.680
moving okay if it is fiscal that's a

00:46:33.920 --> 00:46:41.159
Goods Market thing that means it's going

00:46:36.679 --> 00:46:41.159
to move the yes not the

00:46:43.519 --> 00:46:49.759
LM what is the mechanism here what

00:46:48.000 --> 00:46:53.599
happened

00:46:49.760 --> 00:46:55.400
well remember what we have is I told you

00:46:53.599 --> 00:46:57.160
go always back to this diagram if you

00:46:55.400 --> 00:46:58.400
increase taxes and you keep keep the

00:46:57.159 --> 00:46:59.960
interest rate constant and you start

00:46:58.400 --> 00:47:03.000
from there so so the interest rate

00:46:59.960 --> 00:47:05.000
doesn't move then that will do what what

00:47:03.000 --> 00:47:06.960
increasing taxes did in lecture three

00:47:05.000 --> 00:47:10.000
will reduce aggregate demand and then

00:47:06.960 --> 00:47:12.240
the multiplier will take us to a larger

00:47:10.000 --> 00:47:14.480
decline that the initial fiscal

00:47:12.239 --> 00:47:19.039
contraction okay and that's a decline in

00:47:14.480 --> 00:47:22.679
equilibrium output so that y1 there is

00:47:19.039 --> 00:47:26.318
exactly a this one

00:47:22.679 --> 00:47:27.719
here that y Prime okay I haven't moved

00:47:26.318 --> 00:47:30.239
the interest rate I kept it at the same

00:47:27.719 --> 00:47:32.239
level I had a fysical

00:47:30.239 --> 00:47:36.358
contraction that's what we describe with

00:47:32.239 --> 00:47:37.399
that diagram well that's my new is I

00:47:36.358 --> 00:47:40.279
have a new

00:47:37.400 --> 00:47:44.318
is because for any for the same interest

00:47:40.280 --> 00:47:46.000
rate I have a lower equilibrium output

00:47:44.318 --> 00:47:48.159
and it happens that the FED DM change

00:47:46.000 --> 00:47:49.599
the interest rate so that's going to be

00:47:48.159 --> 00:47:51.480
my equilibrium output the whole curve

00:47:49.599 --> 00:47:54.200
moved to the left that would could tell

00:47:51.480 --> 00:47:56.079
three slides ago but now I know more I

00:47:54.199 --> 00:47:57.960
also know that since the FED hasn't

00:47:56.079 --> 00:48:01.039
reacted I I know exactly what is the new

00:47:57.960 --> 00:48:02.480
equilibrium output which is this I don't

00:48:01.039 --> 00:48:04.880
before we could only tell that the curve

00:48:02.480 --> 00:48:07.440
has shift to the left now since the fan

00:48:04.880 --> 00:48:09.440
react to that fiscal contraction I also

00:48:07.440 --> 00:48:14.000
know the equilibrium output will end up

00:48:09.440 --> 00:48:15.960
at White Prim okay good so I'm want to

00:48:14.000 --> 00:48:17.159
stop here and and and in the next

00:48:15.960 --> 00:48:21.400
lecture we'll

00:48:17.159 --> 00:48:21.399
continue with this