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