Lecture Transcript Notes: US Economy and IS-LM Model

Overview of US Economy

• Net Worth Trend:

  • Steady trend in net worth of US households, with declines during recessions.
  • Sharp decline at onset of COVID-19 due to drop in equity and house prices.
  • Subsequent dramatic rise in wealth due to asset price rallies.
  • 2022 saw a decline, but minor relative to previous gains.

• Impact on Aggregate Demand:

  • Rise in consumer wealth increases aggregate demand as consumers feel richer and spend more.
  • Corporations also experiencing high real investment.
  • Income levels remained stable due to government transfers, notably to lower-income households.
  • Elevated savings rate during COVID-19; now decreasing as people dissave.

• Overheating Economy:

  • Current high demand for travel, restaurants, etc., leading to economic overheating.
  • Overheating is causing upward pressure on aggregate demand.
  • Central bank (Federal Reserve) uses monetary policy to cool the economy.

Introduction to IS-LM Model

• Purpose:

  • Model used to understand aggregate demand and policy reactions.
  • Helps in analyzing monetary and fiscal policies.

• IS Curve (Investment-Savings):

  • Represents equilibrium in the goods market.
  • Investment is a function of output (positive relationship) and interest rate (negative relationship).
  • Higher interest rates reduce investment, shifting the curve downwards.

• LM Curve (Liquidity Preference-Money Supply):

  • Represents equilibrium in financial markets.
  • Traditionally upward sloping, now horizontal due to central banks targeting interest rates directly rather than monetary aggregates.

Economic Overheating and Inflation

• Causes of Overheating:

  • High consumption driven by increased savings and government stimulus.
  • Demand exceeding supply leads to inflation.

• Role of Monetary Policy:

  • Central banks, like the Fed, raise interest rates to control inflation.
  • Interest rate hikes are risky but necessary to stabilize prices.

Construction of IS-LM Model

• IS-LM Intersection:

  • The intersection represents equilibrium in both goods and financial markets.
  • Movement along the IS curve involves changes in interest rates affecting output.
  • Shifts in IS curve caused by fiscal policy changes, e.g., taxes or government spending.

• Fiscal and Monetary Policy Interactions:

  • Expansionary fiscal policy shifts IS right; contractionary shifts IS left.
  • LM curve shifts only if the central bank changes its interest rate target.

Conclusion

• Model's Application:
  • IS-LM model helps in understanding macroeconomic policy impacts on output and interest rates.
  • Important for predicting reactions to fiscal and monetary policy changes, especially in times of economic volatility.
  • Encouragement to understand the practical implications and underlying mechanics of the IS-LM model.