Understanding the US Economy and IS-LM Model

But before I do that, before I get into the ISLM model, let me spend a little time telling you what is going on in the U.S. economy as this will relate to the kind of things I will discuss later. in this lecture. So what you see there is the path of net worth, so wealth essentially, of households and non-profit organizations, households primarily, in the U.S. And what you can see is that, you know, there's a more or less steady trend, obviously in recessions net wealth tends to decline, and it certainly early on in the COVID recession it declined very dramatically because the price of equity, the price of houses, everything declined. with the initial shock, but what you see after that is a dramatic rise in wealth in the U.S. and all around the world, but particularly in the U.S. And what is behind that, well, there are two things that are behind that, but the main one is asset prices. Massive rallies in the equity market, price of houses sort of skyrocketed everywhere, and so on. Last year, 2022, was a bad year for asset buyers. But still, I mean, it's a small decline relative to the big buildup on wealth. Now, why do you think that in this course I would be talking about this at this point? What happens? What do... Remember, in this part of the course, we're trying to come up with a model of aggregate demand and then how it reacts to policy. That's the name of the game in this part of the course. So if I tell you that wealth increased a lot... Why do you think I'm telling you that? Aggregate consumers feel rich, they will tend to consume more, that increase aggregate demand. The point I'm highlighting to here is that there's a big force behind increasing aggregate, which is consumers feel richer. By the way, something similar is happening in corporations, and investment is also pretty high, real investment. The other source of increasing wealth, which is not as dramatic as the previous one, but it's very important, especially in lower income segments of the population, which tend to have a higher propensity to consume, is that incomes did not decline a lot 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 recession. Okay, so people save a lot more. That's sort of the average saving of households. 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. part of the increase in net worth is due to this, it's small relative to this, but this was about, this excess saving amounted to about 2.7, 2.8 trillion dollars, so you get a sense of the order of magnitude. And what 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 as you see massive demand for travel, massive demand for restaurants, hotels, and stuff like that, well that 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? Of course, in this part of the course, for the same reason I told you that networking went a lot. I mean, people had the savings, and they're really willing to spend it. That puts lots of upward pressure on aggregate demand. These pictures capture more or less the same. This captures very much what I said in the previous slide. You see the personal saving rate, that's the average, seven-year average, and you see what happened during COVID. Big spike in the saving rate, decline in the saving rate. The saving rate is much lower than when we released. And remember, the saving rate is... your income minus your consumption. So if you're saving less, you're consuming more relative to your income. Obviously, there's lots of heterogeneity. Some people made a lot of money, some people didn't make a lot of money. Some people save a lot, some people didn't save a lot. And in fact, we do that sort of the lower income segments, a lot of the excess savings is already gone. Accumulated early on, but they spent it also. And so, but what you're beginning to see in some of those segments is even though they don't have excess savings, They're borrowing a lot. So now you see credit card borrowing, which 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, at this moment, the U.S. economy and many economies around the world are, so we will call, overheating. There's a lot of demand for the production capacity of the economy. And that translates, the problem is, 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 lectures more or less from now, is that that leads to high inflation. Intuition tells you that it's a lot of demand relative to supply, well, prices, that happens in micro, and it also happens, but in any event. As a result of this, the U.S. economy is overheating, and therefore monetary policy is very contractual. The Fed has tightened its interest rate to cool down the economy. So how does that happen? Well, that's with the kind of things that we can answer with the IES-LM model. So the Fed is very IES-LM-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 to sort of summarize in the ASLM. 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 ASLM. Bells and whistles, but your starting point is the model where... Anyway, 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, led to a very, an economy that's overheating. And you can see here what happened. I disentangled between consumption of goods and consumption of services. Consumption of services is about two-thirds of consumption. Remember, goods is about one-third. What happens is the scales are different. For goods, they start... But 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 a restaurant, you couldn't travel, you couldn't do anything. So consumption in services collapsed. And now it has been recovering. And that recovery picked up pace last year. Actually, in 2021, it already picked up pace. And by now, we're above the trend. 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 I will get to that after quiz one. What happens to goods consumption? Well, also initially collapsed, but then, well, you know, people were bored at home, they couldn't do anything, they bought lots of gadgets 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... Now it's slowing down, but still if you look relative to trend, consumption of goods is way above what we saw in this episode. So the sum of the two things tells you consumption. And that, at this moment, the Fed wants to cool it down. We're gonna see how you do that. Okay, so now let's get into this set of lectures. And please, please stop me if there is anything that is unclear, because as I said, this is probably... If at the end of the summer you have forgotten everything you have learned in this course, but you remember these two lectures well, stop me. In fact, I normally... I have taught this lecture in one. I decided to try to slow it down as much as I can, because again, I think it's particularly important. discourse and for your stock of knowledge. So one of the main things we're going to be able to do with this model, as I've been saying, is we're going to be able to discuss the main macro-cognitive policy tools. Monetary policy is the main anticyclical 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 with mechanisms that allow you to do things that are more targeted, transfer resources to a specific group of people, and so on. And sometimes monetary policy is just not enough. COVID-19 initial recession was clearly a case of that, and you have to go all in. We'll see what we did there. Pretty dramatic. I think that the COVID-19 recession led probably to what, no, not probably, surely to the largest combined package in history of policy support, in terms of monetary policy and fiscal policy. So that's what we're going to do. After these two lectures, you're going to get to understand, essentially, the joint determination of output and interest rates. We're going 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 study this is what Hicks and Hansen initially called the ISLM. You already sort of hinted that this was coming, but why do you think the name? I noticed that you separate IES 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 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 it. Remember I said as an investment equal to savings, I equals S. So the IES 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. In the financial markets, we look at equilibrium as aggregate demand for money equal to supply of money. Supply of money was M, demand for money was Y times L of R and therefore the LM. That's the reason, that's a mnemonic for why this model is called the IES-LM. The IES stands for the part that has to do with equilibrium in the goods market, the LM has to do with the part that has to do with equilibrium in financial markets. This model is a model that combines those two equilibrium. So we're going to be interested in points. in which both markets are in equilibrium. That's the name of the game here. So let's first develop the IES relation. And the IES relation is really going back to lecture three. When I go back to lecture three, use the same model we used in lecture three with one change. And that change is that remember in lecture three we work a lot on a consumption, the only endogenous The only function we had was a consumption function, 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 flesh out a little more of this investment here. Make it closer to what a realistic function is. It's not a constant, obviously, or it's not totally 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 I? It's 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 Piazza 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. Should purchase of bonds included in the... This is purchase of goods and services by firms, 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 the goods market. So that investment is real investment. Again, purchase of capital, buildings, for the purpose of production and stuff like that. Okay, and this investment 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. 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 it was an increasing function of output. So this, we already had some functions that look like that, and we already know what it does to aggregate demand, no? It makes that curve steeper, remember? And it's the multiplier 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 it is 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 the investment is funded with borrowing. It's more expensive, 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 have an investment, financial investment. So, whether you borrow or not, still if the interest rate is higher, The opportunity cost of building factories is higher and so that's a reason investment is decreasing with respect. So now we go back to 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. Another function is increasing in output, like consumption was, and we also have something that is decreasing in the interest rate. And so this is what we call the IES relation. And the IES relation therefore has all the combinations of output and interest rate that are consistent with equilibrium in the goods market. Listen to what I said. I said the IES relation, or IES curve, has all the combinations of output and interest rate. combinations of output and interest rate that are consistent with equilibrium in the goods market. What about lecture 3? We already had that, but interest rate played no role. So we found one point. They said 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 is not only one point. point, can trace a curve and that's what we call the AES-related. So I remember I told you when we look at the goods market equilibrium, 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 and I'm just making it curve rather than linear simply because I haven't specified the functional form of investment. 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 prevention to consume. That's the reason we had, this was not flat, but upward sloping. No? And we found equilibrium output. 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 we had in lecture three is a little steeper. Why is that? A little steeper. By steeper, I mean if income goes up, then aggregate demand goes up. It used to go up. Exactly, because what made it upward sloping before was the marginal price to consume, but now there is also marginal price to invest, which is also positive. That's the reason. More interesting for this part of the lecture though, for the construction of the Yes curve, is that it's a parameter that we have in ZZ. What are the parameters we had before? We had things like government expenditure, taxes. the autonomous consumption, that's the kind of stuff that we had as parameters of the ZZ curve. By parameters I mean if we change this 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. That curve holds for some given interest rate. If I move the interest rate, 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 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 what the interest rate is, then you can find the equilibrium in the graph, because you can fix this curve. That's for one given interest rate. Okay, do you understand that? That's important, yes? Those of you that are awake, do you understand it or not? It's in the same page here. Okay, good. So let's now, with that, what we're going to do next is construct the IS curve. And how we're going to, remember what I want to try to do is constructing the space of interest rate and output, a curve, which we're going to call the IS 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, and that's going to be my IES curve or relationship. So let's do that. That's a construction of the IES curve. So in the previous chart, we found point A. So point A there is that point. There we are. We had some interest rate, this interest rate. 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 IS 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 the 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. That's an increase in the interest rate. Now let me find what is the 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. Does increasing the interest rate shift the ZZ curve down? It makes investment decline exactly borrowers won't respect therefore 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 its trick, and therefore you end up with a declining output, which is even larger than the initial declining investment as a result of increasing the interest rate. That's what a multiplier does. So say interest rate increased by 100 basis points, that reduces investment by $10 billion, and equilibrium output ends up falling by $15 billion. 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 AES curve, because that's a combination of a new interest rate, I', and output that is consistent with equilibrium in the goods market. How do I know that it's consistent with equilibrium in the goods market? Because I'm there, I'm crossing. 45 degree line means output equal to aggregate. So... And of course you can keep going, trace an entire curve, and all that you'll do is you change the interest rate that will shift this curve, then you do the multiplier and end up with a new equilibrium, and that's another point for your curve. It's clear how important. It's also very important to understand, well, So why is it downward sloping? Why is it downward sloping? What does it mean that it's downward sloping? That means that a combination of output and interest rate that are consistent with equilibrium output are negatively correlated. Meaning, you know, I have a combination high output and low interest rate is consistent with equilibrium output or high interest rate and low output. That's what I find. But why is that? What is the logic behind that, or the mechanism? Well, the way to think about that is exactly the way I did this experiment. It's essentially, 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 keep the level of output at the level it was? My claim is that that's not an equilibrium in the goods market. 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 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 this equilibrium in the goods market? 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. And since one drags the other one, it has to fall by a lot. That has to do with the slope of this curve. That's the reason it's negative. So that's the first thing you have to understand when you construct this curve, going slowly. Please try to understand why is it that... Another way of saying it, when I find that when I change the equilibrium output along this IS curve by moving the interest rate around, what I'm doing is I'm moving along an IS curve. So if I, if the only reason why equilibrium output is changing is because I'm moving the interest rate, that's a movement along the IS curve. I'm tracing points of the IS curve. And I want to draw a contrast between these movements along the IS curve versus things that shift the IS curve. For example, So suppose I increase taxes. The government increases taxes. My claim is that the IS shifts 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 consistent with that. If you have a lower equilibrium... consistent with the same interest rate, that has shifted the IS. It has to be a different IS. And think that I can do that for any given level of interest. I picked this one, but I could have picked that one. I mean the same. I'm saying, if 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 IS curve. I can start moving the interest rate around. But I'm going to have output for any given level of interest rate because I have higher taxes. So how do I know that an increase in taxes will do this? Which diagram would you go to to try to understand this? Let me ask it differently. How do I know that this stuff shifts to the left? How do I know that this increase in taxes will shift this IS curve? It will go into the numbers, and there will be less output. There will be less aggregate demand, and less aggregate demand leads to less output, because output is aggregate. That's what's 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, if I increase taxes, I'm going to shift the ZZ curve down. 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 it. But it's lecture three. In lecture 3 we did see that an increase in taxes would lead to lower exactly by how much taxes increased by 100. C1, 1 over C1. Here would be a little different because there is also remember investment also has a propensity to spend. That's the kind of calculation. What else would shift the IS this way? Decrease in governance trend, it would do that. What else? This is another thing I want you to do. Think of everything, because for sure you'll find a phase identity quiz. Anything that would shift the IS curve. What else would shift the IS curve? Yeah, that's true, but that's not for this part of the course. Remember, we're in a closed economy. So here we assume x equal to m equal to 0, im equal to 0. That comes from after quiz one. What else? Things that were captured. Remember when I began this lecture, I showed you wealth, what had happened, and so on. Well, there's nowhere wealth in this model here, 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 the one and one? Well, C0 captures things like how confident were consumers, how wealthy they felt, and stuff like that. So anything that shifts C0 down, consumer sentiment declines, wealth declines, something like that, will also shift the IS. So that's important. Good. So now, so we're done with the IES for now. Now, with the IES alone, I cannot find what I want. I want to find 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. And in fact, okay. I now need to look at financial markets, which is the other side, the LM relationship. And remember what we have. We have equilibrium in the financial markets. We have two instruments that we could use. Remember, we have only two assets, money and bonds. So we could look at the equilibrium in money or equilibrium in bonds. It's the same. We did it all in terms of money. It's the same because given wealth, if one is in equilibrium, the other one is in equilibrium. So I only need... So money is equal to money demand. I'm going to divide both sides by P. This is not going to be very important, but later we will. And so we're going to have that this is equilibrium in financial markets means that real money supply equals real money demand. So this... You already see it traces combinations of output and interest rate which are consistent with equilibrium in financial markets. 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 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, 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 aggregates. They don't target M. They target the interest rate directly. So they tell you the answer already. They said, when a central bank, when it does policy, it says, look, I tell you what I will be. Then if output moves around, whether that's a problem for M. We provide the M that the market needs in order to have an interest rate equal to the one we want. So it is true that it captures all the combinations of output and interest rate that are consistent with equilibrium in the financial markets, but it's very simple because what the Fed does in the U.S. or what 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 financial market, 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. 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. So suppose that the Fed says, I want this interest rate to be fixed at this level. Call it I0. And now output turns out to be higher. What will the Fed do in order to ensure that I remains at I0? What if the Fed doesn't do anything? So the Fed says I want I equals zero and the Fed is calculating that output will be about a 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? It turns out to be higher than they thought with their M. Interest rate will go up because money demand will exceed money supply. Well, the only way to restore 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 that interest rates are going up, they will provide more money equilibrium and add that level of interest rate despite the fact that... 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. Given the way monetary policy is conducted nowadays, your life is a lot simpler. The M is a horizontal curve. The Fed tells you, the central bank tells you 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 shifts the modern LM? And by modern, I only mean... It doesn't use that terminology. By modern, I mean the Fed decides. Exactly. The only thing that will shift this to your life is very simple. The only thing that will shift the modern LM is that the Fed changes its... A few years back, it would have been more complicated. A change in money demand, a change in money supply, all those things would be shifting the dilemma around. Now, this setup is very simple. It will change only if the Fed changes its mind. Now, obviously the Fed is not just a moody institution. It will change its mind, and sometimes it's forced to change its mind. I mean, they're not happy with the interest rate they're setting nowadays. They've been forced into that. We're very reluctant to go into very high interest rates. But you know, what is happening around with this very high consumption and the impact that is having on inflation, they have been forced into moving interest rates, not only very high, but also very fast. That was very risky. We have been lucky. Nothing has really broken. Normally, when central banks raise interest rates so fast, They break something along the way. Somebody's very clever out there, some bank or something like that. In the UK, we had a little scare with the insurance company. But it's scary to move policy very fast because this is a very important price for financial markets. Everything in financial markets gets priced off. That's a starting, any pricing model for a... stocks or anything will start from that policy rate and then everything builds from this has to move fast you can have lots of dislocation So my goal for today is to just to give you the instruments and then we're going to talk about the variations things that we did in certain episodes. Okay good. So again this part of the course is this part of the of the ISLM model is very easy and it's a lot easier now. So what does the ISLM model? The ISLM model simply means 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. What happens to points to the right? Suppose I... what happens here? If I show you this point in this space. What's wrong with that point? A point along the LM but to the right. What's wrong there? Well, if it is along the LM, I know that I'm okay with financial markets, that those points are consistent with equilibrium in financial markets. But it's not by equilibriums and it has to be inconsistent 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? In here. What do you mean by excess of goods? No, the money, exactly, insufficient demand. There's too much... output for that demand. So that's the reason it's not consistent with equilibrium in the... To the left, it's the opposite. To the left, we have insufficient output for the demand we have. So it's not consistent with equilibrium in the... So the only point that is consistent... Ah, well, you can think... What happens with a point here, for example? That point, because it's in the IS curve, is consistent with equilibrium in the goods market. But it's not consistent with equilibrium in financial markets. What do we have there? Suppose I'm in that point. The interest rate is too high, so that means the money demand is low. Too much money demand for money supply. Those are not. So that's, at the end of the day, you know, this is the only equilibrium. 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. But try to understand very well this diagram, so what happens horizontally and so on. 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 experiments, meaning move parameters of these curves and see how equilibrium output changes. So let's do the first experiment. Yeah. So let's play with this. So now you have your model, and now we're going to start asking interesting questions. The first thing you're going to ask is, well, fiscal policy. How does it work? So here, this is a contraction in fiscal policy. So the same as we did before, remember, we increased taxes. Could have reduced government expenditure, whatever. That would have shifted the IS. We did that. When we look at the IS, we did exactly that. We shift the IS to... And what happens here is if you shift the IS to the left, there's a new combination of output and interest rate that is consistent with equilibrium. So if the Fed doesn't do anything, that means it keeps the LM there. And there's a contractionary fiscal policy. Contractionary in output. That's the reason we call it contractionary. Not only because fiscal, not only because government expenditure declines, but if taxes increase, that's contractionary because it reduces aggregate demand. Equilibrium. So that's canonical contractionary fiscal policy. The left interest rate doesn't move because that's controlled by the Fed. The output, so if somebody asks you what happens if there is a fiscal contraction, you were asking a bit the opposite side, you know, you have a spend perhaps a fiscal expansion. What happens with a fiscal contraction? Well, we lead to lower equilibrium output. What happens if you have a very large fiscal expansion? What moves? Ah, that's something that you should, that's a question. You should always ask yourself when there is any question of ISLM, of ISLM, you should ask which curve moves. Start from that, always. So if we ask you any question about that, it's obvious about ISLM, the first thing you should ask is which... curve will move. So, suppose I tell you, due to COVID, the COVID shock, there was a massive transfer, income transfer to, that is, we have an expansionary fiscal. First thing you should ask is, okay, which curve moves, the LM or the IS? Is the IS? Shift to the right. Does the LN move? No, it has nothing to do with monetary policy. That's the first thing you need to do. Which curve is moving? If it is fiscal, that's a goods market thing. That means it's going to move the IS. What is the mechanism here? What happened? Remember what we have is, I told you, go always back to this diagram. If you increase taxes and you keep the interest rate constant, and you start from there so the interest rate doesn't move, then that will do what increasing taxes did in lecture three. It will reduce aggregate demand, and then the multiplier will take us to a larger decline than the initial fiscal contraction. So that Y1 there is exactly A. this one here. I haven't moved the interest rate, I kept it at the same level. I had a fiscal contraction, that's what we described with that diagram, 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 FedDM changed the interest rate, so that's going to be my equilibrium output. The whole curve moved to the left, that we could tell three slides ago, but now I know more. I also know that since the Fed hasn't reacted, I know exactly what is the new equilibrium output, which is this. Before, we could only tell that the curve has shifted to the left. Now, since the Fed didn't react to that fiscal contraction, I also know the equilibrium output will. So I'm going to stop here, and the next lecture will continue.

And what is behind that, well, there are two things that are behind that, but the main one is asset prices. Massive rallies in the equity market, price of houses sort of skyrocketed everywhere, and so on. Last year, 2022, was a bad year for asset buyers.

But still, I mean, it's a small decline relative to the big buildup on wealth. Now, why do you think that in this course I would be talking about this at this point? What happens?

What do... Remember, in this part of the course, we're trying to come up with a model of aggregate demand and then how it reacts to policy. That's the name of the game in this part of the course. So if I tell you that wealth increased a lot... Why do you think I'm telling you that?

Aggregate consumers feel rich, they will tend to consume more, that increase aggregate demand. The point I'm highlighting to here is that there's a big force behind increasing aggregate, which is consumers feel richer. By the way, something similar is happening in corporations, and investment is also pretty high, real investment. The other source of increasing wealth, which is not as dramatic as the previous one, but it's very important, especially in lower income segments of the population, which tend to have a higher propensity to consume, is that incomes did not decline a lot 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 recession.

Okay, so people save a lot more. That's sort of the average saving of households. 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. part of the increase in net worth is due to this, it's small relative to this, but this was about, this excess saving amounted to about 2.7, 2.8 trillion dollars, so you get a sense of the order of magnitude. And what 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 as you see massive demand for travel, massive demand for restaurants, hotels, and stuff like that, well that 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? Of course, in this part of the course, for the same reason I told you that networking went a lot. I mean, people had the savings, and they're really willing to spend it.

That puts lots of upward pressure on aggregate demand. These pictures capture more or less the same. This captures very much what I said in the previous slide.

You see the personal saving rate, that's the average, seven-year average, and you see what happened during COVID. Big spike in the saving rate, decline in the saving rate. The saving rate is much lower than when we released.

And remember, the saving rate is... your income minus your consumption. So if you're saving less, you're consuming more relative to your income. Obviously, there's lots of heterogeneity.

Some people made a lot of money, some people didn't make a lot of money. Some people save a lot, some people didn't save a lot. And in fact, we do that sort of the lower income segments, a lot of the excess savings is already gone. Accumulated early on, but they spent it also.

And so, but what you're beginning to see in some of those segments is even though they don't have excess savings, They're borrowing a lot. So now you see credit card borrowing, which 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, at this moment, the U.S. economy and many economies around the world are, so we will call, overheating. There's a lot of demand for the production capacity of the economy. And that translates, the problem is, 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 lectures more or less from now, is that that leads to high inflation. Intuition tells you that it's a lot of demand relative to supply, well, prices, that happens in micro, and it also happens, but in any event. As a result of this, the U.S. economy is overheating, and therefore monetary policy is very contractual. The Fed has tightened its interest rate to cool down the economy. So how does that happen?

Well, that's with the kind of things that we can answer with the IES-LM model. So the Fed is very IES-LM-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 to sort of summarize in the ASLM. 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 ASLM. Bells and whistles, but your starting point is the model where...

Anyway, 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, led to a very, an economy that's overheating. And you can see here what happened. I disentangled between consumption of goods and consumption of services. Consumption of services is about two-thirds of consumption.

Remember, goods is about one-third. What happens is the scales are different. For goods, they start... But 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 a restaurant, you couldn't travel, you couldn't do anything. So consumption in services collapsed.

And now it has been recovering. And that recovery picked up pace last year. Actually, in 2021, it already picked up pace.

And by now, we're above the trend. 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 I will get to that after quiz one.

What happens to goods consumption? Well, also initially collapsed, but then, well, you know, people were bored at home, they couldn't do anything, they bought lots of gadgets 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... Now it's slowing down, but still if you look relative to trend, consumption of goods is way above what we saw in this episode. So the sum of the two things tells you consumption. And that, at this moment, the Fed wants to cool it down.

We're gonna see how you do that. Okay, so now let's get into this set of lectures. And please, please stop me if there is anything that is unclear, because as I said, this is probably...

If at the end of the summer you have forgotten everything you have learned in this course, but you remember these two lectures well, stop me. In fact, I normally... I have taught this lecture in one.

I decided to try to slow it down as much as I can, because again, I think it's particularly important. discourse and for your stock of knowledge. So one of the main things we're going to be able to do with this model, as I've been saying, is we're going to be able to discuss the main macro-cognitive policy tools.

Monetary policy is the main anticyclical 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 with mechanisms that allow you to do things that are more targeted, transfer resources to a specific group of people, and so on.

And sometimes monetary policy is just not enough. COVID-19 initial recession was clearly a case of that, and you have to go all in. We'll see what we did there.

Pretty dramatic. I think that the COVID-19 recession led probably to what, no, not probably, surely to the largest combined package in history of policy support, in terms of monetary policy and fiscal policy. So that's what we're going to do. After these two lectures, you're going to get to understand, essentially, the joint determination of output and interest rates.

We're going 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 study this is what Hicks and Hansen initially called the ISLM. You already sort of hinted that this was coming, but why do you think the name?

I noticed that you separate IES 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 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 it. Remember I said as an investment equal to savings, I equals S. So the IES 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. In the financial markets, we look at equilibrium as aggregate demand for money equal to supply of money.

Supply of money was M, demand for money was Y times L of R and therefore the LM. That's the reason, that's a mnemonic for why this model is called the IES-LM. The IES stands for the part that has to do with equilibrium in the goods market, the LM has to do with the part that has to do with equilibrium in financial markets.

This model is a model that combines those two equilibrium. So we're going to be interested in points. in which both markets are in equilibrium. That's the name of the game here.

So let's first develop the IES relation. And the IES relation is really going back to lecture three. When I go back to lecture three, use the same model we used in lecture three with one change. And that change is that remember in lecture three we work a lot on a consumption, the only endogenous The only function we had was a consumption function, 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 flesh out a little more of this investment here. Make it closer to what a realistic function is. It's not a constant, obviously, or it's not totally 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 I? It's 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 Piazza 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. Should purchase of bonds included in the... This is purchase of goods and services by firms, 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 the goods market. So that investment is real investment. Again, purchase of capital, buildings, for the purpose of production and stuff like that.

Okay, and this investment 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.

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 it was an increasing function of output. So this, we already had some functions that look like that, and we already know what it does to aggregate demand, no?

It makes that curve steeper, remember? And it's the multiplier 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 it is 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 the investment is funded with borrowing. It's more expensive, 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 have an investment, financial investment. So, whether you borrow or not, still if the interest rate is higher, The opportunity cost of building factories is higher and so that's a reason investment is decreasing with respect. So now we go back to 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. Another function is increasing in output, like consumption was, and we also have something that is decreasing in the interest rate. And so this is what we call the IES relation. And the IES relation therefore has all the combinations of output and interest rate that are consistent with equilibrium in the goods market.

Listen to what I said. I said the IES relation, or IES curve, has all the combinations of output and interest rate. combinations of output and interest rate that are consistent with equilibrium in the goods market.

What about lecture 3? We already had that, but interest rate played no role. So we found one point.

They said 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 is not only one point. point, can trace a curve and that's what we call the AES-related.

So I remember I told you when we look at the goods market equilibrium, 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 and I'm just making it curve rather than linear simply because I haven't specified the functional form of investment. 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 prevention to consume. That's the reason we had, this was not flat, but upward sloping.

No? And we found equilibrium output. 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 we had in lecture three is a little steeper. Why is that? A little steeper. By steeper, I mean if income goes up, then aggregate demand goes up. It used to go up.

Exactly, because what made it upward sloping before was the marginal price to consume, but now there is also marginal price to invest, which is also positive. That's the reason. More interesting for this part of the lecture though, for the construction of the Yes curve, is that it's a parameter that we have in ZZ.

What are the parameters we had before? We had things like government expenditure, taxes. the autonomous consumption, that's the kind of stuff that we had as parameters of the ZZ curve. By parameters I mean if we change this 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. That curve holds for some given interest rate.

If I move the interest rate, 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 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 what the interest rate is, then you can find the equilibrium in the graph, because you can fix this curve. That's for one given interest rate. Okay, do you understand that?

That's important, yes? Those of you that are awake, do you understand it or not? It's in the same page here. Okay, good.

So let's now, with that, what we're going to do next is construct the IS curve. And how we're going to, remember what I want to try to do is constructing the space of interest rate and output, a curve, which we're going to call the IS 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, and that's going to be my IES curve or relationship. So let's do that. That's a construction of the IES curve.

So in the previous chart, we found point A. So point A there is that point. There we are. We had some interest rate, this interest rate. 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 IS 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 the 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. That's an increase in the interest rate. Now let me find what is the 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. Does increasing the interest rate shift the ZZ curve down? It makes investment decline exactly borrowers won't respect therefore 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 its trick, and therefore you end up with a declining output, which is even larger than the initial declining investment as a result of increasing the interest rate. That's what a multiplier does. So say interest rate increased by 100 basis points, that reduces investment by $10 billion, and equilibrium output ends up falling by $15 billion.

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 AES curve, because that's a combination of a new interest rate, I', and output that is consistent with equilibrium in the goods market. How do I know that it's consistent with equilibrium in the goods market? Because I'm there, I'm crossing.

45 degree line means output equal to aggregate. So... And of course you can keep going, trace an entire curve, and all that you'll do is you change the interest rate that will shift this curve, then you do the multiplier and end up with a new equilibrium, and that's another point for your curve. It's clear how important.

It's also very important to understand, well, So why is it downward sloping? Why is it downward sloping? What does it mean that it's downward sloping?

That means that a combination of output and interest rate that are consistent with equilibrium output are negatively correlated. Meaning, you know, I have a combination high output and low interest rate is consistent with equilibrium output or high interest rate and low output. That's what I find.

But why is that? What is the logic behind that, or the mechanism? Well, the way to think about that is exactly the way I did this experiment.

It's essentially, 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 keep the level of output at the level it was? My claim is that that's not an equilibrium in the goods market.

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 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 this equilibrium in the goods market? 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. And since one drags the other one, it has to fall by a lot.

That has to do with the slope of this curve. That's the reason it's negative. So that's the first thing you have to understand when you construct this curve, going slowly.

Please try to understand why is it that... Another way of saying it, when I find that when I change the equilibrium output along this IS curve by moving the interest rate around, what I'm doing is I'm moving along an IS curve. So if I, if the only reason why equilibrium output is changing is because I'm moving the interest rate, that's a movement along the IS curve. I'm tracing points of the IS curve. And I want to draw a contrast between these movements along the IS curve versus things that shift the IS curve.

For example, So suppose I increase taxes. The government increases taxes. My claim is that the IS shifts 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 consistent with that. If you have a lower equilibrium...

consistent with the same interest rate, that has shifted the IS. It has to be a different IS. And think that I can do that for any given level of interest. I picked this one, but I could have picked that one.

I mean the same. I'm saying, if 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 IS curve.

I can start moving the interest rate around. But I'm going to have output for any given level of interest rate because I have higher taxes. So how do I know that an increase in taxes will do this? Which diagram would you go to to try to understand this? Let me ask it differently.

How do I know that this stuff shifts to the left? How do I know that this increase in taxes will shift this IS curve? It will go into the numbers, and there will be less output.

There will be less aggregate demand, and less aggregate demand leads to less output, because output is aggregate. That's what's 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, if I increase taxes, I'm going to shift the ZZ curve down.

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 it.

But it's lecture three. In lecture 3 we did see that an increase in taxes would lead to lower exactly by how much taxes increased by 100. C1, 1 over C1. Here would be a little different because there is also remember investment also has a propensity to spend. That's the kind of calculation. What else would shift the IS this way?

Decrease in governance trend, it would do that. What else? This is another thing I want you to do. Think of everything, because for sure you'll find a phase identity quiz.

Anything that would shift the IS curve. What else would shift the IS curve? Yeah, that's true, but that's not for this part of the course.

Remember, we're in a closed economy. So here we assume x equal to m equal to 0, im equal to 0. That comes from after quiz one. What else? Things that were captured. Remember when I began this lecture, I showed you wealth, what had happened, and so on.

Well, there's nowhere wealth in this model here, 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 the one and one? Well, C0 captures things like how confident were consumers, how wealthy they felt, and stuff like that.

So anything that shifts C0 down, consumer sentiment declines, wealth declines, something like that, will also shift the IS. So that's important. Good.

So now, so we're done with the IES for now. Now, with the IES alone, I cannot find what I want. I want to find 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.

And in fact, okay. I now need to look at financial markets, which is the other side, the LM relationship. And remember what we have. We have equilibrium in the financial markets.

We have two instruments that we could use. Remember, we have only two assets, money and bonds. So we could look at the equilibrium in money or equilibrium in bonds. It's the same.

We did it all in terms of money. It's the same because given wealth, if one is in equilibrium, the other one is in equilibrium. So I only need... So money is equal to money demand.

I'm going to divide both sides by P. This is not going to be very important, but later we will. And so we're going to have that this is equilibrium in financial markets means that real money supply equals real money demand.

So this... You already see it traces combinations of output and interest rate which are consistent with equilibrium in financial markets. 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 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, 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 aggregates. They don't target M.

They target the interest rate directly. So they tell you the answer already. They said, when a central bank, when it does policy, it says, look, I tell you what I will be. Then if output moves around, whether that's a problem for M. We provide the M that the market needs in order to have an interest rate equal to the one we want.

So it is true that it captures all the combinations of output and interest rate that are consistent with equilibrium in the financial markets, but it's very simple because what the Fed does in the U.S. or what 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 financial market, 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.

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. So suppose that the Fed says, I want this interest rate to be fixed at this level. Call it I0.

And now output turns out to be higher. What will the Fed do in order to ensure that I remains at I0? What if the Fed doesn't do anything? So the Fed says I want I equals zero and the Fed is calculating that output will be about a 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?

It turns out to be higher than they thought with their M. Interest rate will go up because money demand will exceed money supply. Well, the only way to restore 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 that interest rates are going up, they will provide more money equilibrium and add that level of interest rate despite the fact that...

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. Given the way monetary policy is conducted nowadays, your life is a lot simpler. The M is a horizontal curve. The Fed tells you, the central bank tells you 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 shifts the modern LM? And by modern, I only mean... It doesn't use that terminology. By modern, I mean the Fed decides.

Exactly. The only thing that will shift this to your life is very simple. The only thing that will shift the modern LM is that the Fed changes its...

A few years back, it would have been more complicated. A change in money demand, a change in money supply, all those things would be shifting the dilemma around. Now, this setup is very simple.

It will change only if the Fed changes its mind. Now, obviously the Fed is not just a moody institution. It will change its mind, and sometimes it's forced to change its mind.

I mean, they're not happy with the interest rate they're setting nowadays. They've been forced into that. We're very reluctant to go into very high interest rates.

But you know, what is happening around with this very high consumption and the impact that is having on inflation, they have been forced into moving interest rates, not only very high, but also very fast. That was very risky. We have been lucky. Nothing has really broken. Normally, when central banks raise interest rates so fast, They break something along the way.

Somebody's very clever out there, some bank or something like that. In the UK, we had a little scare with the insurance company. But it's scary to move policy very fast because this is a very important price for financial markets. Everything in financial markets gets priced off. That's a starting, any pricing model for a...

stocks or anything will start from that policy rate and then everything builds from this has to move fast you can have lots of dislocation So my goal for today is to just to give you the instruments and then we're going to talk about the variations things that we did in certain episodes. Okay good. So again this part of the course is this part of the of the ISLM model is very easy and it's a lot easier now. So what does the ISLM model?

The ISLM model simply means 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. What happens to points to the right? Suppose I...

what happens here? If I show you this point in this space. What's wrong with that point?

A point along the LM but to the right. What's wrong there? Well, if it is along the LM, I know that I'm okay with financial markets, that those points are consistent with equilibrium in financial markets.

But it's not by equilibriums and it has to be inconsistent 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? In here. What do you mean by excess of goods?

No, the money, exactly, insufficient demand. There's too much... output for that demand.

So that's the reason it's not consistent with equilibrium in the... To the left, it's the opposite. To the left, we have insufficient output for the demand we have.

So it's not consistent with equilibrium in the... So the only point that is consistent... Ah, well, you can think... What happens with a point here, for example? That point, because it's in the IS curve, is consistent with equilibrium in the goods market.

But it's not consistent with equilibrium in financial markets. What do we have there? Suppose I'm in that point. The interest rate is too high, so that means the money demand is low. Too much money demand for money supply.

Those are not. So that's, at the end of the day, you know, this is the only equilibrium. 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.

But try to understand very well this diagram, so what happens horizontally and so on. 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 experiments, meaning move parameters of these curves and see how equilibrium output changes.

So let's do the first experiment. Yeah. So let's play with this.

So now you have your model, and now we're going to start asking interesting questions. The first thing you're going to ask is, well, fiscal policy. How does it work? So here, this is a contraction in fiscal policy. So the same as we did before, remember, we increased taxes.

Could have reduced government expenditure, whatever. That would have shifted the IS. We did that.

When we look at the IS, we did exactly that. We shift the IS to... And what happens here is if you shift the IS to the left, there's a new combination of output and interest rate that is consistent with equilibrium.

So if the Fed doesn't do anything, that means it keeps the LM there. And there's a contractionary fiscal policy. Contractionary in output. That's the reason we call it contractionary.

Not only because fiscal, not only because government expenditure declines, but if taxes increase, that's contractionary because it reduces aggregate demand. Equilibrium. So that's canonical contractionary fiscal policy.

The left interest rate doesn't move because that's controlled by the Fed. The output, so if somebody asks you what happens if there is a fiscal contraction, you were asking a bit the opposite side, you know, you have a spend perhaps a fiscal expansion. What happens with a fiscal contraction? Well, we lead to lower equilibrium output.

What happens if you have a very large fiscal expansion? What moves? Ah, that's something that you should, that's a question. You should always ask yourself when there is any question of ISLM, of ISLM, you should ask which curve moves. Start from that, always.

So if we ask you any question about that, it's obvious about ISLM, the first thing you should ask is which... curve will move. So, suppose I tell you, due to COVID, the COVID shock, there was a massive transfer, income transfer to, that is, we have an expansionary fiscal.

First thing you should ask is, okay, which curve moves, the LM or the IS? Is the IS? Shift to the right.

Does the LN move? No, it has nothing to do with monetary policy. That's the first thing you need to do.

Which curve is moving? If it is fiscal, that's a goods market thing. That means it's going to move the IS. What is the mechanism here? What happened?

Remember what we have is, I told you, go always back to this diagram. If you increase taxes and you keep the interest rate constant, and you start from there so the interest rate doesn't move, then that will do what increasing taxes did in lecture three. It will reduce aggregate demand, and then the multiplier will take us to a larger decline than the initial fiscal contraction. So that Y1 there is exactly A.

this one here. I haven't moved the interest rate, I kept it at the same level. I had a fiscal contraction, that's what we described with that diagram, 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 FedDM changed the interest rate, so that's going to be my equilibrium output. The whole curve moved to the left, that we could tell three slides ago, but now I know more. I also know that since the Fed hasn't reacted, I know exactly what is the new equilibrium output, which is this. Before, we could only tell that the curve has shifted to the left. Now, since the Fed didn't react to that fiscal contraction, I also know the equilibrium output will.

So I'm going to stop here, and the next lecture will continue.

Transcript for:Understanding the US Economy and IS-LM Model

Transcript for:
Understanding the US Economy and IS-LM Model