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 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