okay so let's H let's continue with this islm model remember in the previous lecture we we set up we set it up we cons we built the eslm model I will go over that very quickly in this lecture because I think it's very important for you and then we're going to use it and uh eventually we're going to talk a little bit about the policy response the mcro macroeconomic policy response during the covid-19 ER shock or recession all of the B so the the starting point remember with first thing we did we constructed the relation and the relation was just the same as lecture three but we sort of expel out what what is inside that investment that we had taken as a constant there we said well far more realistic is to make investment itself increasing in output because it's increasing in sales that in one change analysis that we had in lecture three all that will do is change the slope of the of the aggregate demand curve and therefore change the multiplier but we could have solved everything in terms of lecture three what made this a little different from lecture three is that we also said the investment real investment remember this has nothing to do with financial investment real investment is also a decreasing function of the interest rate okay and so er and and that led to the is relationship which essentially says these are all the is curve traces all the combinations of output and interest rate that are consistent with equilibrium in the Goods Market that's the definition of the now of course you know in in in lecture three we were able to determine equilibrium output here we can't why can't we yeah we have two unknowns it's output and the interest rate and we have only one relationship the is LM the curve so the reason for the LM curve is that we need pin down the second variable okay and that's what LM will do and it will be sort of very brutal about it in the past remember it was some upward slope in relationship I said in previously no that's not what the central banks do today just set the interest rate so if the Central Bank sets the interest rate then you can use lecture three to pin down equilibrium in the Goods Market which is what you would effectively be doing here if you fix this interest rate at whatever level the Central Bank wants then now you have one curve for one unknown which is output and that's exactly what we solve in lecture three okay good um so I said you know lecture three now this z z Curve will a little steeper because investment also responds positively to increases in output importantly now we have an interest rate which is a shifter of this aggregate demand in particular if the interest rate goes up what happens to that curve so if the interest rate goes up what happens to the AG demand curve I have two candidates here down or up down yeah because investment drops so you can tell me even more by how much if I tell you how much a change in the interest rate is and I tell you what is a sensitivity of investment to the interest rate you know exactly by how much this thing will come down it's going to be the change in the interest rate time the sensitivity of the investment function to to the interest rate that's not the end of the story as you well know that's the horizontal shift in a great demand but the final decline in output will be larger than that initial decline in investment as a result of the higher interest rate why is that so someone say the fed raises interest rate ER that immediately reduces investment because investment is negative related to the interest rate that immediately decreases aggregate demand which immediately increases decreases output because in this part of the course output is determined by agre demand does the adjustment stop there no that's what the multiplier was about because now with lower income there's lower consumption and actually lower investment as a result of that and we keep going okay so this the final Decline and output is a lot larger and doing that kind of experiment moving the interet around and seeing what happens to equilibrium output is that we derive we constructed the I curve okay that's here is for a cutting the inter no oh this is exactly the experiment I just describe so if you raise the interest rate then aggre demand comes down and then output declines buy a lot more than the initial decline in investment because of the multiplier but eventually we get to another equilibrium output which is that so now we know that this point belongs to the yes curve because it's a combination of output y Prime an interest rate I prime that is consistent with equilibrium in the Goods Market that's what lecture three told us that's what equilibrium in the goods markets look like that's another point of the same is H because I have higher output here lower interest rate straight that's another point of the as that's the reason this downward sloping look at what I just said I said I have another point of the same I how do I know it's the same as and not some other I you know all that I told you there is I found two points two combinations of output and interest rate that are consistent with equilibrium in the Goods Market but I said a little more I said and that's part that's the way we construct one is exactly because there is a lot of other parameters that we're keeping constant there you know that's the distinction between a movement along and is curve which is when the when the only thing I move is the interest rate that allows me to trace a movement along a single is if I move something else like taxes go on expenditure or autonomous consumption by you know something like that then I I will be Shifting the agregate demand for any given interest rate and I want to get a different level of output for any given interest rate which means I'm going to be in a different I okay and that's what we did there no in that case there we would said look I can fix the interest rate any interest rate you want let's pick this one but I could have done it other interest rate here there whatever and now I say what happens if I increase taxes well again you know from lecture three exactly what happen happens when the interest rate is constant because there we didn't even talk about the interest rate nothing was a function of the interest rate and you increase taxes well that will reduce disposable income for any level of output and H that um will lead to contraction our great demand output and so on so forth so that means that for this interest rate now I found another Point another point that is is an equilibrium in the Goods Market but it belongs to a different is because I move one of the parameters which is the taxes okay and now for this higher level of taxes I can play around with the interest rate I can say well what happens if I cut interest rate well if I cut interest rate I'm going to find another equilibrium say here if I cut the interest rate from here to here I'm going to find another equilibrium LEL of output which is consistent with that very same is why is that very same is well because I haven't moved taxes again okay so the reason I'm I'm repeating this is because I I it's very important to understand what what is a movement along the is versus what shift the is good then we move to the LM relation no and the LM relation is just equilibrium in the financial Market this is combinations of output and interest rate that are consistent with equilibrium in financial markets and we constructed from our money supply equal to money demand in nominal terms then we divide it by P which is not very interest in this part of the course because p is constant we're assuming that P is not moving that's the price of goods and services and then we have a this this this equilibrium here now stated in real terms so real money supply is equal to real money demand and as I said had you taken this course a few years back or perhaps in other places I don't know H that would have been an upward slop in relationship so the LM would have been an upward sloping relationship how do I know it's upward sloping well because if if I don't don't change money supply and I increase output then I need to bring Li down and since L Prime is negative the way to bring L down is by increasing the interest rate so that's what would have given you an upward sloping LM curve I said we don't do that now because really Bank central banks abandoned a long time ago in most parts of the world not everywhere this idea of targeting M what they target directly is the interest rate and then they give you whatever M they you need they need in order for the equilibrium in financial markets to be consistent with the interest rate the Central Bank wants to set okay so I said the modern is curve really looks like that the FED in the US Central Bank anywhere else sets the interest rate turkey is a little different but sets the interest rate ER and and and that's a a l now this this particular LM says I you know I it's a flat curve it's not a function of output the F sets the interest rate that's it that's the reason you know it's flat it's not upward slope or anything so I asked the question what shifts the modern LM only the central bank because the central bank is the one that sets the interest rate certainly well let me not complicate sets the interest rate so if the central bank doesn't change its mind then the interest rate is whatever it is and the LM will remain there okay good so we put the two things together and now we can pin down equilibrium output because remember we had when we just look at the is we had combinations of interest rate and output that were consistent with equilibrium in the goods market now we have an an interest rate which is consistent with equilibrium in financial markets that's what the central bank is there to ensure and so at that interest rate we can look into the yes what is the level of output that corresponds to that that's what we get here okay so now we found an equilibrium we found a combination of interest and output that is consistent with equilibrium in both Goods markets and financial markets okay and that's what the eslm model is about it's about finding those combinations okay good is this very clear yes yes okay good so now we can begin to play with this stuff we can one of the main purposes of the islm model is to understand policy macroeconomic policies what you what you should do in certain environments or not well before knowing what you should do in certain environments you need to understand what is that the different macroeconomic policies do to equilibrium output and interest rate and so on and so that's what we began to do and the first experiment was was one of fiscal policy so that's an example of a contractionary fiscal policy that could happen as a contractionary fiscal policy is essentially increasing taxes like like we Illustrated before or a reduction in government expenditure either of those H will lead to a shift in the yes to the left okay remember from lecture three if I increase taxes or reduce government expenditure equilibrium output will fall that's lecture three remember H and and and and so I can chase using lecture three I can I tell you well that yes will shift to the left no we just did that but now we know more because we know that the central bank is also pinning down the interest rate and in this particular example here the central bank did not go along with the treasury Department and say okay I'm going to keep the interest rate whatever it is you do whatever you one with the fiscal policy so this is an example of a situation where fiscal policy contractionary and the Central Bank remains H with its previous Target interest rate target okay so as a result of that a contractionary fiscal policy as the word says a then is a contractionary aggregate demand policy ends up also leading to lower equilibrium output and then I ask I already told you two things T up or G down but what else would do something similar to this which is not policy exactly I want anything that is a shock to aggregate demand different from interest rate or anything like that so for example consumer confidence that thing that we put in c0 or wealth something that wasn't in the mold but clearly is what is behind c0 that would lead to a shock like that and it's contraction that's the reason you know central banks and financial markets are all the time looking at sort of the releases of surveys of consumer confidence and things of that kind because these are the implications of of shocks to to to consumer confidence and so on okay good so what is a what is the mechanism here well you know it we have discussed it multiple times H the contraction in fiscal policy lowers the aggregate demand down then via multiplier you end up lowering output a lot more and this happens for a given interest rate I'm having the same interest rate here and there because I'm looking at at two points along for a fixed LM for a fixed interest rate good so that's a that's a contractionary monetary policy needless to say an expansionary fiscal policy sorry is just a shift in the opposite direction so what will an expansionary fiscal policy do to equilibrium output expansionary okay will increase output okay this was contraction fiscal policy reduce output we'll do the opposite obviously will increase output so that's expansion in fiscal policy and it's a very important tool to move output around when the econom is in a recession or so on so forth the other canonical macroeconomic policies monetary policy and that's an example of an expansionary monetary policy so an expansionary monetary policy Cuts interest rate why is that expansion well look it is expansion you know let me take this as I'm going to do things in a step so claim first an expansion in monetary policy is a reduction in the interest rate so the the central bank now decides to set a lower interest rate than it used to as a result of that no if output didn't change what would happen in the Goods Market so suppose that the FED cuts the interest rate and output doesn't change is that an equilibrium in the Goods Market is that an equili in the Goods Market suppose that the the the the FED cuts the interest rate and now I say okay well nothing will happen here output will stay where it is would have a lower interest rate that's nice wh why is that's not the final outcome of of the monetary policy expansion exactly this is an imbalance no because aggregate demand now a lower interest rate investment will go up this physical investment remember purchase of goods and services by firms for the purpose of building Capital structures and like that so a aggre demand went up so now we have a dise equilibrium there output is less than aggregate demand and we know that output is determined by aggre demand and then we go on through all the mechanism okay so this point is not an equilibrium we're going to end up with a higher level of output at that lower interest rate we have a lower level of output therefore it's not surprising that we call this an expansionary monetary policy so when the FED cuts the interest rate that's an expansionary monetary policy okay will expand aggregate demand good so how does the FED implement this sorry they can do expansionary open market operations yeah there you are perfect so what they they need to do is do some expansion in monetary open market operation no again now it's a little more sophisticated than that but but let's stick with this that is the first thing they'll do is they they'll shift money supply okay they go out there and start buying bonds and and and and giving money to injecting money into the system particularly through the banks so that's initial response that's what we'll cut the interest rate what happens next this this will allow me to illustrate sort of the modern I yes remember the f the fed's decision was not to increase the money supply by you know 35% what the FED communicated to the market was that it was going to cut interest rate by 50 basis points that's the communication so initially the way it does that overnight is it goes out and does exactly that so what it did is what we have there no we had some interest rate I zero the FED now wanted to go to i1 okay so in order to do that well you have to look at this money demand and increase money supply to get to achieve the lower interest rate the question I'm asking you now does it a stop there so the the FED say okay I did my job you know I want to lower the interest rate I'm going to increase m i increase M and now I manag to bring the interest rate down to that point and that they intervene in overnight market so that happens very quickly do you think that the FED now can sleep for a while why not there are many reasons why the F cannot sleep for a long time but but but in this particular case okay yes money demand will increase why no so the first shock was an increas in money supply the point that I think you want to say is that because now the interest rate is lower equilibrium output will go up but if equilibrium go output goes up then what happens in this diagram well the money demand goes up because remember one of the parameters in this curve was output remember this was output times Li that's that that curve there when in this manone demand I had output fixed at y zero but now equilibrium output is higher so this Curve will also shift out okay now you're going to have y1 l i there so what what will the FED do see the FED doesn't do anything and it stops here then the interest rate goes back up not necessarily to the old level but will go up so what the FED will have to do is keep expanding money no sorry ugly diagram but it will keep expanding money up to so it can preserve the interest rate so that's you know in the old analysis you would have stopped in the first shot but nowadays that's not the FED says look I'm going to provide money and I know it takes time for output to expand and all that so I will accommodate all that comes it will not come overnight all this extra demand for money but I know there will be more demand coming along if I'm successful at expanding economic activity okay so the the Central Bank knows that if this ends up happening then that they will have to provide more money than than initially just to preserve the interest at the lower rate again we don't have any concept of time in this course and I don't think that well we'll do a little bit later but things happen in reality in the financial markets they happen very quickly and then they take time the real side is much slower I mean this expansion in output takes a couple of years for example it's slower the reaction of interest rate asset price and so on happens overnight instantly when people do analysis of the impact of monetary policy on on financial assets prices you look at the small Windows the minutes around an announcement or something like that to understand what is the impact when you look at the impact of monetary policies or prices on real activity you look over the span of quarters that's your unit of and and you begin to see effects a quarter later and you keep seeing effects you know eight quarters later so so different time scale in this course we're not worrying about that but but everything happens at once so so really what will happen in this course is that it won't be enough to increase money supply to this point in order to have an interest rate at the final equilibrium level of output at this level I'm going to have to expand money supply a lot more okay that's what I'm saying good so again I can always go back to my lecture three remember I always I told you that that diagram in lecture three was going to be very important the expansionary effects of an expansionary monetary policy can be analyzed in the lecture three diagram because there we take as given an interest rate and now we know that when I have a a higher interest rate a lower interest rate we'll bring this aggregate demand up and then we get them multiplied and blah blah blah blah blah okay that's that's what so this is a movement in the when when monetary policy changes that's another thing that is very important when you do islm analysis whenever you ask a question the first thing you need to think about is which curve is this policy moving or which curve is this shock moving okay and what I know is that monetary policy fiscal policy will always move the is will it move the LM no it has nothing to do with things that happen in financial Market that doesn't mean that the FED may not wish wish to respond to the fiscal expansion or whatever but but but but that's a response that the FED decize is not a direct consequence to the fiscal policy it's not fiscal policy not bandle with with interventions in the financial Market contrary to that is monetary policy I tell you the FED decides to cut interest rate that's a movement of the LM has nothing to do with the is so anything that happens in the is is going to be a movement along the is not a shift of the is so that's that's what we saw here no when when the FED cut interest rate we end up with higher output but that was a result of a shift along the because monetary policy is not an policy it's an LM policy fiscal policy is an as policy that is something that shift the is and not the LM so that is very important to to understand again what moves what okay so let's look at at the anyway so let me pause here because if you understand sort of what I just said it's two third of your quiz so so make sure that you understand it okay I mean if you really understand it obviously we're not going to ask you exactly this but there small perturbations around what I just said okay so now we can use this stuff even more now we understand what the basic monetary policy does we understand what basic fiscal policy does to the economy H let's look at some scenarios this I'm calling all in what what what am I representing there in that diagram so I'm saying all that you see in that diagram is a result of policy decision macroeconomic policy decision exactly that's the reason I'm calling it all in you know that's a case in which both want to be very expansionary okay and so you see that the mon the expansionary monetary policy already sort of increase equilibrium output but then you add to it expansionary fiscal policy which moves theas to the right and you further increase output okay so you end up with a big increase in output as a result of this powerful policy package when do you think you may see situations like that sometimes you see it out of pure responsibility I mean yes people go to Argentina this happens all the time for the wrong reasons but but if if if if H in normal times normal environments when do you think that I should have said normal times in normal environments sort of with sound macroeconomic policy when do you think you would see something like this recessions you know and the biggest during recessions you you need to get the economy out of the of the whole and then you you'll probably you'll first try monetary policy because that's the most direct and quick I mean that's a decision that can be made overnight no but often when the rec is officially deep that's not enough and you need more and that's what you do with fiscal policy there other reasons there are differen between the two policies because we're not looking under the hood here but for example in Co it was very certain group of people were much more affected than others I mean people that work in restaurants those guys just lost their job there was nothing they could do so there was a reason to Target the transfers when you use rate is very Bland policy to everyone when when you use a fiscal policy you can also it's not only the amount you spend but you can also Target the expenditure in certain directions and and so there other reasons why you may want to use the two tools but the main one is the first ordered one is if you're in a deep recession you need everything to try to lift the economy out of that and so that's the kind of packages you see in big recessions now there's a there's a slide that I that I think I have pending from from two lectures ago and and this is a good opportunity to to bring it back remember when we look at equilibrium in financial markets we we came up with this H downward sloping demand money demand then we said well you lower the interest rate there's more more money demand and so on so forth and we said therefore the way the FED lowers interest rate or the Central Bank lowers the interest rate is by increasing money supply the point of this picture is that there's a limit to that and the limit is more or less when the interest rate reaches zero because when the interest rate reaches the nominal interest rate reaches zero then there's no cost in holding bonds remember the the in holding money sorry the only reason for you not to hold all your wealth in the form of money because you were giving up some opportunity cost of investing in bonds which were inconvenient Financial assets because you couldn't transact with them but they pay you higher interest that's the reason you want to go there but once you reach zero interest rate then you're indifferent and you might as well hold if the Central Bank goes out there and doesn't man open market operation you don't need to be compensated for that because you you're totally willing to hold your wealth in the form of money and so monetary policy is no longer effective when you when you reach the what is called the zero lower bound and that's what we call the liquidity TR okay it's called the liquidity trap let me not get into why but but essentially is is that is said you can inject more and more liquidity but you cannot move the interest rate so you lost a policy tool this was the tragedy of Japan for many decades okay they they they were stuck against the zero lower bound the liquidity trap and so they had to go through massive fiscal expansions because they didn't have they were in recession chronic recessions and they didn't have powerful monetary policy tool because they were against the zero lower B so why did I use this opportunity to bring this about because that's for the reason I just described the case of Japan but but I asked the question here what would you advise the government to do when I already told you the answer if if you have an economy is and a recession and and this means you use all the monetary policy that you had conventional mon monetary policy that you have now we have UNC conventional monetary but I'll tell you a little bit more about that later but once you run out of this and you're still in a recession what would you tell the government to do use fiscal policy that's the other tool you are so that's a typical situation you see when countries are the interest rate are already very low they tend to use much more actively fiscal policy because it's the only policy they have left and that has been the case of Japan again since the crash of their financial bubble in the late 80s early 90s so look at the covid-19 response something happened to my figure here but anyways this is zero essentially so this is covid okay the covid shock happened clearly the economy was imploding into recession the FED immediately reacted and cut interest very very aggressively to zero and then we were stack there this is effectively zero I mean they're Technic things why thing moves a little but but this is effectively zero so the US was during that period against really a a a liquidity against the zero lower bound there was no more power for the kind of monetary policy that we have describe here so let me so so that tells you that that there's going to have to be a lots of fiscal policy if you want to get out of that and I'll show you that later there was a lot of fiscal policy but but before getting there I'm going to show you something that you don't need to really know for the quiz But but so you can understand what is going on the newspapers a little better the FED that was not the only precisely because because the situation of Japan was so chronic people began to develop lots of tools alternative tools for central banks to use when you your interest rate this the main interest rate you use is stuck against zero against the zero lower bound and that's what you may have heard is called sometimes unconventional monetary policy QE quantitative easing all those kind of things they represent essentially policies that are like monetary policy but they're not exactly the way we have because they don't they're not interventions in very shortterm bonds there interventions in other assets out there in this course we have it very simple we have only one interest rate in reality there are multiple bonds they are risky bonds they are spread somebody asked about risky Bonds in a few lectures ago there are Express there lots of of interest rates floating around so in principle a central bank could intervene in those other rates as well in fact in Japan they have even intervened in the stock market that tells you how far they can go okay so you so in a richer environment with more financial Assets in principle the FED could go beyond the standard short-term bonds that they go for for their open market operation and that's exactly what they have been doing a way of thinking about that is remember when when we look at a Monet expansion conventional monetary policy we start with a balance sheet like that remember we said the the central bank has bonds and then money if he wants to have an expansion in monetary policy goes out there it buys more bonds and gives them the gives the banks money okay and that expands the balance sheet you end up with more the balance sheet of the Central Bank ends up with more bonds and also with more liabilities because it gave more money to people out Banks and so on so he owes more money so monetary policy naturally expansion and monetary policy naturally leads to an expansion of the balance sheet now for years outside of Japan nobody really cared too much about that because this effect relative to what you saw in the interet was very small I mean yeah the balance sheet was moving a little bit but it was mild no so here we hit the zero lower bound and essentially the FED went out and bought all sort of things first of all the when you hear QE quantitative easing that means mostly that the FED goes out there and buys not only shortterm US Treasury bonds but long-term BS okay because there something called the term spread typically interest rates in the long run are higher than than interest rate in the short right typically controlling for a bunch of things and that's called the term premium well they went and bought those kind of bones they also bought bought bones issued by frenan f what is Freddy ma no Freddy and Fanny H mortgage back Securities a bunch of stuff even loans in fact they created a facility to buy corporate bonds and at some point they created a facility to buy Fallen Angels Bond initially it was only investment great bonds all the companies that have the best possible rating but that wasn't enough so they went out there and and created a facility to buy Fallen angin B Fallen were essentially companies that were Prime companies before covid but you know but after covid they didn't look so good Airlines you know cruises and stuff like that hotels and so on so that was a massive expansion of the balance sheet so in terms of this this guy grew a lot okay but the purpose that's like monetary policy that's what we call unconvention it's different from the standard one but they were doing trying to operate very much like monetary policy operates here you see the balance sheet of the fed you see before the the the global financial crisis or the Great Recession of 2008 2009 ER the balance sheet wasn't an interesting thing to look at as the central bank because the idea they did the regular open market operations and you know for for anti-al policy but you would see small Wiggles in the size of the balance sheet relative to the size of the balance sheet in the global financial crisis they hit the zero lower Bound for the first time the US and so there you saw massive expansion of the bance this is the number of assets the same happen to liabilities they out side of it is they're injecting massive amount of money into the economy okay so there use a big expansion the recovery from the global fin was hard because the financial sector was very compromised so it took them a while they kept doing these kind of policies then they began to unwind the balance sheet and then Co came and that's what I was showing you before massive they send the interest rate to zero that wasn't enough and then they went out and bought lots of other Financial assets which work very much like monetary policy big thing and now they're unwinding the thing now we're we're in the opposite process we have inflation we want to get out of this situation they unwinding but you can see the size of that is huge huge I mean this is you know the balance sheet that a couple of decades ago had was was when the of the order $1 trillion which is more or less the money that is circulating around ER now it's $9 trillion massive theion and all central banks major central banks look like this I mean the ACB also looks like this the bank of Japan H looks like this but actually you don't see this blips that much because they began to do them here okay so they have been accumulating for a long time they have been using this kind of policy what about so coming back now to the course what about fiscal policy well I'm showing you different countries around the world massive fix fiscal expansion during the covid episode massive I mean this is you know the US the fiscal expansion if you combine all the packages so the order of 20% of GDP that's huge for fiscal you don't see things like this and this happen almost everywhere okay now you don't see things like that outside of Wars this was really like a war there's no doubt of that the kind amount of expansion in fiscal policy we saw was comparable to what you see in a war so there you have it big recession huge recession massive policy response both monetary of a conventional and unconventional kind and fiscal and again this was not unique to the US it happened essentially everywhere China is a little different for reasons I think I mentioned uh in the first lecture but I may talk more about that later good okay so another policy mix this is different so what do we have there that's another policy mix that we see fairly frequently so what is that LM going down that's expansion in monetary policy I going to the left that's contractionary fiscal policy okay so when do you think you would do such a thing or countries would engage and things like this again what if you want to like reduce like government spending you want to off a recession exactly that's that's exactly the the conditions when you want to do this it's called consolidation of the fiscal deficit sometimes you you you know you have a large fiscal deficit that's leading to accumulation of public debt that doesn't look so good so the the the government the central the treasur in the case of the US may may decide that he wants to reduce fiscal policy but he's afraid because and doing so is going to cause a recession and the purpose and there is no problem of output being overheating that it's just that the fiscal accounts look look they weak so if that's a situation that is if the economy is not going is not going through an overheating period perod and so on and you want to reduce the fiscal deficit in some places it will be explicit in some places implicit but you know the central because the central bank has a goal to keep prices stable and an output close to the potential output so even if there's no explicit coordination if the if the government announce a massive fiscal consolation package say reduce going expenditure by 10% the Central Bank knows that that's going to cause a recession and so the Central Bank naturally will respond by cutting interest rate to that because the recession is not needed if if the if the US announced today a a fiscal contraction of 5% I'm not sure the FED would do anything just stay there put okay because we have an economy is overheating but but so that's what you would do in a situation in which you want to fix the fiscal account and the economy is more or less at the at the normal time it's not it's not over here heating when would you do the opposite or when it's not when would you do the opposite is when are you likely to see the opposite so first of all what is the opposite the opposite is a combination of a fiscal expansion with a Monet contraction okay when do you think you would see such a thing either maybe when government has a budging maybe when rates are too high yeah okay that's true but but I'm not sure that's yeah but that requires a to concerted decision and so on H it's true yeah valid question it's not the one I wanted I wanted something more interesting but more exciting but but those are valid answers War you know War typically is all in no okay let me not I know it's a strange question but but I know where I'm heading a um suppose that the government decides to spend for whatever reason and the Central Bank says Whoa We don't need that expenditure now so you know we don't need this exp fiscal expansion now because we're on the margin of overheating and now I'm going to get this big fiscal expansion then the fed the central bank is likely to react to that and high interest rate that will will make very upset the government it always happens the government gets very upset guy say look I'm trying to span the economy and you're fighting me okay but that's the nature of the that's the reason central banks are meant to be independent so they can they can offset that and the reason I wanted to highlight the example is I think some of that and somebody asked that question I think in the previous lecture ER happened to the US economy one of the reasons we are in an overheating situation right now is because the US had a big fiscal expansion early in 2021 and that fiscal expansion was at the time in which there wasn't much spare capacity in the economy so we were very close to Full Employment the supply side was very constrained and so on and so there may have been good reasons for the fiscal package transfers to people that you need to transfer and so on but the macroeconomic consequence of that very naturally was going to lead to overheating and and the and the FED did not respond to that and I think that's one of the reasons people think sometimes that the fed well there's no doubt exposed that the Fed was behind the curve but one of the reasons they were behind the curve is that they there was this big fiscal expansion which naturally was going to span output and they did not react to it and eventually they reacted but it took them a long time and by then we had inflation and all that okay so that's a situation in which we should have seen a picture like the opposite of this but we didn't see the picture we didn't see the monetary part and that's the reason we end up ended up with an economy that is overheating okay yeah I mean it's always it's a very uncertain environment here yeah they thought this was going to be very transitory that that that there was enough inflationary Dynamics disinflationary dynamics that that would have settled that Expos is obviously it was a mistake but it's exposed I mean there was a lot of noise and so on then it cames the the Russian war that sort of increased the price of oil dramatically and that sort of created lots of bad Dynamic so they were unlucky that part is a part that I think that that again they thought we were going through a temporary situation they didn't think that it was going to be strong enough they thought the supply side was going to expand a lot faster than it did ER so they may have been right in not fighting it but over a horizon of three years and they found everything very compressing to three months and that led to to a problem uh so the last thing I want to show you is is is is um that this mod how this mod Works in practice if you if you I mean obviously you're not going to estimate exactly the model I show you if you have a real model we have Dynamics and many more things but the the the the more complete version of what I just show you the islm show you many people have estimated sort of you know how do for example I've estimated the response of of of the economy to monetary shocks or to fiscal expansion and so on and they trace out different Dynamics different variables and and you know and check whether that's consistent with the slm framework or not and the point of this figure is that it's is very consistent with that but let me show you a little bit all time so this is the effect on different variable of a surprise increase in the in the federal funds rate that's the monetary policy rate okay federal funds rate is the is the interest rate that the FED sets and what you see that in practice what what you see is um this is the impact on retail sales on sales out really more or less and yeah in practice the output doesn't respond immediately it takes a while it takes several quarters but eventually hits you and that's one of the big issues with monetary policy today that is that clearly inflation is not under control but they have done a lot and we know that that it takes time for the economy to really perceive the full impact of a monetary policy and so that's a tension now because lots of people pushing the FED to do more because we still have 6% inflation but they have done a lot and they know the monetary policy works with lags with long and variable lags is a famous sentence and so you know it takes about six quarters to really see the mess how much mess has been cost right now it will take a while so I have to see you see output well it's more like sales the same thing initially declines slowly but but it takes a while but it does have a very large effect this is employment same thing something this these diagrams you don't you don't well this unemployment naturally the other side of it is unemployment also will build up slowly so unemployment is very low now but we don't know when you the economy really feels the impact of all the monetary policy has been done in the last eight months or so where will unemployment end and the big problem for the FED today is something that you don't need to understand until the second part of the course is that prices do decline eventually but it takes a long time so to control inflation with monetary policy takes a while a long time let's see whether the economy consumers and so on have the patience to to hang in there okay e