WEBVTT 00:00:00.000 --> 00:00:01.952 align:middle line:90% [SQUEAKING] 00:00:01.952 --> 00:00:03.416 align:middle line:90% [RUSTLING] 00:00:03.416 --> 00:00:05.368 align:middle line:90% [CLICKING] 00:00:05.368 --> 00:00:16.620 align:middle line:90% 00:00:16.620 --> 00:00:19.560 align:middle line:84% RICARDO CABALLERO: But before I do 00:00:19.560 --> 00:00:23.370 align:middle line:84% that, before I get into the IS-LM model, 00:00:23.370 --> 00:00:27.510 align:middle line:84% let me spend a little time telling you what is going on 00:00:27.510 --> 00:00:32.520 align:middle line:84% in the US economy, as this will relate to the kind of things 00:00:32.520 --> 00:00:35.670 align:middle line:84% that we'll discuss later in this lecture. 00:00:35.670 --> 00:00:39.830 align:middle line:84% So what you see there is the path of net worth, so wealth, 00:00:39.830 --> 00:00:44.510 align:middle line:84% essentially, of households and nonprofit organizations, 00:00:44.510 --> 00:00:48.020 align:middle line:90% households primarily in the US. 00:00:48.020 --> 00:00:50.510 align:middle line:84% And what you can see is that there is a more or less steady 00:00:50.510 --> 00:00:51.010 align:middle line:90% trend. 00:00:51.010 --> 00:00:55.310 align:middle line:84% Obviously, in recessions, net wealth tends to decline. 00:00:55.310 --> 00:00:58.070 align:middle line:84% And certainly, early on in the COVID recession, 00:00:58.070 --> 00:01:01.280 align:middle line:84% it declined very dramatically, because the price of equity, 00:01:01.280 --> 00:01:05.090 align:middle line:84% the price of houses, everything declined with the initial shock. 00:01:05.090 --> 00:01:08.870 align:middle line:84% But what you see after that is a dramatic rise in wealth 00:01:08.870 --> 00:01:11.510 align:middle line:84% in the US, and all around the world, but particularly, 00:01:11.510 --> 00:01:13.270 align:middle line:90% in the US. 00:01:13.270 --> 00:01:15.300 align:middle line:84% And what is behind that, well, there 00:01:15.300 --> 00:01:16.800 align:middle line:84% are two things that are behind that, 00:01:16.800 --> 00:01:19.710 align:middle line:84% but the main one is asset prices. 00:01:19.710 --> 00:01:22.560 align:middle line:84% You have massive rallies in the equity market. 00:01:22.560 --> 00:01:24.950 align:middle line:84% The price of houses sort of skyrocketed 00:01:24.950 --> 00:01:27.470 align:middle line:90% everywhere, and so on. 00:01:27.470 --> 00:01:31.190 align:middle line:84% Last year, 2022, was a bad year for asset values. 00:01:31.190 --> 00:01:33.980 align:middle line:84% The equity market declined pretty sharply in the US. 00:01:33.980 --> 00:01:36.450 align:middle line:84% But still, I mean, it's a small decline 00:01:36.450 --> 00:01:39.690 align:middle line:84% relative to the big buildup of wealth. 00:01:39.690 --> 00:01:43.750 align:middle line:84% Now, why do you think that, in this course, 00:01:43.750 --> 00:01:47.860 align:middle line:84% I would be talking about this at this point? 00:01:47.860 --> 00:01:49.240 align:middle line:90% What happens? 00:01:49.240 --> 00:01:51.800 align:middle line:84% Remember, in this part of the course, 00:01:51.800 --> 00:01:54.490 align:middle line:84% we're trying to come up with a model of aggregate demand, 00:01:54.490 --> 00:01:57.130 align:middle line:84% and then, how aggregate demand reacts to policy. 00:01:57.130 --> 00:01:59.570 align:middle line:84% That's the name of the game in this part of the course. 00:01:59.570 --> 00:02:02.560 align:middle line:84% So if I tell you that wealth increases a lot, 00:02:02.560 --> 00:02:04.480 align:middle line:84% why do you think I'm telling you that? 00:02:04.480 --> 00:02:09.229 align:middle line:90% 00:02:09.229 --> 00:02:10.100 align:middle line:90% Aggregate demand. 00:02:10.100 --> 00:02:10.998 align:middle line:90% Consumers will reach. 00:02:10.998 --> 00:02:12.290 align:middle line:90% They will tend to consume more. 00:02:12.290 --> 00:02:13.790 align:middle line:84% That will increase aggregate demand. 00:02:13.790 --> 00:02:16.220 align:middle line:84% So the point I'm highlighting to here 00:02:16.220 --> 00:02:19.340 align:middle line:84% is that there is a big force behind increasing 00:02:19.340 --> 00:02:22.370 align:middle line:84% aggregate demand, which is consumers feel richer. 00:02:22.370 --> 00:02:25.220 align:middle line:84% By the way, something similar is happening in corporations, 00:02:25.220 --> 00:02:27.470 align:middle line:84% and investment is also pretty high 00:02:27.470 --> 00:02:30.150 align:middle line:84% because of that, real investment. 00:02:30.150 --> 00:02:33.890 align:middle line:84% The other source of increasing wealth, 00:02:33.890 --> 00:02:36.410 align:middle line:84% which is not as dramatic as the previous one, 00:02:36.410 --> 00:02:39.380 align:middle line:84% but it's very important, especially in lower income 00:02:39.380 --> 00:02:42.560 align:middle line:84% segments of the population which tend to have a higher propensity 00:02:42.560 --> 00:02:52.130 align:middle line:84% to consume is that incomes did not decline a lot during COVID. 00:02:52.130 --> 00:02:54.350 align:middle line:84% And in some cases, they even increased 00:02:54.350 --> 00:02:57.140 align:middle line:84% because of the large transfers that we saw from the government 00:02:57.140 --> 00:03:00.110 align:middle line:84% to individual households, especially lower income 00:03:00.110 --> 00:03:00.950 align:middle line:90% households. 00:03:00.950 --> 00:03:04.970 align:middle line:84% And at the same time, there wasn't much to spend on. 00:03:04.970 --> 00:03:07.790 align:middle line:84% So that meant that the saving rate also 00:03:07.790 --> 00:03:11.660 align:middle line:84% went up a lot in the US during the COVID recession. 00:03:11.660 --> 00:03:12.920 align:middle line:90% So people save a lot more. 00:03:12.920 --> 00:03:16.630 align:middle line:84% That's sort of the average saving, household savings. 00:03:16.630 --> 00:03:18.830 align:middle line:90% This is by quarter, I think. 00:03:18.830 --> 00:03:19.670 align:middle line:90% No, monthly. 00:03:19.670 --> 00:03:22.070 align:middle line:84% But that's what we saw in the past. 00:03:22.070 --> 00:03:23.690 align:middle line:84% Look at during the COVID recession. 00:03:23.690 --> 00:03:26.592 align:middle line:90% People save a lot more. 00:03:26.592 --> 00:03:29.300 align:middle line:84% And what you're seeing today is, obviously, they save a lot more. 00:03:29.300 --> 00:03:33.350 align:middle line:84% That's part of the increase in net worth is due to this. 00:03:33.350 --> 00:03:35.060 align:middle line:84% It's small relative to the amount 00:03:35.060 --> 00:03:36.650 align:middle line:90% of wealth we saw increase. 00:03:36.650 --> 00:03:41.900 align:middle line:84% But this was about-- this excess saving amounted to about $2.7, 00:03:41.900 --> 00:03:43.325 align:middle line:90% $2.8 trillion. 00:03:43.325 --> 00:03:45.200 align:middle line:84% So you get a sense of the order of magnitude. 00:03:45.200 --> 00:03:49.010 align:middle line:84% And what is happening now is what people are desaving so now 00:03:49.010 --> 00:03:52.100 align:middle line:84% people are saving less than they used to 00:03:52.100 --> 00:03:53.720 align:middle line:84% because now, they have opportunity 00:03:53.720 --> 00:03:55.730 align:middle line:90% to spend the stuff on. 00:03:55.730 --> 00:03:58.370 align:middle line:84% And so that's where you see massive demand for travel, 00:03:58.370 --> 00:04:01.620 align:middle line:84% massive demand for restaurants, hotels, and stuff like that. 00:04:01.620 --> 00:04:04.980 align:middle line:84% Well, that has a lot to do with people have the money to do it. 00:04:04.980 --> 00:04:06.890 align:middle line:84% They haven't been able to do it for a while. 00:04:06.890 --> 00:04:08.990 align:middle line:84% So now, they're doing a lot of that. 00:04:08.990 --> 00:04:13.055 align:middle line:84% Why would I be telling you this now in the course, 00:04:13.055 --> 00:04:14.180 align:middle line:90% in this part of the course? 00:04:14.180 --> 00:04:16.940 align:middle line:84% For the same reason I told you that net worth went a lot. 00:04:16.940 --> 00:04:20.060 align:middle line:84% I mean, people had the savings, and they're really 00:04:20.060 --> 00:04:20.899 align:middle line:90% willing to spend it. 00:04:20.899 --> 00:04:26.020 align:middle line:84% That puts lots of upward pressure on aggregate demand. 00:04:26.020 --> 00:04:28.540 align:middle line:84% These pictures capture more or less the same. 00:04:28.540 --> 00:04:31.400 align:middle line:84% This captures very much what I said in the previous slide. 00:04:31.400 --> 00:04:33.170 align:middle line:84% You see the personal saving rate. 00:04:33.170 --> 00:04:35.260 align:middle line:90% That's the average. 00:04:35.260 --> 00:04:37.464 align:middle line:90% I don't remember, over-- 00:04:37.464 --> 00:04:39.680 align:middle line:90% oh, seven-year average. 00:04:39.680 --> 00:04:41.500 align:middle line:84% And you see what happened during COVID. 00:04:41.500 --> 00:04:46.510 align:middle line:84% Big spike in the savings rate, and now, big decline 00:04:46.510 --> 00:04:48.880 align:middle line:84% in the saving rate, where saving rate is much 00:04:48.880 --> 00:04:50.590 align:middle line:90% lower than what normally is. 00:04:50.590 --> 00:04:54.430 align:middle line:84% And remember, the saving rate is your income 00:04:54.430 --> 00:04:55.460 align:middle line:90% minus your consumption. 00:04:55.460 --> 00:04:57.210 align:middle line:84% So if you're saving less, you're consuming 00:04:57.210 --> 00:04:58.780 align:middle line:90% more relative to your income. 00:04:58.780 --> 00:05:01.750 align:middle line:90% That's the way it works. 00:05:01.750 --> 00:05:03.820 align:middle line:84% Obviously, there is lots of heterogeneity. 00:05:03.820 --> 00:05:05.680 align:middle line:84% Some people made a lot of money, some people 00:05:05.680 --> 00:05:08.230 align:middle line:84% didn't make a lot of money during COVID. 00:05:08.230 --> 00:05:10.480 align:middle line:84% Some people save a lot, some people didn't save a lot. 00:05:10.480 --> 00:05:18.070 align:middle line:84% And in fact, we do know that on the lower income segments, 00:05:18.070 --> 00:05:20.500 align:middle line:84% a lot of the excess saving is already gone. 00:05:20.500 --> 00:05:23.770 align:middle line:84% I mean, it accumulated early on, but they spent it also 00:05:23.770 --> 00:05:26.413 align:middle line:90% much earlier. 00:05:26.413 --> 00:05:28.830 align:middle line:84% But what you're beginning to see in some of those segments 00:05:28.830 --> 00:05:30.990 align:middle line:84% is even though they don't have access savings, 00:05:30.990 --> 00:05:33.320 align:middle line:90% they're borrowing a lot. 00:05:33.320 --> 00:05:35.510 align:middle line:84% So now, you see credit card borrowing, 00:05:35.510 --> 00:05:39.680 align:middle line:84% which had declined a lot, and now, has increased quite a bit. 00:05:39.680 --> 00:05:41.830 align:middle line:84% And again, what do you borrow for? 00:05:41.830 --> 00:05:42.890 align:middle line:90% Well, for consumption. 00:05:42.890 --> 00:05:46.610 align:middle line:84% So that also funds additional consumption. 00:05:46.610 --> 00:05:49.930 align:middle line:84% So for all these reasons, at this moment, 00:05:49.930 --> 00:05:53.270 align:middle line:84% the US economy, and many economies around the world, 00:05:53.270 --> 00:05:55.480 align:middle line:90% are what we call overheating. 00:05:55.480 --> 00:05:57.790 align:middle line:84% There's a lot of demand for the production, 00:05:57.790 --> 00:05:59.800 align:middle line:90% that capacity of the economy. 00:05:59.800 --> 00:06:01.813 align:middle line:84% And that translates-- the problem, 00:06:01.813 --> 00:06:03.230 align:middle line:84% say, well, what's wrong with that? 00:06:03.230 --> 00:06:05.350 align:middle line:84% Well, the problem is, something you don't understand 00:06:05.350 --> 00:06:07.100 align:middle line:84% at this part of the course, you understand 00:06:07.100 --> 00:06:09.010 align:middle line:84% but you don't have a model for, but you 00:06:09.010 --> 00:06:13.380 align:middle line:84% will have six lectures, more or less, from now is 00:06:13.380 --> 00:06:16.000 align:middle line:90% that leads to high inflation. 00:06:16.000 --> 00:06:18.400 align:middle line:84% You don't know that, but intuition tells you 00:06:18.400 --> 00:06:20.590 align:middle line:84% that it's a lot of demand relative to supply. 00:06:20.590 --> 00:06:22.300 align:middle line:90% Well, prices tend to go up. 00:06:22.300 --> 00:06:26.380 align:middle line:84% That happens in micro, and it also happens in macro. 00:06:26.380 --> 00:06:27.650 align:middle line:90% We'll learn that later. 00:06:27.650 --> 00:06:30.100 align:middle line:84% But in any event, as a result of this, 00:06:30.100 --> 00:06:34.990 align:middle line:84% the US economy is overheating, and therefore, monetary policy 00:06:34.990 --> 00:06:36.850 align:middle line:90% has been very contractionary. 00:06:36.850 --> 00:06:39.880 align:middle line:84% The Fed has been tightening interest rate 00:06:39.880 --> 00:06:41.990 align:middle line:90% to cool down the economy. 00:06:41.990 --> 00:06:44.290 align:middle line:90% So how does that happen? 00:06:44.290 --> 00:06:46.110 align:middle line:84% Well, that's the kind of things that we can 00:06:46.110 --> 00:06:48.700 align:middle line:90% answer with the IS-LM model. 00:06:48.700 --> 00:06:52.260 align:middle line:90% So the Fed is very IS-LM like. 00:06:52.260 --> 00:06:54.330 align:middle line:84% I mean, that's the way they think. 00:06:54.330 --> 00:06:55.500 align:middle line:90% The model is richer. 00:06:55.500 --> 00:06:57.250 align:middle line:84% They have more equations, and so on. 00:06:57.250 --> 00:06:59.610 align:middle line:84% But they are thinking in terms of the mechanism 00:06:59.610 --> 00:07:03.750 align:middle line:84% that we're about to summarize in the IS-LM model. 00:07:03.750 --> 00:07:07.350 align:middle line:84% So if you have an economy that has this problem, 00:07:07.350 --> 00:07:11.350 align:middle line:84% and you are in the central bank, you need to use monetary policy. 00:07:11.350 --> 00:07:13.530 align:middle line:84% Well, to understand how the thing works, 00:07:13.530 --> 00:07:15.360 align:middle line:90% you need the IS-LM model. 00:07:15.360 --> 00:07:16.930 align:middle line:90% That's a starting point. 00:07:16.930 --> 00:07:18.480 align:middle line:84% Then you can add bells and whistles. 00:07:18.480 --> 00:07:22.270 align:middle line:84% But your starting point is the model we're about to see. 00:07:22.270 --> 00:07:24.670 align:middle line:84% Anyway, so what you see is what I was saying, 00:07:24.670 --> 00:07:26.920 align:middle line:84% is that all that wealth, all that excess saving, 00:07:26.920 --> 00:07:31.900 align:middle line:84% all that pent up demand, if you will, led to lots of-- 00:07:31.900 --> 00:07:32.900 align:middle line:90% led to a very-- 00:07:32.900 --> 00:07:34.150 align:middle line:90% an economy that's overheating. 00:07:34.150 --> 00:07:35.890 align:middle line:84% And you can see here what happened. 00:07:35.890 --> 00:07:40.090 align:middle line:84% I disentangled between consumption of goods 00:07:40.090 --> 00:07:42.250 align:middle line:90% and consumption of services. 00:07:42.250 --> 00:07:44.438 align:middle line:84% Consumption of service is about 2/3 of consumption. 00:07:44.438 --> 00:07:45.730 align:middle line:90% Remember, we talked about that. 00:07:45.730 --> 00:07:47.830 align:middle line:90% And goods is about 1/3. 00:07:47.830 --> 00:07:51.490 align:middle line:84% What happens is the scales are different. 00:07:51.490 --> 00:07:53.080 align:middle line:90% This is for goods. 00:07:53.080 --> 00:07:55.750 align:middle line:90% That's for services. 00:07:55.750 --> 00:07:59.720 align:middle line:84% But what you see here is that was a trend. 00:07:59.720 --> 00:08:02.920 align:middle line:84% So consumption in services was growing at a steady pace, 00:08:02.920 --> 00:08:05.568 align:middle line:90% then COVID came and collapsed. 00:08:05.568 --> 00:08:08.110 align:middle line:84% I mean, you couldn't go to a restaurant, you couldn't travel, 00:08:08.110 --> 00:08:08.985 align:middle line:90% couldn't do anything. 00:08:08.985 --> 00:08:11.710 align:middle line:84% So consumption in services collapsed. 00:08:11.710 --> 00:08:13.180 align:middle line:90% And now, it has been recovering. 00:08:13.180 --> 00:08:17.350 align:middle line:84% And that recovery picked up pace last year, actually, 00:08:17.350 --> 00:08:20.500 align:middle line:84% in 2021, already picked up pace, and by now, we're 00:08:20.500 --> 00:08:22.130 align:middle line:90% above the trend. 00:08:22.130 --> 00:08:25.880 align:middle line:84% So service consumption that collapsed during COVID now 00:08:25.880 --> 00:08:27.910 align:middle line:90% has fully recovered. 00:08:27.910 --> 00:08:29.560 align:middle line:84% While, at the same time, the capacity 00:08:29.560 --> 00:08:31.977 align:middle line:84% to produce in the service sector hasn't recovered equally. 00:08:31.977 --> 00:08:35.530 align:middle line:84% But we'll get to that after quiz 1. 00:08:35.530 --> 00:08:37.220 align:middle line:84% What happens to goods consumption? 00:08:37.220 --> 00:08:37.720 align:middle line:90% Well. 00:08:37.720 --> 00:08:40.990 align:middle line:84% Also initially collapsed, but then, well, people 00:08:40.990 --> 00:08:41.799 align:middle line:90% were bored at home. 00:08:41.799 --> 00:08:42.882 align:middle line:90% They couldn't do anything. 00:08:42.882 --> 00:08:45.230 align:middle line:84% They bought lots of gadgets and stuff like that. 00:08:45.230 --> 00:08:48.490 align:middle line:84% So goods consumption went up very sharply during COVID, 00:08:48.490 --> 00:08:50.350 align:middle line:90% way above the trend, you see? 00:08:50.350 --> 00:08:52.840 align:middle line:84% There is COVID collapse, and then, people 00:08:52.840 --> 00:08:56.680 align:middle line:84% began to buy all sorts of gadgets. 00:08:56.680 --> 00:08:58.090 align:middle line:90% Now, it's slowing down. 00:08:58.090 --> 00:09:01.150 align:middle line:84% But still, if you look relative to trend, consumption of goods 00:09:01.150 --> 00:09:02.830 align:middle line:84% is way above what it would have been 00:09:02.830 --> 00:09:04.460 align:middle line:90% in the absence of this episode. 00:09:04.460 --> 00:09:06.490 align:middle line:84% So the sum of the two things tells you 00:09:06.490 --> 00:09:10.150 align:middle line:84% that you have an economy with a lot of consumption. 00:09:10.150 --> 00:09:13.990 align:middle line:84% And that, at this moment, the Fed wants to cool down. 00:09:13.990 --> 00:09:16.220 align:middle line:84% It's too much for the economy to take. 00:09:16.220 --> 00:09:18.070 align:middle line:84% So the Fed wants to cool it down. 00:09:18.070 --> 00:09:22.440 align:middle line:84% And we're going to see how you do that. 00:09:22.440 --> 00:09:26.250 align:middle line:84% OK, so now, let's get into this set of lectures. 00:09:26.250 --> 00:09:29.250 align:middle line:84% And please, stop me if there's anything that is unclear, 00:09:29.250 --> 00:09:31.675 align:middle line:84% because as I said, this is probably-- if I hear over 00:09:31.675 --> 00:09:34.050 align:middle line:84% the summer you have forgotten everything you have learned 00:09:34.050 --> 00:09:36.780 align:middle line:84% in this course, but you remember these two lectures well, 00:09:36.780 --> 00:09:37.395 align:middle line:90% I'll be happy. 00:09:37.395 --> 00:09:40.270 align:middle line:90% 00:09:40.270 --> 00:09:42.440 align:middle line:90% So stop me if you do. 00:09:42.440 --> 00:09:46.630 align:middle line:84% In fact, normally, I have taught this lecture in one. 00:09:46.630 --> 00:09:48.942 align:middle line:84% I decided to try to slow it down as much as I can 00:09:48.942 --> 00:09:50.650 align:middle line:84% because, again, I think it's particularly 00:09:50.650 --> 00:09:56.280 align:middle line:84% important for this course, and for your stock of knowledge. 00:09:56.280 --> 00:09:58.110 align:middle line:84% So one of the main things we're going 00:09:58.110 --> 00:10:00.360 align:middle line:84% to be able to do with this model, as I've been saying, 00:10:00.360 --> 00:10:02.010 align:middle line:84% is we're going to be able to discuss 00:10:02.010 --> 00:10:04.050 align:middle line:84% the main macroeconomic policy tools, which 00:10:04.050 --> 00:10:05.320 align:middle line:90% are monetary policy-- 00:10:05.320 --> 00:10:09.000 align:middle line:84% monetary policy is main anti-cyclical tool, 00:10:09.000 --> 00:10:11.610 align:middle line:84% but we're also going to be able to understand fiscal policy. 00:10:11.610 --> 00:10:15.870 align:middle line:84% And fiscal policy is not exactly equivalent to monetary policy. 00:10:15.870 --> 00:10:17.340 align:middle line:84% It works through the mechanism that 00:10:17.340 --> 00:10:19.298 align:middle line:84% allows you to do things that are more targeted, 00:10:19.298 --> 00:10:23.410 align:middle line:84% transfer resources to a specific group of people, and so on. 00:10:23.410 --> 00:10:26.260 align:middle line:84% And sometimes monetary policy is just not enough. 00:10:26.260 --> 00:10:28.500 align:middle line:84% And the COVID-19 initial recession 00:10:28.500 --> 00:10:32.040 align:middle line:84% was clearly a case of that, and you had to go all in, 00:10:32.040 --> 00:10:34.980 align:middle line:90% and we'll see what we did there. 00:10:34.980 --> 00:10:38.070 align:middle line:84% It was pretty dramatic as an intervention. 00:10:38.070 --> 00:10:41.400 align:middle line:84% The COVID-19 recession led probably to what-- no, 00:10:41.400 --> 00:10:42.540 align:middle line:90% not probably. 00:10:42.540 --> 00:10:46.320 align:middle line:84% Surely to the largest combined package in history of policy 00:10:46.320 --> 00:10:51.435 align:middle line:84% support in terms of monetary policy and fiscal policy. 00:10:51.435 --> 00:10:59.108 align:middle line:90% 00:10:59.108 --> 00:11:00.650 align:middle line:84% After these two lectures you're going 00:11:00.650 --> 00:11:04.220 align:middle line:84% to get to understand essentially the joint determination 00:11:04.220 --> 00:11:08.030 align:middle line:84% of output and interest rate, and we're going to be able to study, 00:11:08.030 --> 00:11:11.960 align:middle line:84% as I said before, the impact of monetary and fiscal policy. 00:11:11.960 --> 00:11:13.880 align:middle line:84% And this framework that we're going 00:11:13.880 --> 00:11:16.760 align:middle line:84% to use to develop, to study this is 00:11:16.760 --> 00:11:24.830 align:middle line:84% what Hicks and Hansen initially called the IS-LM model. 00:11:24.830 --> 00:11:27.780 align:middle line:84% I already hinted that this was coming, 00:11:27.780 --> 00:11:29.420 align:middle line:90% but why do you think the name? 00:11:29.420 --> 00:11:36.980 align:middle line:90% 00:11:36.980 --> 00:11:42.267 align:middle line:84% I notice that you separate IS from LM. 00:11:42.267 --> 00:11:43.850 align:middle line:84% Remember what we're trying to do here. 00:11:43.850 --> 00:11:46.780 align:middle line:84% We're trying to look at the joint determination of output 00:11:46.780 --> 00:11:47.530 align:middle line:90% and interest rate. 00:11:47.530 --> 00:11:48.990 align:middle line:84% That is, we're trying to determine 00:11:48.990 --> 00:11:51.490 align:middle line:84% at the joint equilibrium of goods 00:11:51.490 --> 00:11:53.875 align:middle line:90% markets and financial markets. 00:11:53.875 --> 00:11:57.110 align:middle line:90% 00:11:57.110 --> 00:11:59.592 align:middle line:84% When we describe the equilibrium in the goods market, 00:11:59.592 --> 00:12:01.800 align:middle line:84% we said there is an alternative way of describing it. 00:12:01.800 --> 00:12:06.080 align:middle line:84% Remember, I said as an investment equal to savings-- 00:12:06.080 --> 00:12:10.423 align:middle line:84% I equal to S. So the IS part of the name 00:12:10.423 --> 00:12:13.090 align:middle line:84% comes from the part that has to do with equilibrium in the goods 00:12:13.090 --> 00:12:13.750 align:middle line:90% market. 00:12:13.750 --> 00:12:16.630 align:middle line:84% IS-- investment equal to savings. 00:12:16.630 --> 00:12:19.420 align:middle line:84% And the LM part has to do-- remember, 00:12:19.420 --> 00:12:22.780 align:middle line:84% L was that component of aggregate demand 00:12:22.780 --> 00:12:24.730 align:middle line:90% we had in the financial markets. 00:12:24.730 --> 00:12:27.730 align:middle line:84% We look at equilibrium as aggregate demand-- sorry, 00:12:27.730 --> 00:12:30.340 align:middle line:84% demand for money equal to supply of money. 00:12:30.340 --> 00:12:35.170 align:middle line:84% Supply of money was M. Demand for money was y times L of I, 00:12:35.170 --> 00:12:37.660 align:middle line:90% and therefore the LM part. 00:12:37.660 --> 00:12:38.410 align:middle line:90% That's the reason. 00:12:38.410 --> 00:12:42.280 align:middle line:84% That's a mnemonic for why this model is called the IS-LM. 00:12:42.280 --> 00:12:44.730 align:middle line:84% IS stands for the part that has to do with the equilibrium 00:12:44.730 --> 00:12:45.760 align:middle line:90% in the goods market. 00:12:45.760 --> 00:12:47.510 align:middle line:84% LM has to do with the part that has 00:12:47.510 --> 00:12:49.510 align:middle line:84% to do with the equilibrium in financial markets. 00:12:49.510 --> 00:12:53.290 align:middle line:84% This model is a model that combines those two equilibrium. 00:12:53.290 --> 00:12:58.330 align:middle line:84% So we're going to be interested in points in which both markets 00:12:58.330 --> 00:13:00.420 align:middle line:90% are in equilibrium. 00:13:00.420 --> 00:13:04.110 align:middle line:84% That's the name of the game here. 00:13:04.110 --> 00:13:07.220 align:middle line:84% So let's first develop the IS relation. 00:13:07.220 --> 00:13:11.870 align:middle line:84% And the IS relation is really going back to lecture three. 00:13:11.870 --> 00:13:13.910 align:middle line:84% We're going to go back to lecture three, 00:13:13.910 --> 00:13:19.980 align:middle line:84% use the same model we used in lecture three with one change. 00:13:19.980 --> 00:13:21.240 align:middle line:90% And that change is-- 00:13:21.240 --> 00:13:24.630 align:middle line:84% remember in lecture three, we worked a lot on our consumption. 00:13:24.630 --> 00:13:26.970 align:middle line:84% The only endogenous-- the only function 00:13:26.970 --> 00:13:29.670 align:middle line:84% we had was a consumption function, remember? 00:13:29.670 --> 00:13:32.220 align:middle line:84% And then all the rest we took as given-- government 00:13:32.220 --> 00:13:34.260 align:middle line:84% expenditure was given, investment was given. 00:13:34.260 --> 00:13:35.815 align:middle line:90% All that was given. 00:13:35.815 --> 00:13:37.440 align:middle line:84% We're going to relax one of those here, 00:13:37.440 --> 00:13:41.100 align:middle line:84% and we're going to flesh out a little more this investment 00:13:41.100 --> 00:13:46.860 align:middle line:84% here, make it closer to what a realistic function is. 00:13:46.860 --> 00:13:48.030 align:middle line:90% Not a constant, obviously. 00:13:48.030 --> 00:13:51.250 align:middle line:84% It's not totally exogenous to equilibrium output and so on. 00:13:51.250 --> 00:13:54.480 align:middle line:84% In fact, we do know that real investment, 00:13:54.480 --> 00:13:57.450 align:middle line:84% this physical investment-- remember, what is this I? 00:13:57.450 --> 00:13:58.560 align:middle line:90% It's investment. 00:13:58.560 --> 00:14:00.243 align:middle line:84% This is purchase of goods and services 00:14:00.243 --> 00:14:02.160 align:middle line:84% by firms for the purpose of building capital-- 00:14:02.160 --> 00:14:04.410 align:middle line:84% equipment, structures, and stuff like that. 00:14:04.410 --> 00:14:06.690 align:middle line:84% I saw in Piazza-- very quickly, I'm not into that, 00:14:06.690 --> 00:14:09.750 align:middle line:84% but I see more or less the flow-- 00:14:09.750 --> 00:14:12.240 align:middle line:84% that somebody asked, "should bonds be included 00:14:12.240 --> 00:14:14.370 align:middle line:90% in investment?" 00:14:14.370 --> 00:14:16.870 align:middle line:90% What is the answer? 00:14:16.870 --> 00:14:18.460 align:middle line:90% In that investment. 00:14:18.460 --> 00:14:25.420 align:middle line:90% I. 00:14:25.420 --> 00:14:29.080 align:middle line:84% Should purchase of bonds be included in that investment? 00:14:29.080 --> 00:14:33.340 align:middle line:90% 00:14:33.340 --> 00:14:34.480 align:middle line:90% No. 00:14:34.480 --> 00:14:38.530 align:middle line:84% This is purchase of goods and services by firms, no? 00:14:38.530 --> 00:14:40.255 align:middle line:84% Capital, machines, stuff like that. 00:14:40.255 --> 00:14:42.130 align:middle line:84% The other thing, it's a financial investment. 00:14:42.130 --> 00:14:43.630 align:middle line:84% It's nothing to do with the goods market. 00:14:43.630 --> 00:14:45.963 align:middle line:84% It's something that has to do with the financial market, 00:14:45.963 --> 00:14:48.647 align:middle line:84% not with the goods market equilibrium. 00:14:48.647 --> 00:14:50.230 align:middle line:84% So that investment is real investment. 00:14:50.230 --> 00:14:53.200 align:middle line:84% Again, purchase of capital, buildings 00:14:53.200 --> 00:14:58.060 align:middle line:84% for the purpose of production and stuff like that. 00:14:58.060 --> 00:15:03.340 align:middle line:84% And this investment is a function of two things at least. 00:15:03.340 --> 00:15:05.200 align:middle line:90% The first one is activity. 00:15:05.200 --> 00:15:08.020 align:middle line:84% When output is high, sales are high, 00:15:08.020 --> 00:15:09.880 align:middle line:90% companies tend to invest more. 00:15:09.880 --> 00:15:14.200 align:middle line:84% They buy more equipment, they buy more buildings, they expand. 00:15:14.200 --> 00:15:18.460 align:middle line:84% So investment is an increasing function of output very much 00:15:18.460 --> 00:15:21.250 align:middle line:84% like consumption, remember, was an increasing function of output 00:15:21.250 --> 00:15:23.540 align:middle line:84% because income is increasing in output 00:15:23.540 --> 00:15:26.480 align:middle line:84% So it was an increasing function of output. 00:15:26.480 --> 00:15:29.680 align:middle line:84% So these, we already had seen functions that looked like that, 00:15:29.680 --> 00:15:32.210 align:middle line:84% and we already know what it does to aggregate demand. 00:15:32.210 --> 00:15:35.360 align:middle line:84% It makes that curve steeper, remember? 00:15:35.360 --> 00:15:37.580 align:middle line:84% And it's the multiplier behind that. 00:15:37.580 --> 00:15:39.770 align:middle line:84% Investment gives you something similar there. 00:15:39.770 --> 00:15:41.690 align:middle line:84% But there is a second component which 00:15:41.690 --> 00:15:43.430 align:middle line:84% is also present in consumption but is not 00:15:43.430 --> 00:15:47.970 align:middle line:84% as important as for investment, which is the interest rate. 00:15:47.970 --> 00:15:50.100 align:middle line:84% In particular, when the interest rate goes up 00:15:50.100 --> 00:15:53.910 align:middle line:84% for any given level of income or output, 00:15:53.910 --> 00:15:55.500 align:middle line:90% then investment goes down. 00:15:55.500 --> 00:15:56.875 align:middle line:84% Why do you think that's the case? 00:15:56.875 --> 00:16:01.026 align:middle line:90% 00:16:01.026 --> 00:16:01.990 align:middle line:90% AUDIENCE: [INAUDIBLE]. 00:16:01.990 --> 00:16:02.948 align:middle line:90% RICARDO CABALLERO: Yes. 00:16:02.948 --> 00:16:05.200 align:middle line:84% Most of investment is funded with borrowing, 00:16:05.200 --> 00:16:08.770 align:middle line:84% and borrowing becomes more expensive so you don't do it. 00:16:08.770 --> 00:16:10.850 align:middle line:84% Even if you don't need to borrow, 00:16:10.850 --> 00:16:12.910 align:middle line:84% there's an opportunity cost of those funds. 00:16:12.910 --> 00:16:15.280 align:middle line:84% You can use it to build machines to produce 00:16:15.280 --> 00:16:17.560 align:middle line:84% or you can do something else like have an investment, 00:16:17.560 --> 00:16:18.860 align:middle line:90% financial investment. 00:16:18.860 --> 00:16:23.200 align:middle line:84% So whether you borrow or not, if still the interest rate 00:16:23.200 --> 00:16:30.580 align:middle line:84% is higher, the opportunity costs of building factories is higher. 00:16:30.580 --> 00:16:33.070 align:middle line:84% And so that's the reason investment 00:16:33.070 --> 00:16:36.630 align:middle line:84% is decreasing with respect to the interest rate. 00:16:36.630 --> 00:16:39.465 align:middle line:84% So now we go back to our equilibrium 00:16:39.465 --> 00:16:41.840 align:middle line:84% in the goods market, which we said production is whatever 00:16:41.840 --> 00:16:42.860 align:middle line:90% aggregate demand wants. 00:16:42.860 --> 00:16:45.920 align:middle line:84% So output is going to be equal to aggregate demand. 00:16:45.920 --> 00:16:49.760 align:middle line:84% Aggregate demand is the same old aggregate demand we had, 00:16:49.760 --> 00:16:52.760 align:middle line:84% except that now we flesh out what is inside that investment 00:16:52.760 --> 00:16:56.510 align:middle line:84% function there, which we have another function is increasing 00:16:56.510 --> 00:17:00.020 align:middle line:84% output like consumption was, but we also 00:17:00.020 --> 00:17:02.370 align:middle line:84% have something that is decreasing in the interest rate. 00:17:02.370 --> 00:17:05.569 align:middle line:84% And so this is what we call the IS relation. 00:17:05.569 --> 00:17:10.280 align:middle line:84% And so the IS relation therefore has all the combinations 00:17:10.280 --> 00:17:13.910 align:middle line:84% of output and interest rate that are consistent with equilibrium 00:17:13.910 --> 00:17:17.400 align:middle line:90% in the goods market. 00:17:17.400 --> 00:17:18.690 align:middle line:90% Listen to what I said. 00:17:18.690 --> 00:17:25.920 align:middle line:84% I said the IS relation or IS curve has all the combinations 00:17:25.920 --> 00:17:30.000 align:middle line:84% of output and interest rate that are consistent with equilibrium 00:17:30.000 --> 00:17:32.690 align:middle line:90% in the goods market. 00:17:32.690 --> 00:17:33.760 align:middle line:90% What about lecture three? 00:17:33.760 --> 00:17:37.570 align:middle line:90% 00:17:37.570 --> 00:17:41.800 align:middle line:84% We already had that, but interest rate played no role, 00:17:41.800 --> 00:17:43.900 align:middle line:90% so we found one point. 00:17:43.900 --> 00:17:45.400 align:middle line:84% We said there is one level of output 00:17:45.400 --> 00:17:47.775 align:middle line:84% which is consistent with equilibrium in the goods market. 00:17:47.775 --> 00:17:49.000 align:middle line:90% That's what we found. 00:17:49.000 --> 00:17:50.800 align:middle line:84% Now since we have an interest rate there, 00:17:50.800 --> 00:17:53.030 align:middle line:84% we have two variables for one curve, 00:17:53.030 --> 00:17:55.315 align:middle line:84% so we can trace a curve, which is not only one point. 00:17:55.315 --> 00:17:58.990 align:middle line:90% 00:17:58.990 --> 00:17:59.865 align:middle line:90% We can trace a curve. 00:17:59.865 --> 00:18:04.960 align:middle line:90% 00:18:04.960 --> 00:18:07.800 align:middle line:84% And that's what we call the IS relation. 00:18:07.800 --> 00:18:11.820 align:middle line:84% So I remember I told you when we look at the goods market 00:18:11.820 --> 00:18:13.470 align:middle line:84% equilibrium, remember this diagram 00:18:13.470 --> 00:18:16.490 align:middle line:84% because you're going to come back to it many times. 00:18:16.490 --> 00:18:17.783 align:middle line:90% And there you are. 00:18:17.783 --> 00:18:20.450 align:middle line:84% So remember when we look at the equilibrium in the goods market, 00:18:20.450 --> 00:18:22.180 align:middle line:90% we had something like that. 00:18:22.180 --> 00:18:24.560 align:middle line:84% I'm just making it curve rather than linear simply 00:18:24.560 --> 00:18:27.380 align:middle line:84% because I haven't specified the functional form of investment, 00:18:27.380 --> 00:18:28.790 align:middle line:90% but it doesn't matter, really. 00:18:28.790 --> 00:18:30.260 align:middle line:90% Make it linear. 00:18:30.260 --> 00:18:32.367 align:middle line:84% But remember, that's the way we found equilibrium 00:18:32.367 --> 00:18:33.200 align:middle line:90% in the goods market. 00:18:33.200 --> 00:18:35.750 align:middle line:84% We have an aggregate demand, and it was increasing. 00:18:35.750 --> 00:18:38.360 align:middle line:84% The slope was positive because we had a marginal propensity 00:18:38.360 --> 00:18:39.050 align:middle line:90% to consume. 00:18:39.050 --> 00:18:42.860 align:middle line:84% That's the reason this was not flat, but upward sloping. 00:18:42.860 --> 00:18:46.310 align:middle line:84% And we found equilibrium output that way. 00:18:46.310 --> 00:18:48.980 align:middle line:90% So this is lecture three. 00:18:48.980 --> 00:18:52.940 align:middle line:84% We're back in lecture three here but with two things, 00:18:52.940 --> 00:18:54.390 align:middle line:90% two differences. 00:18:54.390 --> 00:18:57.590 align:middle line:84% The first one is that this ZZ curve 00:18:57.590 --> 00:18:59.540 align:middle line:84% relative to the one we had in lecture three 00:18:59.540 --> 00:19:00.980 align:middle line:90% is a little steeper. 00:19:00.980 --> 00:19:02.000 align:middle line:90% Why is that? 00:19:02.000 --> 00:19:13.800 align:middle line:90% 00:19:13.800 --> 00:19:17.010 align:middle line:84% Why is it that it's a little steeper than that-- by steeper, 00:19:17.010 --> 00:19:20.160 align:middle line:84% I mean if income goes up, then aggregate demand goes up 00:19:20.160 --> 00:19:24.235 align:middle line:90% by more than it used to go up. 00:19:24.235 --> 00:19:25.652 align:middle line:84% AUDIENCE: Is it because investment 00:19:25.652 --> 00:19:26.730 align:middle line:90% is also not [INAUDIBLE]? 00:19:26.730 --> 00:19:29.700 align:middle line:84% RICARDO CABALLERO: Exactly, because what made it upward 00:19:29.700 --> 00:19:32.010 align:middle line:84% sloping before was the marginal propensity to consume. 00:19:32.010 --> 00:19:34.510 align:middle line:84% But now there is also a marginal propensity to invest, 00:19:34.510 --> 00:19:37.440 align:middle line:84% which is also positive, and that's 00:19:37.440 --> 00:19:39.480 align:middle line:84% the reason it's a little steeper. 00:19:39.480 --> 00:19:41.940 align:middle line:84% More interesting for this part of the lecture, though, 00:19:41.940 --> 00:19:44.490 align:middle line:84% for the construction of the IS curve 00:19:44.490 --> 00:19:48.000 align:middle line:84% is that it's a parameter that we have there in ZZ. 00:19:48.000 --> 00:19:51.030 align:middle line:84% What are the parameters we had before in that curve? 00:19:51.030 --> 00:19:54.360 align:middle line:84% We had things like government expenditure, taxes, 00:19:54.360 --> 00:19:56.400 align:middle line:90% the autonomous consumption. 00:19:56.400 --> 00:19:58.200 align:middle line:84% That's the kind of stuff that we had 00:19:58.200 --> 00:20:00.630 align:middle line:90% as parameters of that ZZ curve. 00:20:00.630 --> 00:20:03.150 align:middle line:84% By parameters I mean if we change those parameters, 00:20:03.150 --> 00:20:05.190 align:middle line:90% we shift that curve. 00:20:05.190 --> 00:20:09.080 align:middle line:84% Now, for this particular ZZ we have an extra parameter, 00:20:09.080 --> 00:20:10.730 align:middle line:90% which is a very interesting. 00:20:10.730 --> 00:20:12.490 align:middle line:90% What is that? 00:20:12.490 --> 00:20:15.160 align:middle line:90% It's there, I think. 00:20:15.160 --> 00:20:18.030 align:middle line:90% It's the interest rate. 00:20:18.030 --> 00:20:23.540 align:middle line:84% That curve holds for some given interest rate. 00:20:23.540 --> 00:20:27.610 align:middle line:84% If I move the interest rate, I'm going to move this curve around. 00:20:27.610 --> 00:20:28.750 align:middle line:90% That's very important. 00:20:28.750 --> 00:20:32.270 align:middle line:90% 00:20:32.270 --> 00:20:34.430 align:middle line:84% One of the parameters there, the star 00:20:34.430 --> 00:20:38.000 align:middle line:84% parameter I would say for this minute of the lecture, at least 00:20:38.000 --> 00:20:41.660 align:middle line:84% for this moment in the lecture, is the interest rate. 00:20:41.660 --> 00:20:44.000 align:middle line:84% I can find an equilibrium because I couldn't 00:20:44.000 --> 00:20:46.167 align:middle line:84% find an equilibrium in the goods market 00:20:46.167 --> 00:20:47.750 align:middle line:84% if you don't tell me what the interest 00:20:47.750 --> 00:20:49.403 align:middle line:90% rate is, because it's a curve. 00:20:49.403 --> 00:20:51.570 align:middle line:84% Remember I told you, it's a relationship, the curve. 00:20:51.570 --> 00:20:54.260 align:middle line:84% So if I tell you what the interest rate is, 00:20:54.260 --> 00:20:56.870 align:middle line:84% then you can find the equilibrium in the goods market 00:20:56.870 --> 00:20:58.355 align:middle line:90% because you can fix this curve. 00:20:58.355 --> 00:21:00.980 align:middle line:90% 00:21:00.980 --> 00:21:02.690 align:middle line:84% That's for one given interest rate. 00:21:02.690 --> 00:21:05.420 align:middle line:90% 00:21:05.420 --> 00:21:07.192 align:middle line:90% OK. 00:21:07.192 --> 00:21:08.150 align:middle line:90% Do you understand that? 00:21:08.150 --> 00:21:09.680 align:middle line:90% That's important. 00:21:09.680 --> 00:21:11.490 align:middle line:90% Yes? 00:21:11.490 --> 00:21:14.850 align:middle line:84% Those of you that are awake, you understand it or not? 00:21:14.850 --> 00:21:17.460 align:middle line:84% Not everyone is in the same page here. 00:21:17.460 --> 00:21:18.180 align:middle line:90% OK, good. 00:21:18.180 --> 00:21:22.985 align:middle line:90% 00:21:22.985 --> 00:21:27.880 align:middle line:84% So what we're going to do next is construct the IS curve. 00:21:27.880 --> 00:21:29.550 align:middle line:84% And how are we going to-- remember, 00:21:29.550 --> 00:21:32.040 align:middle line:84% what I want to try to do is constructing 00:21:32.040 --> 00:21:34.900 align:middle line:84% the space of interest rate and output, a curve, 00:21:34.900 --> 00:21:38.590 align:middle line:84% which we're going to call the IS curve. 00:21:38.590 --> 00:21:40.510 align:middle line:84% Here we have a point in that curve, 00:21:40.510 --> 00:21:42.400 align:middle line:84% because for one level of interest rate 00:21:42.400 --> 00:21:44.210 align:middle line:90% I found the equilibrium output. 00:21:44.210 --> 00:21:46.660 align:middle line:84% So to construct the curve, what I need to do 00:21:46.660 --> 00:21:48.040 align:middle line:84% is start moving the interest rate 00:21:48.040 --> 00:21:50.710 align:middle line:84% and see how the equilibrium output changes, 00:21:50.710 --> 00:21:53.260 align:middle line:90% and that will trace a curve. 00:21:53.260 --> 00:21:57.150 align:middle line:84% And that's going to be my IS curve or relationship. 00:21:57.150 --> 00:21:59.160 align:middle line:90% So let's do that. 00:21:59.160 --> 00:22:02.310 align:middle line:84% That's the construction of the IS curve. 00:22:02.310 --> 00:22:07.080 align:middle line:84% So in the previous chart we found point A, 00:22:07.080 --> 00:22:11.500 align:middle line:90% So point A there is that point. 00:22:11.500 --> 00:22:12.640 align:middle line:90% There we are. 00:22:12.640 --> 00:22:15.220 align:middle line:90% We had some interest rate. 00:22:15.220 --> 00:22:17.690 align:middle line:90% This interest rate. 00:22:17.690 --> 00:22:19.810 align:middle line:84% Believe me, that was a parameter of the ZZ curve 00:22:19.810 --> 00:22:21.820 align:middle line:90% I showed you before. 00:22:21.820 --> 00:22:27.180 align:middle line:84% Gave us equilibrium output A. So that's a point in the IS 00:22:27.180 --> 00:22:30.690 align:middle line:84% because that's a combination of interest rate and output, 00:22:30.690 --> 00:22:33.350 align:middle line:84% which is consistent with the equilibrium in the goods market. 00:22:33.350 --> 00:22:34.910 align:middle line:90% That's a point in the IS. 00:22:34.910 --> 00:22:37.070 align:middle line:90% That's the definition of IS. 00:22:37.070 --> 00:22:39.380 align:middle line:84% So now what I'm going to do to construct my IS 00:22:39.380 --> 00:22:41.060 align:middle line:84% is, OK, let me move the interest rate. 00:22:41.060 --> 00:22:45.140 align:middle line:84% Let me raise interest rate from I to I prime. 00:22:45.140 --> 00:22:47.560 align:middle line:84% OK, that's an increase in the interest rate. 00:22:47.560 --> 00:22:50.680 align:middle line:84% And now let me find what is the new equilibrium in the goods 00:22:50.680 --> 00:22:53.860 align:middle line:84% market for a given interest rate which is higher than the one 00:22:53.860 --> 00:22:55.390 align:middle line:90% I used to have. 00:22:55.390 --> 00:23:00.230 align:middle line:84% That amounts to shifting the ZZ curve down. 00:23:00.230 --> 00:23:02.080 align:middle line:84% Why does increasing the interest rate 00:23:02.080 --> 00:23:06.893 align:middle line:84% shift the ZZ curve down, the aggregate demand down? 00:23:06.893 --> 00:23:08.810 align:middle line:84% AUDIENCE: Because it makes borrowing lifetime. 00:23:08.810 --> 00:23:09.830 align:middle line:84% RICARDO CABALLERO: It makes investment. 00:23:09.830 --> 00:23:10.910 align:middle line:90% The client-- exactly. 00:23:10.910 --> 00:23:13.700 align:middle line:84% Borrowers will expect, therefore investment declines. 00:23:13.700 --> 00:23:16.830 align:middle line:84% So that means for any given level of output, 00:23:16.830 --> 00:23:20.670 align:middle line:84% now aggregate demand is lower because investment is lower. 00:23:20.670 --> 00:23:23.060 align:middle line:84% And then you get the multiplier to do its trick, 00:23:23.060 --> 00:23:25.350 align:middle line:84% and therefore, you end up with a decline in output 00:23:25.350 --> 00:23:29.028 align:middle line:84% which is even larger than the initial decline in investment 00:23:29.028 --> 00:23:31.070 align:middle line:84% as a result of the increase in the interest rate. 00:23:31.070 --> 00:23:32.690 align:middle line:90% That's what a multiplier does. 00:23:32.690 --> 00:23:37.730 align:middle line:84% So say interest rate increased by 100 basis points. 00:23:37.730 --> 00:23:42.710 align:middle line:84% That reduces investment by, say, $10 billion, 00:23:42.710 --> 00:23:47.030 align:middle line:84% and equilibrium output ends up falling by $15 billion 00:23:47.030 --> 00:23:49.280 align:middle line:84% because of the multiplier and so on. 00:23:49.280 --> 00:23:52.700 align:middle line:84% But the point is after I do all my convergence to this new lower 00:23:52.700 --> 00:23:56.090 align:middle line:84% equilibrium level of output, I have a second point 00:23:56.090 --> 00:24:00.140 align:middle line:84% in my IS curve, because that's a combination of a new interest 00:24:00.140 --> 00:24:03.860 align:middle line:84% rate, I prime, an output that is consistent with the equilibrium 00:24:03.860 --> 00:24:04.795 align:middle line:90% in the goods market. 00:24:04.795 --> 00:24:06.920 align:middle line:84% How do I know that it's consistent with equilibrium 00:24:06.920 --> 00:24:07.753 align:middle line:90% in the goods market? 00:24:07.753 --> 00:24:08.850 align:middle line:90% Because I'm there. 00:24:08.850 --> 00:24:09.660 align:middle line:90% I'm crossing. 00:24:09.660 --> 00:24:12.730 align:middle line:84% 45-degree line, that means output equal to aggregate 00:24:12.730 --> 00:24:13.230 align:middle line:90% demand. 00:24:13.230 --> 00:24:14.855 align:middle line:84% That's equilibrium in the goods market. 00:24:14.855 --> 00:24:19.960 align:middle line:90% 00:24:19.960 --> 00:24:24.533 align:middle line:84% And of course you can keep going and trace an entire curve. 00:24:24.533 --> 00:24:26.950 align:middle line:84% And all that you'll do is you'll change the interest rate. 00:24:26.950 --> 00:24:28.075 align:middle line:90% That will shift this curve. 00:24:28.075 --> 00:24:32.298 align:middle line:84% Then you do the multiplier and end up with a new equilibrium, 00:24:32.298 --> 00:24:33.965 align:middle line:84% and that's another point for your curve. 00:24:33.965 --> 00:24:36.815 align:middle line:90% 00:24:36.815 --> 00:24:38.690 align:middle line:84% So is it clear how we constructed that curve? 00:24:38.690 --> 00:24:42.030 align:middle line:90% 00:24:42.030 --> 00:24:43.490 align:middle line:90% Very important. 00:24:43.490 --> 00:24:46.260 align:middle line:90% OK, good. 00:24:46.260 --> 00:24:48.540 align:middle line:84% It's also very important to understand-- 00:24:48.540 --> 00:24:50.255 align:middle line:90% so why is it downward sloping? 00:24:50.255 --> 00:24:51.005 align:middle line:90% That's a question. 00:24:51.005 --> 00:24:56.340 align:middle line:90% 00:24:56.340 --> 00:24:57.465 align:middle line:90% Why is it downward sloping? 00:24:57.465 --> 00:25:02.880 align:middle line:90% 00:25:02.880 --> 00:25:05.360 align:middle line:84% What does it mean that it's downward sloping? 00:25:05.360 --> 00:25:08.390 align:middle line:84% That means that the combination of output and interest rate 00:25:08.390 --> 00:25:11.090 align:middle line:84% that are consistent when equilibrium output are 00:25:11.090 --> 00:25:14.120 align:middle line:84% negatively correlated, meaning I have 00:25:14.120 --> 00:25:17.990 align:middle line:84% a combination of high output and low interest rate-- 00:25:17.990 --> 00:25:22.640 align:middle line:84% it's consistent with [INAUDIBLE],, or high interest 00:25:22.640 --> 00:25:23.840 align:middle line:90% rate and low output. 00:25:23.840 --> 00:25:27.090 align:middle line:90% That's what I find here. 00:25:27.090 --> 00:25:28.040 align:middle line:90% But why is that? 00:25:28.040 --> 00:25:31.980 align:middle line:84% What is the logic of behind that? 00:25:31.980 --> 00:25:33.960 align:middle line:90% Or the mechanism. 00:25:33.960 --> 00:25:35.850 align:middle line:84% The way to think about that is exactly 00:25:35.850 --> 00:25:38.880 align:middle line:90% the way I did this experiment. 00:25:38.880 --> 00:25:43.830 align:middle line:84% It's to say, let me think what happens if I increase 00:25:43.830 --> 00:25:47.640 align:middle line:84% the interest rate and I keep the level of output where it was. 00:25:47.640 --> 00:25:49.830 align:middle line:84% So what happens if I increase the interest rate 00:25:49.830 --> 00:25:54.610 align:middle line:84% and I keep the level of output at the level it was? 00:25:54.610 --> 00:25:58.160 align:middle line:84% My claim is that that's not an equilibrium in the goods market. 00:25:58.160 --> 00:25:59.140 align:middle line:90% What is it? 00:25:59.140 --> 00:26:03.720 align:middle line:90% 00:26:03.720 --> 00:26:05.940 align:middle line:84% So I'm saying suppose I increase the interest rate 00:26:05.940 --> 00:26:07.870 align:middle line:90% but I keep the output constant. 00:26:07.870 --> 00:26:10.830 align:middle line:84% So output is here, higher interest rate, 00:26:10.830 --> 00:26:13.980 align:middle line:90% aggregate demand is there. 00:26:13.980 --> 00:26:15.633 align:middle line:90% So what is the problem? 00:26:15.633 --> 00:26:18.050 align:middle line:84% My claim is that's not an equilibrium in the goods market. 00:26:18.050 --> 00:26:19.580 align:middle line:84% We're going to need a lower level of output 00:26:19.580 --> 00:26:21.080 align:middle line:84% to have an equilibrium in the goods market. 00:26:21.080 --> 00:26:22.747 align:middle line:84% That's the reason it's downward sloping. 00:26:22.747 --> 00:26:26.060 align:middle line:84% But why is that not an equilibrium in the goods market? 00:26:26.060 --> 00:26:28.400 align:middle line:84% Or what is the nature of the disequilibrium in the goods 00:26:28.400 --> 00:26:29.190 align:middle line:90% market there? 00:26:29.190 --> 00:26:31.273 align:middle line:84% What do we have-- an excess demand, excess supply? 00:26:31.273 --> 00:26:33.320 align:middle line:90% 00:26:33.320 --> 00:26:36.260 align:middle line:84% Excess supply, meaning there isn't enough demand 00:26:36.260 --> 00:26:39.380 align:middle line:84% to support that supply, so supply 00:26:39.380 --> 00:26:43.910 align:middle line:84% has to fall in order to restore equilibrium in that market, 00:26:43.910 --> 00:26:46.180 align:middle line:90% in the goods market. 00:26:46.180 --> 00:26:50.170 align:middle line:84% And since one drags the other one, it has to fall by a lot. 00:26:50.170 --> 00:26:54.870 align:middle line:84% That has to do with the slope of this curve. 00:26:54.870 --> 00:26:56.470 align:middle line:84% But that's the reason is negatively. 00:26:56.470 --> 00:26:58.470 align:middle line:84% So that's the first thing you have to understand 00:26:58.470 --> 00:27:00.210 align:middle line:90% when you construct this curve. 00:27:00.210 --> 00:27:04.950 align:middle line:84% I know I'm going slowly, but it's important. 00:27:04.950 --> 00:27:06.660 align:middle line:90% Please try to understand-- 00:27:06.660 --> 00:27:10.160 align:middle line:90% 00:27:10.160 --> 00:27:13.310 align:middle line:90% another way of saying it-- 00:27:13.310 --> 00:27:18.680 align:middle line:84% when I change the equilibrium output along this IS curve 00:27:18.680 --> 00:27:22.160 align:middle line:84% by moving the interest rate around, what I'm doing 00:27:22.160 --> 00:27:25.910 align:middle line:90% is I'm moving along an IS curve. 00:27:25.910 --> 00:27:29.300 align:middle line:84% So if the only reason why equilibrium output is changing 00:27:29.300 --> 00:27:32.270 align:middle line:84% is because I'm moving the interest rate, 00:27:32.270 --> 00:27:36.370 align:middle line:84% that's a movement along the IS curve. 00:27:36.370 --> 00:27:39.400 align:middle line:84% So I'm tracing points of the IS curve. 00:27:39.400 --> 00:27:40.270 align:middle line:90% Good. 00:27:40.270 --> 00:27:43.270 align:middle line:84% And I want to draw a contrast between these movements 00:27:43.270 --> 00:27:48.385 align:middle line:84% along the IS curve versus things that shift the Is curve. 00:27:48.385 --> 00:27:51.580 align:middle line:90% 00:27:51.580 --> 00:27:55.680 align:middle line:90% For example, that. 00:27:55.680 --> 00:28:00.094 align:middle line:90% So suppose I increase taxes. 00:28:00.094 --> 00:28:01.070 align:middle line:90% I don't increase taxes. 00:28:01.070 --> 00:28:03.430 align:middle line:90% The government increases taxes. 00:28:03.430 --> 00:28:08.240 align:middle line:84% My claim is that the IS shift to the left. 00:28:08.240 --> 00:28:11.760 align:middle line:84% That is, for any given level of interest rate-- 00:28:11.760 --> 00:28:14.910 align:middle line:90% pick any interest you want. 00:28:14.910 --> 00:28:16.690 align:middle line:90% Say this one. 00:28:16.690 --> 00:28:18.640 align:middle line:84% You're going to have a lower equilibrium 00:28:18.640 --> 00:28:21.170 align:middle line:84% output consistent with that interest rate. 00:28:21.170 --> 00:28:23.410 align:middle line:84% You have a lower equilibrium consistent 00:28:23.410 --> 00:28:27.073 align:middle line:84% with the same interest rate that has shifted the IS. 00:28:27.073 --> 00:28:28.240 align:middle line:90% It has to be a different IS. 00:28:28.240 --> 00:28:30.758 align:middle line:90% 00:28:30.758 --> 00:28:33.300 align:middle line:84% And think that I can do that for any given [INAUDIBLE] event. 00:28:33.300 --> 00:28:35.400 align:middle line:84% I pick this one, but I could have picked that one. 00:28:35.400 --> 00:28:36.480 align:middle line:90% Would have been the same. 00:28:36.480 --> 00:28:39.280 align:middle line:84% I'm saying, if you increase taxes, 00:28:39.280 --> 00:28:43.202 align:middle line:84% that's going to lead to lower equilibrium output. 00:28:43.202 --> 00:28:47.030 align:middle line:84% So that means that for this higher level of taxes, 00:28:47.030 --> 00:28:50.707 align:middle line:84% I will have to trace a different IS curve. 00:28:50.707 --> 00:28:52.540 align:middle line:84% I can start moving the interest rate around, 00:28:52.540 --> 00:28:54.415 align:middle line:84% but I'm going to have a lower level of output 00:28:54.415 --> 00:28:56.200 align:middle line:84% for any given level of interest rate 00:28:56.200 --> 00:28:59.400 align:middle line:90% because I have higher taxes. 00:28:59.400 --> 00:29:04.230 align:middle line:84% So how do I know that an increase in taxes will do this? 00:29:04.230 --> 00:29:07.995 align:middle line:84% Which diagram would you go to to try to understand this? 00:29:07.995 --> 00:29:15.350 align:middle line:90% 00:29:15.350 --> 00:29:18.680 align:middle line:90% So let me ask it differently. 00:29:18.680 --> 00:29:20.730 align:middle line:84% How do I know that this stuff shift to the left? 00:29:20.730 --> 00:29:22.882 align:middle line:90% So I give you more open space. 00:29:22.882 --> 00:29:24.590 align:middle line:84% How do I know that this increase in taxes 00:29:24.590 --> 00:29:26.828 align:middle line:84% will shift this IS curve to the left? 00:29:26.828 --> 00:29:28.620 align:middle line:84% How would you go about thinking about that? 00:29:28.620 --> 00:29:30.935 align:middle line:84% AUDIENCE: Well, I think there's more taxes than people 00:29:30.935 --> 00:29:36.230 align:middle line:84% [INAUDIBLE] --disposable income, so they're not 00:29:36.230 --> 00:29:39.230 align:middle line:84% going to spend as much money, and there'll be less outcome. 00:29:39.230 --> 00:29:40.640 align:middle line:84% RICARDO CABALLERO: Their would be less aggregate demand, 00:29:40.640 --> 00:29:43.130 align:middle line:84% and less aggregate demand leads to less output because output 00:29:43.130 --> 00:29:44.422 align:middle line:90% is aggregate-demand determined. 00:29:44.422 --> 00:29:44.990 align:middle line:90% Exactly. 00:29:44.990 --> 00:29:47.280 align:middle line:84% That's what equilibrium in the goods market. 00:29:47.280 --> 00:29:51.440 align:middle line:84% So you can go back to this diagram. 00:29:51.440 --> 00:29:55.190 align:middle line:84% I could say ignore these labels here and say, for any given 00:29:55.190 --> 00:29:58.220 align:middle line:84% level of interest rate, pick any, if I increase taxes, 00:29:58.220 --> 00:30:02.470 align:middle line:84% I'm going to shift the ZZ curve down. 00:30:02.470 --> 00:30:04.460 align:middle line:90% So ignore this [INAUDIBLE]. 00:30:04.460 --> 00:30:07.330 align:middle line:84% Suppose that I fix the interest rate but I now 00:30:07.330 --> 00:30:08.890 align:middle line:90% change taxes, increase taxes. 00:30:08.890 --> 00:30:09.940 align:middle line:84% I'm going to do exactly the same here. 00:30:09.940 --> 00:30:11.170 align:middle line:90% I'm going to move this down. 00:30:11.170 --> 00:30:13.690 align:middle line:84% And it's going to be a different IS curve, though, because-- 00:30:13.690 --> 00:30:15.670 align:middle line:84% I shouldn't have used this diagram. 00:30:15.670 --> 00:30:16.840 align:middle line:90% Let me keep your answer. 00:30:16.840 --> 00:30:19.150 align:middle line:84% I should have put it on your diagram. 00:30:19.150 --> 00:30:21.130 align:middle line:90% But it's lecture three. 00:30:21.130 --> 00:30:25.750 align:middle line:84% In lecture three we did see that an increase in taxes 00:30:25.750 --> 00:30:28.780 align:middle line:84% would lead to lower equilibrium output. 00:30:28.780 --> 00:30:30.330 align:middle line:84% In fact, we know exactly by how much. 00:30:30.330 --> 00:30:33.277 align:middle line:84% If taxes increase by 100, then you 00:30:33.277 --> 00:30:34.860 align:middle line:84% know that the equilibrium output would 00:30:34.860 --> 00:30:41.110 align:middle line:84% decline by C1 times 1 over minus C1 are your change in taxes. 00:30:41.110 --> 00:30:43.360 align:middle line:84% Here would be a little different because there is also 00:30:43.360 --> 00:30:49.120 align:middle line:84% remembered investment also has a propensity to spend 00:30:49.120 --> 00:30:50.530 align:middle line:90% as a function of output. 00:30:50.530 --> 00:30:51.970 align:middle line:84% So it would be a little different, 00:30:51.970 --> 00:30:55.560 align:middle line:84% but that's the kind of calculation. 00:30:55.560 --> 00:30:58.470 align:middle line:84% What else would shift the IS this way? 00:30:58.470 --> 00:31:03.400 align:middle line:90% 00:31:03.400 --> 00:31:05.150 align:middle line:84% AUDIENCE: Decrease in government spending. 00:31:05.150 --> 00:31:06.290 align:middle line:84% RICARDO CABALLERO: Decrease in government expenditure 00:31:06.290 --> 00:31:06.832 align:middle line:90% will do that. 00:31:06.832 --> 00:31:08.480 align:middle line:90% What else? 00:31:08.480 --> 00:31:11.930 align:middle line:84% This is another thing I want you to do-- think of everything-- 00:31:11.930 --> 00:31:14.540 align:middle line:84% because for sure you're going to face that in the quiz-- 00:31:14.540 --> 00:31:17.180 align:middle line:84% anything that would shift the IS curve. 00:31:17.180 --> 00:31:18.680 align:middle line:84% What else would shift the IS curve? 00:31:18.680 --> 00:31:21.458 align:middle line:90% 00:31:21.458 --> 00:31:23.078 align:middle line:90% AUDIENCE: Decreasing export. 00:31:23.078 --> 00:31:24.620 align:middle line:84% RICARDO CABALLERO: Yeah, that's true, 00:31:24.620 --> 00:31:28.050 align:middle line:84% but that's not for this part of the course. 00:31:28.050 --> 00:31:30.180 align:middle line:84% Remember, we're in a closed economy. 00:31:30.180 --> 00:31:33.490 align:middle line:84% So here we assume x equal to M equal to zero. 00:31:33.490 --> 00:31:36.110 align:middle line:90% IM equal to zero. 00:31:36.110 --> 00:31:38.090 align:middle line:90% That comes after quiz one. 00:31:38.090 --> 00:31:38.705 align:middle line:90% What else? 00:31:38.705 --> 00:31:44.668 align:middle line:90% 00:31:44.668 --> 00:31:46.210 align:middle line:84% Things that were captured-- remember, 00:31:46.210 --> 00:31:48.370 align:middle line:84% when I began this lecture, I showed you wealth, 00:31:48.370 --> 00:31:49.870 align:middle line:90% what had happened, and so on. 00:31:49.870 --> 00:31:52.210 align:middle line:84% There's nowhere wealth in this model here. 00:31:52.210 --> 00:31:53.650 align:middle line:90% It's just output. 00:31:53.650 --> 00:31:56.710 align:middle line:84% But wealth affects how much consumers consume. 00:31:56.710 --> 00:31:58.510 align:middle line:90% So autonomous consumption. 00:31:58.510 --> 00:32:01.930 align:middle line:84% There were lots of stuff hidden in that C0, that constant C0. 00:32:01.930 --> 00:32:04.060 align:middle line:90% Remember C0 plus one and one. 00:32:04.060 --> 00:32:08.020 align:middle line:84% Well, C0 captures things like how confident 00:32:08.020 --> 00:32:11.180 align:middle line:84% were consumers, how wealthy they felt, and stuff like that. 00:32:11.180 --> 00:32:14.530 align:middle line:84% So anything that shifts C0 down, consumer sentiment 00:32:14.530 --> 00:32:17.170 align:middle line:84% declines, wealth declines, something like that, 00:32:17.170 --> 00:32:21.550 align:middle line:90% will also shift IS to the left. 00:32:21.550 --> 00:32:24.620 align:middle line:90% So that's important. 00:32:24.620 --> 00:32:25.580 align:middle line:90% Good. 00:32:25.580 --> 00:32:29.870 align:middle line:90% So we're done with IS for now. 00:32:29.870 --> 00:32:33.230 align:middle line:84% Now with IS alone I cannot find what I want. 00:32:33.230 --> 00:32:38.330 align:middle line:84% I want to find combinations of interest rate and output 00:32:38.330 --> 00:32:40.010 align:middle line:84% that are consistent with equilibrium 00:32:40.010 --> 00:32:42.530 align:middle line:84% in the goods and financial markets. 00:32:42.530 --> 00:32:44.210 align:middle line:84% This doesn't do it because it gives you 00:32:44.210 --> 00:32:46.842 align:middle line:84% only combinations that are consistent with equilibrium 00:32:46.842 --> 00:32:47.675 align:middle line:90% in the goods market. 00:32:47.675 --> 00:32:53.040 align:middle line:90% 00:32:53.040 --> 00:32:56.190 align:middle line:84% So I now need to look at financial markets, which 00:32:56.190 --> 00:32:58.080 align:middle line:84% is the other side, the LM relationship. 00:32:58.080 --> 00:33:00.960 align:middle line:90% And remember what we had. 00:33:00.960 --> 00:33:04.022 align:middle line:84% We had equilibrium in the financial markets. 00:33:04.022 --> 00:33:05.730 align:middle line:84% We had two instruments that we could use. 00:33:05.730 --> 00:33:07.350 align:middle line:84% Remember we had only two assets-- 00:33:07.350 --> 00:33:09.280 align:middle line:90% money and bonds. 00:33:09.280 --> 00:33:13.140 align:middle line:84% So we could look at the equilibrium in money 00:33:13.140 --> 00:33:14.282 align:middle line:90% or equilibrium in bonds. 00:33:14.282 --> 00:33:14.865 align:middle line:90% It's the same. 00:33:14.865 --> 00:33:17.370 align:middle line:90% 00:33:17.370 --> 00:33:20.770 align:middle line:84% But we did it all in terms of money. 00:33:20.770 --> 00:33:22.230 align:middle line:84% It's the same because given wealth, 00:33:22.230 --> 00:33:23.855 align:middle line:84% if one is in equilibrium, the other one 00:33:23.855 --> 00:33:25.270 align:middle line:84% has to be in equilibrium as well. 00:33:25.270 --> 00:33:30.180 align:middle line:84% So I only need to look at one, and we're looking at money. 00:33:30.180 --> 00:33:34.300 align:middle line:84% So money is equal to money demand. 00:33:34.300 --> 00:33:35.838 align:middle line:84% I'm going to divide both sides by P. 00:33:35.838 --> 00:33:37.630 align:middle line:84% This is not going to be very important now, 00:33:37.630 --> 00:33:39.080 align:middle line:90% but later it will be. 00:33:39.080 --> 00:33:40.750 align:middle line:84% And so we're going to have that-- 00:33:40.750 --> 00:33:43.990 align:middle line:84% This is equilibrium in financial markets. 00:33:43.990 --> 00:33:50.110 align:middle line:84% Means that real money supply equals real money demand. 00:33:50.110 --> 00:33:53.620 align:middle line:90% That's what we have here. 00:33:53.620 --> 00:33:57.300 align:middle line:84% So this, you already see it traces combinations 00:33:57.300 --> 00:33:58.920 align:middle line:84% of output and interest rate which 00:33:58.920 --> 00:34:01.725 align:middle line:84% are consistent with equilibrium in financial markets. 00:34:01.725 --> 00:34:04.720 align:middle line:90% 00:34:04.720 --> 00:34:09.120 align:middle line:84% In the past, that's the way the LM would be described. 00:34:09.120 --> 00:34:12.449 align:middle line:84% We would fix M and say, well, this will give you 00:34:12.449 --> 00:34:15.659 align:middle line:90% an upward-sloping curve. 00:34:15.659 --> 00:34:20.070 align:middle line:84% Because this is downward sloping, so if this guy goes up, 00:34:20.070 --> 00:34:22.983 align:middle line:84% I need to-- if this is constant, this guy goes up. 00:34:22.983 --> 00:34:24.150 align:middle line:90% This guy needs to come down. 00:34:24.150 --> 00:34:25.139 align:middle line:90% What does that? 00:34:25.139 --> 00:34:27.330 align:middle line:90% What does bring L down? 00:34:27.330 --> 00:34:29.739 align:middle line:84% I going up, because L prime is negative. 00:34:29.739 --> 00:34:32.429 align:middle line:84% So that's the way LM used to be described. 00:34:32.429 --> 00:34:34.800 align:middle line:84% Your life is a lot simpler today. 00:34:34.800 --> 00:34:38.010 align:middle line:84% It's a lot simpler because central banks don't 00:34:38.010 --> 00:34:39.380 align:middle line:90% target monetary aggregates. 00:34:39.380 --> 00:34:41.880 align:middle line:84% They don't target M. They target the interest rate directly. 00:34:41.880 --> 00:34:45.630 align:middle line:84% So they tell you the answer already. 00:34:45.630 --> 00:34:47.699 align:middle line:84% The central bank, when it does policy, 00:34:47.699 --> 00:34:50.760 align:middle line:84% it says, look, I tell you what I will be. 00:34:50.760 --> 00:34:53.980 align:middle line:84% Then if output moves around or whatever, 00:34:53.980 --> 00:34:55.500 align:middle line:84% it's a problem for M. We'll provide 00:34:55.500 --> 00:34:58.050 align:middle line:84% the M that the market needs in order to have an interest 00:34:58.050 --> 00:35:01.440 align:middle line:90% rate equal to the one we want. 00:35:01.440 --> 00:35:05.332 align:middle line:84% So it is true that it captures all the combinations of output 00:35:05.332 --> 00:35:07.540 align:middle line:84% and interest that are consistent with the equilibrium 00:35:07.540 --> 00:35:13.335 align:middle line:84% in the financial markets, but it's very simple because what 00:35:13.335 --> 00:35:17.570 align:middle line:84% the fed does in the US or other central banks do is they say, 00:35:17.570 --> 00:35:19.670 align:middle line:84% OK, this is the interest rate we want. 00:35:19.670 --> 00:35:22.840 align:middle line:84% And now you can put any amount of output you want. 00:35:22.840 --> 00:35:25.890 align:middle line:84% As long as we remain committed to this interest rate, 00:35:25.890 --> 00:35:27.640 align:middle line:84% it will be consistent with the equilibrium 00:35:27.640 --> 00:35:31.390 align:middle line:84% in the financial markets because we will do it so. 00:35:31.390 --> 00:35:34.450 align:middle line:84% And the way we will do it so is we'll provide as much M 00:35:34.450 --> 00:35:37.222 align:middle line:84% as the market needs so that that combination of output 00:35:37.222 --> 00:35:38.680 align:middle line:84% and interest rate is an equilibrium 00:35:38.680 --> 00:35:40.720 align:middle line:90% in the financial market. 00:35:40.720 --> 00:35:45.010 align:middle line:84% That's a very long way of saying that the fed sets I 00:35:45.010 --> 00:35:51.820 align:middle line:84% and then M is whatever is needed for this equation 00:35:51.820 --> 00:35:52.700 align:middle line:90% to be in equilibrium. 00:35:52.700 --> 00:35:54.675 align:middle line:84% So if output rises and the fed doesn't 00:35:54.675 --> 00:35:56.050 align:middle line:84% want to change the interest rate, 00:35:56.050 --> 00:35:59.190 align:middle line:90% that means you need to change M. 00:35:59.190 --> 00:36:01.790 align:middle line:84% So suppose that the fed says, I want this interest rate 00:36:01.790 --> 00:36:05.030 align:middle line:90% to be fixed at this level. 00:36:05.030 --> 00:36:06.860 align:middle line:90% Call it I0. 00:36:06.860 --> 00:36:08.900 align:middle line:84% And now output turns out to be higher. 00:36:08.900 --> 00:36:11.650 align:middle line:90% 00:36:11.650 --> 00:36:16.320 align:middle line:84% What will the fed do in order to ensure that I remains at I0? 00:36:16.320 --> 00:36:19.890 align:middle line:84% What if the fed doesn't do anything? 00:36:19.890 --> 00:36:21.830 align:middle line:84% So the fed says, I want I equals 0, 00:36:21.830 --> 00:36:23.660 align:middle line:84% and the fed is calculating that output 00:36:23.660 --> 00:36:25.730 align:middle line:90% will be about a certain level. 00:36:25.730 --> 00:36:29.240 align:middle line:84% And it turns out that output is higher. 00:36:29.240 --> 00:36:34.350 align:middle line:84% What happens if the fed doesn't react and keeps the interest 00:36:34.350 --> 00:36:36.580 align:middle line:90% rate at I0? 00:36:36.580 --> 00:36:40.630 align:middle line:84% An output tends to be higher than what they thought when they 00:36:40.630 --> 00:36:44.350 align:middle line:84% provided the M that they thought the market needed 00:36:44.350 --> 00:36:47.137 align:middle line:84% to be in equilibrium with that interest rate. 00:36:47.137 --> 00:36:47.845 align:middle line:90% What will happen? 00:36:47.845 --> 00:36:52.420 align:middle line:90% 00:36:52.420 --> 00:36:55.390 align:middle line:84% The interest rate will go up because money demand 00:36:55.390 --> 00:36:56.687 align:middle line:90% will exceed money supply. 00:36:56.687 --> 00:36:59.020 align:middle line:84% The only way to restore equilibrium is for interest rate 00:36:59.020 --> 00:37:00.390 align:middle line:90% to go up. 00:37:00.390 --> 00:37:02.590 align:middle line:84% But the fed doesn't want that, so what 00:37:02.590 --> 00:37:05.090 align:middle line:84% the Fed will do is when it feels that, it feels the interest 00:37:05.090 --> 00:37:08.600 align:middle line:84% rates are going up, they will provide more money 00:37:08.600 --> 00:37:11.450 align:middle line:84% so they can restore equilibrium in the financial markets 00:37:11.450 --> 00:37:14.240 align:middle line:84% at that level of interest rate despite the fact 00:37:14.240 --> 00:37:16.710 align:middle line:84% that output ended up being higher than they thought. 00:37:16.710 --> 00:37:21.860 align:middle line:84% So all this is a long-winded way to say that the modern LM is 00:37:21.860 --> 00:37:22.700 align:middle line:90% horizontal. 00:37:22.700 --> 00:37:25.440 align:middle line:90% 00:37:25.440 --> 00:37:29.130 align:middle line:84% A few years ago, that curve would have been upward sloping. 00:37:29.130 --> 00:37:32.970 align:middle line:84% But given the way monetary policy is conducted nowadays, 00:37:32.970 --> 00:37:35.040 align:middle line:90% your life is a lot simpler. 00:37:35.040 --> 00:37:38.010 align:middle line:90% The LM is a horizontal curve. 00:37:38.010 --> 00:37:41.460 align:middle line:84% The fed tells you, the central bank tells you 00:37:41.460 --> 00:37:43.140 align:middle line:84% what the interest rate has to be, 00:37:43.140 --> 00:37:45.210 align:middle line:84% and then it will give whatever M, will 00:37:45.210 --> 00:37:46.780 align:middle line:90% provide whatever M is needed. 00:37:46.780 --> 00:37:48.900 align:middle line:84% So that's the equilibrium interest rate. 00:37:48.900 --> 00:37:54.420 align:middle line:90% 00:37:54.420 --> 00:37:56.360 align:middle line:90% So what shifts the modern LM? 00:37:56.360 --> 00:37:59.730 align:middle line:90% 00:37:59.730 --> 00:38:01.710 align:middle line:90% And by modern, I only mean-- 00:38:01.710 --> 00:38:03.430 align:middle line:84% the book doesn't use that terminology, 00:38:03.430 --> 00:38:07.080 align:middle line:84% but by modern I mean that the fed decides 00:38:07.080 --> 00:38:08.612 align:middle line:90% what the interest rate is. 00:38:08.612 --> 00:38:10.570 align:middle line:84% AUDIENCE: Won't that change your interest rate? 00:38:10.570 --> 00:38:11.260 align:middle line:90% RICARDO CABALLERO: Exactly. 00:38:11.260 --> 00:38:12.430 align:middle line:90% The only thing that will shift-- 00:38:12.430 --> 00:38:13.472 align:middle line:90% your life is very simple. 00:38:13.472 --> 00:38:17.170 align:middle line:84% The only thing that will shift the modern LM 00:38:17.170 --> 00:38:19.810 align:middle line:84% is that the fed changes its mind. 00:38:19.810 --> 00:38:22.520 align:middle line:90% 00:38:22.520 --> 00:38:25.730 align:middle line:84% A few years back it would have been more complicated. 00:38:25.730 --> 00:38:28.370 align:middle line:90% A change in money demand. 00:38:28.370 --> 00:38:29.510 align:middle line:90% A change in money supply. 00:38:29.510 --> 00:38:32.450 align:middle line:84% All those things would be shifting the LM around. 00:38:32.450 --> 00:38:35.330 align:middle line:84% Now in this setup it's very simple. 00:38:35.330 --> 00:38:38.360 align:middle line:84% It will change only if the feds changes its mind. 00:38:38.360 --> 00:38:42.830 align:middle line:84% Now obviously the fed is not just a moody institution. 00:38:42.830 --> 00:38:44.870 align:middle line:84% It will change the mind, and sometimes it's 00:38:44.870 --> 00:38:47.672 align:middle line:90% forced to change its mind. 00:38:47.672 --> 00:38:49.130 align:middle line:84% They're not happy with the interest 00:38:49.130 --> 00:38:51.170 align:middle line:90% rate they're setting nowadays. 00:38:51.170 --> 00:38:52.880 align:middle line:90% They have been forced into that. 00:38:52.880 --> 00:38:55.370 align:middle line:84% They were very reluctant to go into this very high interest 00:38:55.370 --> 00:38:56.510 align:middle line:90% rate. 00:38:56.510 --> 00:39:00.230 align:middle line:84% But what is happening around with this very high consumption 00:39:00.230 --> 00:39:03.560 align:middle line:84% and the impact that is having on inflation, they have been forced 00:39:03.560 --> 00:39:06.830 align:middle line:84% into moving interest rate not only very high but also very 00:39:06.830 --> 00:39:11.100 align:middle line:90% fast, and that was very risky. 00:39:11.100 --> 00:39:14.870 align:middle line:84% We have been lucky that nothing has really broken. 00:39:14.870 --> 00:39:18.170 align:middle line:84% Normally when central banks raise interest rates so fast, 00:39:18.170 --> 00:39:19.803 align:middle line:84% they break something along the way. 00:39:19.803 --> 00:39:22.220 align:middle line:84% Somebody is very levered out there, some bank or something 00:39:22.220 --> 00:39:24.410 align:middle line:90% like that, and you can blow up. 00:39:24.410 --> 00:39:27.980 align:middle line:84% In the UK we had a little scare with some insurance companies, 00:39:27.980 --> 00:39:34.070 align:middle line:84% but that was for a different reason. 00:39:34.070 --> 00:39:37.680 align:middle line:84% But it's scary to move policy very fast because this 00:39:37.680 --> 00:39:40.420 align:middle line:84% is a very important price for financial markets. 00:39:40.420 --> 00:39:43.260 align:middle line:84% Everything in financial market gets priced off-- 00:39:43.260 --> 00:39:46.620 align:middle line:84% that's the starting-- any pricing model for stocks 00:39:46.620 --> 00:39:48.587 align:middle line:84% or anything will start from that policy rate, 00:39:48.587 --> 00:39:50.170 align:middle line:84% and then everything builds from there. 00:39:50.170 --> 00:39:54.300 align:middle line:84% So if this has to move fast, you can have lots of dislocation. 00:39:54.300 --> 00:39:57.232 align:middle line:84% So my goal for today is just to give you the instruments, 00:39:57.232 --> 00:39:59.690 align:middle line:84% and then we're going to all talk about combinations, things 00:39:59.690 --> 00:40:03.230 align:middle line:84% that we did in certain episodes and things of that kind. 00:40:03.230 --> 00:40:04.460 align:middle line:90% OK, good. 00:40:04.460 --> 00:40:09.470 align:middle line:84% So again, this part of the IS-LM model is very easy, 00:40:09.470 --> 00:40:13.130 align:middle line:84% and it's a lot easier now than it was a few years back. 00:40:13.130 --> 00:40:16.220 align:middle line:90% So what does the IS-LM model? 00:40:16.220 --> 00:40:20.480 align:middle line:84% The IS-LM model simply mean puts the two curves together. 00:40:20.480 --> 00:40:23.660 align:middle line:84% Now we have two curves in the space of output and interest 00:40:23.660 --> 00:40:28.450 align:middle line:84% rate and two unknowns, which is output and the interest rate. 00:40:28.450 --> 00:40:33.310 align:middle line:84% So we have one combination only, A, 00:40:33.310 --> 00:40:37.780 align:middle line:84% that is consistent with both equilibrium in the goods market 00:40:37.780 --> 00:40:40.900 align:middle line:84% and equilibrium in financial markets. 00:40:40.900 --> 00:40:46.060 align:middle line:90% That's the point A. 00:40:46.060 --> 00:40:49.840 align:middle line:84% What happens to points to the right? 00:40:49.840 --> 00:40:53.890 align:middle line:84% What happens here if I show you this point in this space? 00:40:53.890 --> 00:40:56.890 align:middle line:90% 00:40:56.890 --> 00:40:58.540 align:middle line:90% What's wrong with that point? 00:40:58.540 --> 00:41:06.500 align:middle line:90% 00:41:06.500 --> 00:41:09.460 align:middle line:84% So a point along the LM but to the right. 00:41:09.460 --> 00:41:10.630 align:middle line:90% What's wrong there? 00:41:10.630 --> 00:41:16.730 align:middle line:90% 00:41:16.730 --> 00:41:20.540 align:middle line:84% If it is along the LM I know that I'm 00:41:20.540 --> 00:41:21.690 align:middle line:90% OK with financial markets. 00:41:21.690 --> 00:41:23.690 align:middle line:84% Those points are consistent with the equilibrium 00:41:23.690 --> 00:41:26.380 align:middle line:90% in financial markets. 00:41:26.380 --> 00:41:27.850 align:middle line:84% But it's not my equilibrium, so it 00:41:27.850 --> 00:41:29.230 align:middle line:84% has to be inconsistent with the other one. 00:41:29.230 --> 00:41:30.730 align:middle line:84% It's not consistent with equilibrium 00:41:30.730 --> 00:41:32.450 align:middle line:90% in the goods markets. 00:41:32.450 --> 00:41:34.510 align:middle line:84% In fact, you know more than that. 00:41:34.510 --> 00:41:36.160 align:middle line:90% What's wrong with goods market? 00:41:36.160 --> 00:41:38.530 align:middle line:84% There's an imbalance there, but in which direction? 00:41:38.530 --> 00:41:42.090 align:middle line:90% 00:41:42.090 --> 00:41:42.830 align:middle line:90% That point here. 00:41:42.830 --> 00:41:46.654 align:middle line:90% 00:41:46.654 --> 00:41:48.860 align:middle line:90% AUDIENCE: Excess of goods. 00:41:48.860 --> 00:41:51.230 align:middle line:84% RICARDO CABALLERO: What do you mean by excess of goods? 00:41:51.230 --> 00:41:52.772 align:middle line:84% AUDIENCE: The demand is not meeting-- 00:41:52.772 --> 00:41:54.022 align:middle line:90% RICARDO CABALLERO: No, demand. 00:41:54.022 --> 00:41:54.547 align:middle line:90% Exactly. 00:41:54.547 --> 00:41:55.380 align:middle line:90% Insufficient demand. 00:41:55.380 --> 00:41:58.450 align:middle line:84% There is too much output for that demand. 00:41:58.450 --> 00:42:00.840 align:middle line:84% So that's the reason it's not consistent with equilibrium 00:42:00.840 --> 00:42:02.730 align:middle line:90% in the goods market. 00:42:02.730 --> 00:42:06.030 align:middle line:90% To the left it's the opposite. 00:42:06.030 --> 00:42:10.450 align:middle line:84% To the left we have insufficient output for the demand we have, 00:42:10.450 --> 00:42:13.240 align:middle line:84% so it's not consistent with the equilibrium in the goods market. 00:42:13.240 --> 00:42:16.110 align:middle line:84% So the only point that is consistent-- well, you 00:42:16.110 --> 00:42:18.885 align:middle line:84% can think, what happens with a point here, for example? 00:42:18.885 --> 00:42:21.400 align:middle line:90% 00:42:21.400 --> 00:42:23.240 align:middle line:84% That point, because it's in the IS curve, 00:42:23.240 --> 00:42:25.413 align:middle line:84% is consistent with equilibrium in the goods market, 00:42:25.413 --> 00:42:27.080 align:middle line:84% but it's not consistent with equilibrium 00:42:27.080 --> 00:42:30.470 align:middle line:90% in financial markets. 00:42:30.470 --> 00:42:31.670 align:middle line:90% What do we have there? 00:42:31.670 --> 00:42:34.050 align:middle line:90% Suppose I'm in that point. 00:42:34.050 --> 00:42:35.820 align:middle line:84% The interest is too high, so that means-- 00:42:35.820 --> 00:42:37.800 align:middle line:84% and the demand is low, so too much 00:42:37.800 --> 00:42:39.750 align:middle line:90% money demand for money supply. 00:42:39.750 --> 00:42:42.390 align:middle line:90% That's what you have. 00:42:42.390 --> 00:42:46.270 align:middle line:84% So at the end of the day, this is the only equilibrium point 00:42:46.270 --> 00:42:46.770 align:middle line:90% we have. 00:42:46.770 --> 00:42:49.350 align:middle line:84% And all the experiments we're going to do next 00:42:49.350 --> 00:42:51.870 align:middle line:84% have to do with moving one curve or the other 00:42:51.870 --> 00:42:56.190 align:middle line:84% and see what happens to trace new equilibrium points. 00:42:56.190 --> 00:42:58.800 align:middle line:84% But try to understand very well these diagrams, 00:42:58.800 --> 00:43:04.050 align:middle line:84% so what happens when I move up, horizontally, and so on, 00:43:04.050 --> 00:43:06.438 align:middle line:84% and convince yourself that this is the only combination. 00:43:06.438 --> 00:43:07.980 align:middle line:84% It's pretty easy to convince yourself 00:43:07.980 --> 00:43:10.560 align:middle line:84% that it's the only combination, but think a little. 00:43:10.560 --> 00:43:13.890 align:middle line:84% Try to get away from point A and see what happens. 00:43:13.890 --> 00:43:16.840 align:middle line:84% I guess the best way to do that is just to do experiments, 00:43:16.840 --> 00:43:19.110 align:middle line:84% meaning move parameters of these curves 00:43:19.110 --> 00:43:21.390 align:middle line:84% and see how equilibrium output changes and so on. 00:43:21.390 --> 00:43:25.730 align:middle line:90% 00:43:25.730 --> 00:43:30.035 align:middle line:84% So let's do the first experiment. 00:43:30.035 --> 00:43:30.535 align:middle line:90% Yeah. 00:43:30.535 --> 00:43:34.020 align:middle line:90% 00:43:34.020 --> 00:43:36.550 align:middle line:90% So let's play with this. 00:43:36.550 --> 00:43:38.940 align:middle line:84% So now you have your model, and now we 00:43:38.940 --> 00:43:41.470 align:middle line:84% can start asking interesting questions. 00:43:41.470 --> 00:43:44.170 align:middle line:84% The first thing you can ask is fiscal policy. 00:43:44.170 --> 00:43:46.460 align:middle line:90% How does it work? 00:43:46.460 --> 00:43:50.380 align:middle line:90% Well-- sorry. 00:43:50.380 --> 00:43:52.835 align:middle line:84% So this is a contractionary fiscal policy. 00:43:52.835 --> 00:43:54.460 align:middle line:84% So the same as we did before, remember, 00:43:54.460 --> 00:43:57.160 align:middle line:84% we increased taxes or we could have reduced government 00:43:57.160 --> 00:43:58.300 align:middle line:90% expenditure, whatever. 00:43:58.300 --> 00:44:00.700 align:middle line:90% That would have shifted IS. 00:44:00.700 --> 00:44:01.660 align:middle line:90% We did that. 00:44:01.660 --> 00:44:04.060 align:middle line:84% When we look at IS, we did exactly that. 00:44:04.060 --> 00:44:07.450 align:middle line:90% We shift the IS to the left. 00:44:07.450 --> 00:44:10.290 align:middle line:84% And what happens here is, well, if you 00:44:10.290 --> 00:44:13.980 align:middle line:84% shift IS to the left there is a new combination of output 00:44:13.980 --> 00:44:16.270 align:middle line:84% and interest rate that is consistent with equilibrium 00:44:16.270 --> 00:44:20.680 align:middle line:84% in both markets, and that's a lower output. 00:44:20.680 --> 00:44:22.690 align:middle line:84% So if the fed doesn't do anything, 00:44:22.690 --> 00:44:24.640 align:middle line:84% that means it keeps the LM there, 00:44:24.640 --> 00:44:27.520 align:middle line:84% and there's a contractionary fiscal policy, 00:44:27.520 --> 00:44:30.277 align:middle line:84% that will lead to a contraction in output as well. 00:44:30.277 --> 00:44:32.110 align:middle line:84% That's the reason we call it contractionary. 00:44:32.110 --> 00:44:33.680 align:middle line:90% Not only because fiscal-- 00:44:33.680 --> 00:44:36.040 align:middle line:84% not only because government expenditure declined. 00:44:36.040 --> 00:44:39.610 align:middle line:84% But if taxes increase, that's contractionary 00:44:39.610 --> 00:44:42.970 align:middle line:84% because it reduces aggregate demand, and the equilibrium, 00:44:42.970 --> 00:44:43.990 align:middle line:90% that will reduce output. 00:44:43.990 --> 00:44:48.830 align:middle line:90% 00:44:48.830 --> 00:44:52.910 align:middle line:84% So that's canonical contractionary fiscal policy. 00:44:52.910 --> 00:44:54.862 align:middle line:90% You move output to the left. 00:44:54.862 --> 00:44:56.570 align:middle line:84% Interest rate doesn't move because that's 00:44:56.570 --> 00:45:02.700 align:middle line:84% controlled by the fed, but output declines. 00:45:02.700 --> 00:45:04.830 align:middle line:84% So if somebody asks you what happens 00:45:04.830 --> 00:45:07.410 align:middle line:84% if there is a fiscal contraction, 00:45:07.410 --> 00:45:10.860 align:middle line:84% you were asking a bit the opposite side, 00:45:10.860 --> 00:45:12.510 align:middle line:90% that people may have spent-- 00:45:12.510 --> 00:45:15.360 align:middle line:84% we had perhaps a fiscal expansion that was very large. 00:45:15.360 --> 00:45:18.420 align:middle line:84% But what happens with a fiscal contraction? 00:45:18.420 --> 00:45:20.212 align:middle line:84% That will lead to lower equilibrium output. 00:45:20.212 --> 00:45:21.587 align:middle line:84% I keep pressing the wrong button. 00:45:21.587 --> 00:45:22.690 align:middle line:90% Lower equilibrium output. 00:45:22.690 --> 00:45:26.680 align:middle line:84% What happens if you have a very large fiscal expansion? 00:45:26.680 --> 00:45:30.110 align:middle line:84% What happens if you have a very large fiscal expansion? 00:45:30.110 --> 00:45:31.640 align:middle line:90% What moves? 00:45:31.640 --> 00:45:33.410 align:middle line:84% That's something you should-- that's 00:45:33.410 --> 00:45:35.780 align:middle line:84% a question-- you should always ask yourself 00:45:35.780 --> 00:45:39.920 align:middle line:84% when there is any question of IS-LM, 00:45:39.920 --> 00:45:43.180 align:middle line:84% you should ask which curve moves. 00:45:43.180 --> 00:45:46.350 align:middle line:90% Start from that always. 00:45:46.350 --> 00:45:50.140 align:middle line:84% If we ask you any question that it's obvious about IS-LM, 00:45:50.140 --> 00:45:53.900 align:middle line:84% the first thing you should ask is which curve will move. 00:45:53.900 --> 00:46:01.630 align:middle line:84% So suppose I tell you due to COVID, the COVID shock, 00:46:01.630 --> 00:46:07.060 align:middle line:84% there was a massive income transfer 00:46:07.060 --> 00:46:09.550 align:middle line:90% to low-income individuals. 00:46:09.550 --> 00:46:13.240 align:middle line:84% That is we had a very expansionary fiscal policy. 00:46:13.240 --> 00:46:14.910 align:middle line:84% First thing you should ask is OK, 00:46:14.910 --> 00:46:17.070 align:middle line:84% which curve moves-- the LM or the IS? 00:46:17.070 --> 00:46:20.170 align:middle line:90% If I do that. 00:46:20.170 --> 00:46:21.280 align:middle line:90% It's the IS. 00:46:21.280 --> 00:46:23.230 align:middle line:90% Shift to the right. 00:46:23.230 --> 00:46:24.260 align:middle line:90% Does LM move? 00:46:24.260 --> 00:46:24.760 align:middle line:90% No. 00:46:24.760 --> 00:46:28.060 align:middle line:84% Has nothing to do with monetary policy. 00:46:28.060 --> 00:46:29.810 align:middle line:84% So that's the first thing you need to do. 00:46:29.810 --> 00:46:32.600 align:middle line:90% Which curve is moving? 00:46:32.600 --> 00:46:35.210 align:middle line:84% If it is fiscal, that's a good market thing. 00:46:35.210 --> 00:46:38.750 align:middle line:84% That means it's going to move the IS. 00:46:38.750 --> 00:46:39.580 align:middle line:90% Not the LM. 00:46:39.580 --> 00:46:44.720 align:middle line:90% 00:46:44.720 --> 00:46:46.860 align:middle line:90% What is the mechanism here? 00:46:46.860 --> 00:46:47.505 align:middle line:90% What happened? 00:46:47.505 --> 00:46:50.790 align:middle line:90% 00:46:50.790 --> 00:46:52.980 align:middle line:90% Remember what we have. 00:46:52.980 --> 00:46:55.140 align:middle line:84% I told you, go always back to this diagram. 00:46:55.140 --> 00:46:57.990 align:middle line:84% If you increase taxes and you keep the interest rate constant 00:46:57.990 --> 00:47:00.930 align:middle line:84% and you start from there so the interest rate doesn't move, 00:47:00.930 --> 00:47:04.020 align:middle line:84% then that will do what increasing taxes did 00:47:04.020 --> 00:47:06.480 align:middle line:84% in lecture three- it will reduce aggregate demand, 00:47:06.480 --> 00:47:08.910 align:middle line:84% and then the multiplier will take us 00:47:08.910 --> 00:47:13.410 align:middle line:84% to a larger decline than the initial fiscal contraction. 00:47:13.410 --> 00:47:15.460 align:middle line:84% And that's a declining equilibrium output. 00:47:15.460 --> 00:47:23.680 align:middle line:84% So that y1 one there is exactly this one here. 00:47:23.680 --> 00:47:25.403 align:middle line:90% That y prime. 00:47:25.403 --> 00:47:26.820 align:middle line:84% I haven't moved the interest rate. 00:47:26.820 --> 00:47:28.570 align:middle line:90% I kept it at the same level. 00:47:28.570 --> 00:47:31.040 align:middle line:90% I had a fiscal contraction. 00:47:31.040 --> 00:47:34.010 align:middle line:84% That's what we described with that diagram. 00:47:34.010 --> 00:47:36.140 align:middle line:90% That's my new IS. 00:47:36.140 --> 00:47:41.170 align:middle line:84% I have a new IS because for the same interest rate 00:47:41.170 --> 00:47:44.170 align:middle line:84% I have a lower equilibrium output. 00:47:44.170 --> 00:47:45.670 align:middle line:84% And it happens that the fed didn't 00:47:45.670 --> 00:47:48.730 align:middle line:84% change the interest rate, so that's going to be [INAUDIBLE].. 00:47:48.730 --> 00:47:50.380 align:middle line:84% With the whole curve moved to the left, 00:47:50.380 --> 00:47:53.980 align:middle line:84% that we could tell three slides ago, but now I know more. 00:47:53.980 --> 00:47:56.640 align:middle line:84% I also know that since the fed hasn't reacted, 00:47:56.640 --> 00:47:58.390 align:middle line:84% I know exactly what is the new equilibrium 00:47:58.390 --> 00:48:00.953 align:middle line:90% output, which is this. 00:48:00.953 --> 00:48:03.620 align:middle line:84% Before, we could only tell that the curve has shift to the left. 00:48:03.620 --> 00:48:07.000 align:middle line:84% Now, since the fed didn't react to that fiscal contraction, 00:48:07.000 --> 00:48:10.630 align:middle line:84% I also know the equilibrium output will end up at y prime. 00:48:10.630 --> 00:48:11.996 align:middle line:90% OK. 00:48:11.996 --> 00:48:13.460 align:middle line:90% Good. 00:48:13.460 --> 00:48:16.380 align:middle line:84% So I'm going to stop here, and in the next lecture 00:48:16.380 --> 00:48:19.870 align:middle line:90% we'll continue with this. 00:48:19.870 --> 00:48:33.000 align:middle line:90%