WEBVTT 00:00:00.000 --> 00:00:01.996 align:middle line:90% [SQUEAKING] 00:00:01.996 --> 00:00:04.491 align:middle line:90% [RUSTLING] 00:00:04.491 --> 00:00:06.986 align:middle line:90% [CLICKING] 00:00:06.986 --> 00:00:16.383 align:middle line:90% 00:00:16.383 --> 00:00:17.800 align:middle line:84% RICARDO J. CABALLERO: OK, so let's 00:00:17.800 --> 00:00:20.180 align:middle line:90% continue with this IS-LM model. 00:00:20.180 --> 00:00:21.590 align:middle line:84% Remember in the previous lecture, 00:00:21.590 --> 00:00:24.310 align:middle line:90% we set up-- we set it up. 00:00:24.310 --> 00:00:26.605 align:middle line:90% We built the IS-LM model. 00:00:26.605 --> 00:00:29.980 align:middle line:84% And we'll go over that very quickly in this lecture 00:00:29.980 --> 00:00:32.030 align:middle line:84% because I think it's very important for you. 00:00:32.030 --> 00:00:33.430 align:middle line:90% And then, we're going to use it. 00:00:33.430 --> 00:00:35.380 align:middle line:84% And eventually, we're going to talk 00:00:35.380 --> 00:00:38.110 align:middle line:84% a little bit about the policy response, 00:00:38.110 --> 00:00:45.280 align:middle line:84% the macroeconomic policy response during the COVID-19 00:00:45.280 --> 00:00:48.530 align:middle line:84% shock, or recession, all of the above. 00:00:48.530 --> 00:00:52.250 align:middle line:90% 00:00:52.250 --> 00:00:54.860 align:middle line:84% So the starting point-- remember, the first thing 00:00:54.860 --> 00:00:57.320 align:middle line:84% we did, we constructed the IS relation. 00:00:57.320 --> 00:01:01.200 align:middle line:84% And the IS relation was just the same as lecture 3. 00:01:01.200 --> 00:01:04.849 align:middle line:84% But we sort of spelled out what is inside that investment 00:01:04.849 --> 00:01:06.960 align:middle line:84% that we had taken as a constant there. 00:01:06.960 --> 00:01:09.290 align:middle line:84% We said, well, far more realistic 00:01:09.290 --> 00:01:11.460 align:middle line:84% is to make investment itself increasing 00:01:11.460 --> 00:01:14.360 align:middle line:84% in output because it's increasing in sales. 00:01:14.360 --> 00:01:18.330 align:middle line:84% That won't change the analysis that we had in lecture three. 00:01:18.330 --> 00:01:21.800 align:middle line:84% All that will do is change the slope of the aggregate demand 00:01:21.800 --> 00:01:23.960 align:middle line:84% curve, and therefore change the multiplier. 00:01:23.960 --> 00:01:25.670 align:middle line:84% But we could have solved everything 00:01:25.670 --> 00:01:27.710 align:middle line:90% in terms of lecture three. 00:01:27.710 --> 00:01:30.200 align:middle line:84% What made this a little different from lecture three 00:01:30.200 --> 00:01:32.990 align:middle line:84% is that we also said the investment-- 00:01:32.990 --> 00:01:34.550 align:middle line:84% real investment-- remember, this has 00:01:34.550 --> 00:01:37.190 align:middle line:84% nothing to do with financial investment-- real investment is 00:01:37.190 --> 00:01:40.070 align:middle line:84% also a decreasing function of the interest rate. 00:01:40.070 --> 00:01:44.795 align:middle line:90% 00:01:44.795 --> 00:01:48.380 align:middle line:84% And that led to the IS relationship, which essentially 00:01:48.380 --> 00:01:51.470 align:middle line:84% says these are all-- the IS curve traces 00:01:51.470 --> 00:01:54.530 align:middle line:84% all the combinations of output and interest rate 00:01:54.530 --> 00:01:57.550 align:middle line:84% that are consistent with equilibrium in the goods market. 00:01:57.550 --> 00:01:59.040 align:middle line:84% That's the definition of that IS. 00:01:59.040 --> 00:02:02.150 align:middle line:84% Now, of course, in lecture three, 00:02:02.150 --> 00:02:05.080 align:middle line:84% we were able to determine the equilibrium output. 00:02:05.080 --> 00:02:07.940 align:middle line:90% Here, we can't. 00:02:07.940 --> 00:02:08.784 align:middle line:90% Why can't we? 00:02:08.784 --> 00:02:16.502 align:middle line:90% 00:02:16.502 --> 00:02:18.710 align:middle line:84% AUDIENCE: Because we're tracing a curve [INAUDIBLE].. 00:02:18.710 --> 00:02:20.168 align:middle line:84% RICARDO J. CABALLERO: Yeah, we have 00:02:20.168 --> 00:02:22.140 align:middle line:84% to announce its output and the interest rate. 00:02:22.140 --> 00:02:26.660 align:middle line:84% And we have only one relationship, the IS curve. 00:02:26.660 --> 00:02:29.360 align:middle line:84% So the reason for the LM curve is 00:02:29.360 --> 00:02:32.660 align:middle line:84% that we need to pin down the second variable. 00:02:32.660 --> 00:02:35.040 align:middle line:90% And that's what LM will do. 00:02:35.040 --> 00:02:37.272 align:middle line:84% And it will be sort of very brutal about it. 00:02:37.272 --> 00:02:39.980 align:middle line:84% In the past, you remember it was some upward-sloping relationship 00:02:39.980 --> 00:02:42.230 align:middle line:84% [INAUDIBLE] said in the previous-- no, that's not what 00:02:42.230 --> 00:02:43.710 align:middle line:90% the central banks do today. 00:02:43.710 --> 00:02:45.360 align:middle line:90% They just set the interest rate. 00:02:45.360 --> 00:02:47.630 align:middle line:84% So if the central bank sets the interest rate, 00:02:47.630 --> 00:02:49.520 align:middle line:84% then you can use lecture three to pin down 00:02:49.520 --> 00:02:52.850 align:middle line:84% equilibrium in the goods market, which is what you would 00:02:52.850 --> 00:02:54.710 align:middle line:90% effectively be doing here. 00:02:54.710 --> 00:02:57.380 align:middle line:84% If you fix this interest rate at whatever level 00:02:57.380 --> 00:02:59.300 align:middle line:84% the central bank wants, then now you 00:02:59.300 --> 00:03:01.740 align:middle line:84% have one curve for one unknown, which is output. 00:03:01.740 --> 00:03:04.580 align:middle line:84% And that's exactly what we saw in lecture three. 00:03:04.580 --> 00:03:06.695 align:middle line:90% OK? 00:03:06.695 --> 00:03:07.195 align:middle line:90% Good. 00:03:07.195 --> 00:03:10.100 align:middle line:90% 00:03:10.100 --> 00:03:13.820 align:middle line:84% So I said, lecture three now, this ZZ curve [INAUDIBLE] 00:03:13.820 --> 00:03:16.550 align:middle line:84% a little steeper because investment also 00:03:16.550 --> 00:03:20.520 align:middle line:84% responds positively to increases in output. 00:03:20.520 --> 00:03:22.570 align:middle line:84% Importantly, now we have an interest rate, 00:03:22.570 --> 00:03:25.470 align:middle line:84% which is a shifted of this aggregate demand. 00:03:25.470 --> 00:03:27.960 align:middle line:84% In particular, if the interest rate goes up, 00:03:27.960 --> 00:03:29.120 align:middle line:90% what happens to that curve? 00:03:29.120 --> 00:03:34.850 align:middle line:90% 00:03:34.850 --> 00:03:37.097 align:middle line:84% So as the interest rate goes up, what 00:03:37.097 --> 00:03:38.680 align:middle line:84% happens to the aggregate demand curve? 00:03:38.680 --> 00:03:41.750 align:middle line:90% 00:03:41.750 --> 00:03:46.350 align:middle line:84% I have two candidates here, down or up. 00:03:46.350 --> 00:03:47.270 align:middle line:90% AUDIENCE: Goes down? 00:03:47.270 --> 00:03:48.395 align:middle line:90% RICARDO J. CABALLERO: Down. 00:03:48.395 --> 00:03:50.230 align:middle line:90% Yeah, because investment drops. 00:03:50.230 --> 00:03:53.227 align:middle line:84% So you can tell me even more by how much-- if I tell you 00:03:53.227 --> 00:03:54.810 align:middle line:84% how much a change in the interest rate 00:03:54.810 --> 00:03:58.260 align:middle line:84% is, and I tell you what is the sensitivity of investment 00:03:58.260 --> 00:04:00.240 align:middle line:84% to the interest rate, you know exactly 00:04:00.240 --> 00:04:01.928 align:middle line:84% by how much this thing will come down. 00:04:01.928 --> 00:04:03.720 align:middle line:84% It's going to be the change in the interest 00:04:03.720 --> 00:04:08.655 align:middle line:84% rate times the sensitivity of the investment function 00:04:08.655 --> 00:04:10.290 align:middle line:90% to the interest rate. 00:04:10.290 --> 00:04:12.800 align:middle line:84% That's not the end of the story, as you well know. 00:04:12.800 --> 00:04:15.000 align:middle line:84% That's the horizontal shift in aggregate demand. 00:04:15.000 --> 00:04:16.709 align:middle line:84% But the final decline in output will 00:04:16.709 --> 00:04:19.860 align:middle line:84% be larger than that initial decline in investment 00:04:19.860 --> 00:04:21.899 align:middle line:84% as a result of the higher interest rate. 00:04:21.899 --> 00:04:22.880 align:middle line:90% Why is that? 00:04:22.880 --> 00:04:26.370 align:middle line:90% 00:04:26.370 --> 00:04:32.850 align:middle line:84% So someone, say the Fed, raises interest rate, 00:04:32.850 --> 00:04:35.580 align:middle line:84% that immediately reduces investment 00:04:35.580 --> 00:04:39.510 align:middle line:84% because investment is negatively related to the interest rate. 00:04:39.510 --> 00:04:43.080 align:middle line:84% That immediately decreases aggregate demand, which 00:04:43.080 --> 00:04:44.952 align:middle line:90% immediately decreases output. 00:04:44.952 --> 00:04:46.410 align:middle line:84% Because in this part of the course, 00:04:46.410 --> 00:04:49.600 align:middle line:84% output is determined by aggregate demand. 00:04:49.600 --> 00:04:52.850 align:middle line:84% Thus, the adjustments stopped there. 00:04:52.850 --> 00:04:55.490 align:middle line:84% No, that's what the multiplier was about. 00:04:55.490 --> 00:04:58.580 align:middle line:84% Because now with lower income, there is lower consumption 00:04:58.580 --> 00:05:01.020 align:middle line:84% and actually lower investment as a result of that, 00:05:01.020 --> 00:05:02.410 align:middle line:90% and we keep going. 00:05:02.410 --> 00:05:06.140 align:middle line:84% So the final decline in output is a lot larger. 00:05:06.140 --> 00:05:08.480 align:middle line:84% And doing that kind of experiment, 00:05:08.480 --> 00:05:10.310 align:middle line:84% moving the interest rate around and seeing 00:05:10.310 --> 00:05:12.020 align:middle line:84% what happens to equilibrium output, 00:05:12.020 --> 00:05:17.780 align:middle line:84% is that we derive-- we constructed the IS curve. 00:05:17.780 --> 00:05:21.965 align:middle line:84% Here is for-- a cut in the interest rate. 00:05:21.965 --> 00:05:24.470 align:middle line:84% Oh, this is exactly the experiment I just described. 00:05:24.470 --> 00:05:27.080 align:middle line:84% So if you raise the interest rate, 00:05:27.080 --> 00:05:28.820 align:middle line:84% then aggregate demand comes down. 00:05:28.820 --> 00:05:30.653 align:middle line:84% And then output declines by a lot more 00:05:30.653 --> 00:05:32.570 align:middle line:84% than the initial decline in investment because 00:05:32.570 --> 00:05:34.550 align:middle line:84% of the multiplier, but eventually, we 00:05:34.550 --> 00:05:37.370 align:middle line:84% get to another equilibrium output, which is that. 00:05:37.370 --> 00:05:40.520 align:middle line:84% So now we know that this point belongs to the IS curve 00:05:40.520 --> 00:05:44.390 align:middle line:84% because it's a combination of output, Y-prime, and interest 00:05:44.390 --> 00:05:47.090 align:middle line:84% rate, I-prime, that is consistent with the equilibrium 00:05:47.090 --> 00:05:48.090 align:middle line:90% in the goods market. 00:05:48.090 --> 00:05:49.910 align:middle line:84% That's what lecture three told us. 00:05:49.910 --> 00:05:53.020 align:middle line:84% That's what equilibrium in the goods markets look like. 00:05:53.020 --> 00:05:56.010 align:middle line:84% That's another point of the same IS. 00:05:56.010 --> 00:06:00.220 align:middle line:84% Because I have higher output here, lower interest rate. 00:06:00.220 --> 00:06:01.560 align:middle line:90% That's another point of the IS. 00:06:01.560 --> 00:06:03.960 align:middle line:84% That's the reason this is downward sloping. 00:06:03.960 --> 00:06:05.190 align:middle line:90% Look at what I just said. 00:06:05.190 --> 00:06:09.240 align:middle line:84% I said, I have another point of the same IS. 00:06:09.240 --> 00:06:13.950 align:middle line:84% How do I know it's the same IS and not some other IS? 00:06:13.950 --> 00:06:19.445 align:middle line:90% 00:06:19.445 --> 00:06:22.640 align:middle line:84% All that I told you there is I found two points, 00:06:22.640 --> 00:06:25.310 align:middle line:84% two combinations of output and interest rate, 00:06:25.310 --> 00:06:28.170 align:middle line:84% that are consistent with equilibrium in the goods market. 00:06:28.170 --> 00:06:29.370 align:middle line:90% But I said a little more. 00:06:29.370 --> 00:06:32.575 align:middle line:84% I said, and that's part-- that's the way we construct one IS. 00:06:32.575 --> 00:06:34.870 align:middle line:90% 00:06:34.870 --> 00:06:37.620 align:middle line:84% AUDIENCE: Because you're holding everything like tax [INAUDIBLE].. 00:06:37.620 --> 00:06:38.370 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:06:38.370 --> 00:06:40.912 align:middle line:84% Because there is a lot of other parameters that we're keeping 00:06:40.912 --> 00:06:43.360 align:middle line:90% constant there. 00:06:43.360 --> 00:06:45.160 align:middle line:84% That's the distinction between a movement 00:06:45.160 --> 00:06:47.110 align:middle line:90% along an IS curve, which is-- 00:06:47.110 --> 00:06:49.060 align:middle line:84% the only thing I move is the interest rate 00:06:49.060 --> 00:06:53.410 align:middle line:84% that allows me to trace a movement along a single IS. 00:06:53.410 --> 00:06:57.040 align:middle line:84% If I move something else, like taxes, foreign expenditure, 00:06:57.040 --> 00:06:59.590 align:middle line:90% or autonomous consumption by-- 00:06:59.590 --> 00:07:03.850 align:middle line:84% something like that, then I will be shifting the aggregate demand 00:07:03.850 --> 00:07:05.450 align:middle line:90% for any given interest rate. 00:07:05.450 --> 00:07:06.910 align:middle line:84% And I'm going to get a different level of output 00:07:06.910 --> 00:07:08.743 align:middle line:84% for any given interest rate, which means I'm 00:07:08.743 --> 00:07:12.060 align:middle line:90% going to be in a different IS. 00:07:12.060 --> 00:07:13.740 align:middle line:90% And that's what we did there. 00:07:13.740 --> 00:07:16.680 align:middle line:84% In that case there, we said, look, 00:07:16.680 --> 00:07:19.210 align:middle line:84% I can fix the interest rate, any interest rate you want. 00:07:19.210 --> 00:07:20.080 align:middle line:90% Let's pick this one. 00:07:20.080 --> 00:07:22.163 align:middle line:84% But I could have done it at an interest rate here, 00:07:22.163 --> 00:07:23.410 align:middle line:90% there, whatever. 00:07:23.410 --> 00:07:26.530 align:middle line:84% And now, I say, what happens if I increase taxes? 00:07:26.530 --> 00:07:29.340 align:middle line:84% Well, again, you know from lecture three exactly what 00:07:29.340 --> 00:07:31.362 align:middle line:84% happens when the interest rate is constant 00:07:31.362 --> 00:07:33.820 align:middle line:84% because there, we didn't even talk about the interest rate. 00:07:33.820 --> 00:07:36.525 align:middle line:84% Nothing was a function of the interest rate. 00:07:36.525 --> 00:07:37.980 align:middle line:90% And you increase taxes. 00:07:37.980 --> 00:07:39.720 align:middle line:84% Well, that would reduce disposable income 00:07:39.720 --> 00:07:45.173 align:middle line:84% for any given level of output, and that 00:07:45.173 --> 00:07:47.590 align:middle line:84% will lead to a contraction in aggregate demand and output, 00:07:47.590 --> 00:07:48.630 align:middle line:90% and so on, and so forth. 00:07:48.630 --> 00:07:51.610 align:middle line:84% So that means that for this interest rate, 00:07:51.610 --> 00:07:53.940 align:middle line:90% now I found another point-- 00:07:53.940 --> 00:07:57.660 align:middle line:84% another point that is an equilibrium in the goods market. 00:07:57.660 --> 00:08:00.060 align:middle line:84% But it belongs to a different IS because I 00:08:00.060 --> 00:08:02.840 align:middle line:84% moved one of the parameters, which is the taxes. 00:08:02.840 --> 00:08:04.902 align:middle line:84% And now for this higher level of taxes, 00:08:04.902 --> 00:08:06.610 align:middle line:84% I can play around with the interest rate. 00:08:06.610 --> 00:08:08.920 align:middle line:84% I can say, well, what happens if I cut interest rates? 00:08:08.920 --> 00:08:10.295 align:middle line:84% Well, if I cut the interest rate, 00:08:10.295 --> 00:08:13.135 align:middle line:84% we're going to find another equilibrium, say here-- 00:08:13.135 --> 00:08:15.010 align:middle line:84% if I cut the interest rate from here to here, 00:08:15.010 --> 00:08:18.200 align:middle line:84% I'm going to find another equilibrium level of output 00:08:18.200 --> 00:08:20.710 align:middle line:84% which is consistent with that very same IS. 00:08:20.710 --> 00:08:22.240 align:middle line:90% Why is that very same IS? 00:08:22.240 --> 00:08:25.130 align:middle line:84% Well, because I haven't moved taxes again. 00:08:25.130 --> 00:08:29.275 align:middle line:84% So the reason I'm repeating this is because, I told you, 00:08:29.275 --> 00:08:30.650 align:middle line:84% it's very important to understand 00:08:30.650 --> 00:08:35.210 align:middle line:84% what is a movement along the IS versus what shifts the IS. 00:08:35.210 --> 00:08:37.860 align:middle line:90% OK? 00:08:37.860 --> 00:08:39.500 align:middle line:90% Good. 00:08:39.500 --> 00:08:42.080 align:middle line:84% Then, we move to the LM relation. 00:08:42.080 --> 00:08:44.390 align:middle line:84% And the LM relation is just equilibrium 00:08:44.390 --> 00:08:45.800 align:middle line:90% in the financial markets. 00:08:45.800 --> 00:08:47.960 align:middle line:84% This is combinations of output and interest rate 00:08:47.960 --> 00:08:49.460 align:middle line:84% that are consistent with equilibrium 00:08:49.460 --> 00:08:51.350 align:middle line:90% in financial markets. 00:08:51.350 --> 00:08:54.890 align:middle line:84% And we constructed from our money supply 00:08:54.890 --> 00:08:57.510 align:middle line:84% equal to money demand in nominal terms. 00:08:57.510 --> 00:08:59.210 align:middle line:84% Then, we divided by P, which is not 00:08:59.210 --> 00:09:01.002 align:middle line:84% very interesting in this part of the course 00:09:01.002 --> 00:09:01.950 align:middle line:90% because P is constant. 00:09:01.950 --> 00:09:03.570 align:middle line:84% We are assuming that P is not moving. 00:09:03.570 --> 00:09:05.910 align:middle line:84% That's the price of goods and services. 00:09:05.910 --> 00:09:09.020 align:middle line:84% And then we have this equilibrium here 00:09:09.020 --> 00:09:10.770 align:middle line:90% now stated in real terms. 00:09:10.770 --> 00:09:15.030 align:middle line:84% So real money supply is equal to real money demand. 00:09:15.030 --> 00:09:18.770 align:middle line:84% And as I said, had you taken this course a few years back, 00:09:18.770 --> 00:09:22.310 align:middle line:84% or perhaps in other places, that would have been 00:09:22.310 --> 00:09:23.880 align:middle line:90% an upward-sloping relationship. 00:09:23.880 --> 00:09:26.393 align:middle line:84% So the LM would have been an upward-sloping relationship. 00:09:26.393 --> 00:09:27.810 align:middle line:84% How do I know it's upward-sloping? 00:09:27.810 --> 00:09:30.590 align:middle line:84% Well, because if I don't change money supply 00:09:30.590 --> 00:09:35.160 align:middle line:84% and I increase output, then I need to bring LI down. 00:09:35.160 --> 00:09:39.300 align:middle line:84% And since L-prime is negative, the way to bring L down 00:09:39.300 --> 00:09:40.900 align:middle line:84% is by increasing the interest rate. 00:09:40.900 --> 00:09:42.780 align:middle line:84% So that's what it would have given you, 00:09:42.780 --> 00:09:45.880 align:middle line:90% an upward-sloping LM curve. 00:09:45.880 --> 00:09:48.780 align:middle line:84% I said, we don't do that now because, really, banks, 00:09:48.780 --> 00:09:51.540 align:middle line:84% central banks abandoned a long time ago in most parts 00:09:51.540 --> 00:09:55.440 align:middle line:84% of the world-- not everywhere-- this idea of targeting M. 00:09:55.440 --> 00:09:57.810 align:middle line:84% But they target directly the interest rate, 00:09:57.810 --> 00:10:00.390 align:middle line:84% and then they give you whatever M that you need-- 00:10:00.390 --> 00:10:04.375 align:middle line:84% they need in order for the equilibrium in financial markets 00:10:04.375 --> 00:10:06.000 align:middle line:84% to be consistent with the interest rate 00:10:06.000 --> 00:10:08.870 align:middle line:90% the central bank wants to set. 00:10:08.870 --> 00:10:13.615 align:middle line:84% So I said the modern IS curve really looks like that. 00:10:13.615 --> 00:10:17.440 align:middle line:84% The Fed and the US central bank, anywhere else, 00:10:17.440 --> 00:10:19.270 align:middle line:90% sets the interest rate. 00:10:19.270 --> 00:10:20.620 align:middle line:90% Turkey is a little different. 00:10:20.620 --> 00:10:23.130 align:middle line:84% [SOFT LAUGHS] But sets the interest rate. 00:10:23.130 --> 00:10:27.630 align:middle line:90% 00:10:27.630 --> 00:10:29.340 align:middle line:90% And that's the LM. 00:10:29.340 --> 00:10:33.420 align:middle line:90% Now, this particular LM says-- 00:10:33.420 --> 00:10:34.630 align:middle line:90% it's a flat curve. 00:10:34.630 --> 00:10:35.950 align:middle line:90% It's not a function of output. 00:10:35.950 --> 00:10:38.530 align:middle line:90% The Fed sets the interest rate. 00:10:38.530 --> 00:10:39.320 align:middle line:90% That's it. 00:10:39.320 --> 00:10:41.230 align:middle line:90% That's the reason. 00:10:41.230 --> 00:10:42.040 align:middle line:90% It's flat. 00:10:42.040 --> 00:10:44.040 align:middle line:84% It's not upward-sloping or anything. 00:10:44.040 --> 00:10:46.870 align:middle line:84% So I asked the question, what shifts the modern LM? 00:10:46.870 --> 00:10:49.720 align:middle line:90% 00:10:49.720 --> 00:10:51.053 align:middle line:90% Only the central bank. 00:10:51.053 --> 00:10:53.470 align:middle line:84% Because the central bank is the one that sets the interest 00:10:53.470 --> 00:10:56.770 align:middle line:90% rate, certainly in-- 00:10:56.770 --> 00:11:00.467 align:middle line:84% well, let me not complicate things. 00:11:00.467 --> 00:11:01.550 align:middle line:90% So it's the interest rate. 00:11:01.550 --> 00:11:03.910 align:middle line:84% So if the central bank doesn't change its mind, 00:11:03.910 --> 00:11:06.050 align:middle line:84% then the interest rate is whatever it is, 00:11:06.050 --> 00:11:08.140 align:middle line:90% and the LM will remain there. 00:11:08.140 --> 00:11:09.520 align:middle line:90% OK? 00:11:09.520 --> 00:11:10.830 align:middle line:90% Good. 00:11:10.830 --> 00:11:12.600 align:middle line:84% So we put the two things together, 00:11:12.600 --> 00:11:14.890 align:middle line:84% and now we can pin down equilibrium output. 00:11:14.890 --> 00:11:17.460 align:middle line:84% Because remember, we had-- when we just looked at the IS, 00:11:17.460 --> 00:11:19.523 align:middle line:84% we had combinations of interest rate and output 00:11:19.523 --> 00:11:21.940 align:middle line:84% that were consistent with equilibrium in the goods market. 00:11:21.940 --> 00:11:24.053 align:middle line:84% Now we have an interest rate which 00:11:24.053 --> 00:11:25.470 align:middle line:84% is consistent with the equilibrium 00:11:25.470 --> 00:11:27.990 align:middle line:84% in financial markets, that's what the central bank is there 00:11:27.990 --> 00:11:29.040 align:middle line:90% to ensure. 00:11:29.040 --> 00:11:31.320 align:middle line:84% And so at that interest rate, we can 00:11:31.320 --> 00:11:33.420 align:middle line:84% look into the IS, what is the level of output that 00:11:33.420 --> 00:11:34.540 align:middle line:90% corresponds to that. 00:11:34.540 --> 00:11:35.860 align:middle line:90% That's what we get here. 00:11:35.860 --> 00:11:39.580 align:middle line:90% So now, we found an equilibrium. 00:11:39.580 --> 00:11:41.490 align:middle line:84% We found a combination of interest and output 00:11:41.490 --> 00:11:44.520 align:middle line:84% that is consistent with the equilibrium in both goods 00:11:44.520 --> 00:11:47.000 align:middle line:90% markets and financial markets. 00:11:47.000 --> 00:11:49.630 align:middle line:84% And that's what the IS-LM model is about. 00:11:49.630 --> 00:11:54.390 align:middle line:84% It's about finding those combinations. 00:11:54.390 --> 00:11:54.890 align:middle line:90% Good. 00:11:54.890 --> 00:11:59.750 align:middle line:90% 00:11:59.750 --> 00:12:02.100 align:middle line:90% Is this very clear? 00:12:02.100 --> 00:12:02.600 align:middle line:90% Yes? 00:12:02.600 --> 00:12:05.180 align:middle line:90% 00:12:05.180 --> 00:12:08.180 align:middle line:90% OK, good. 00:12:08.180 --> 00:12:11.140 align:middle line:84% So now we can begin to play with this stuff. 00:12:11.140 --> 00:12:13.250 align:middle line:84% One of the main purposes of the IS-LM model 00:12:13.250 --> 00:12:18.570 align:middle line:84% is to understand policy, macroeconomic policies, 00:12:18.570 --> 00:12:21.080 align:middle line:84% what you should do in certain environments or not. 00:12:21.080 --> 00:12:22.580 align:middle line:84% Well, before knowing what you should 00:12:22.580 --> 00:12:24.320 align:middle line:84% do in certain environments, you need 00:12:24.320 --> 00:12:26.720 align:middle line:84% to understand what is it that the different macroeconomic 00:12:26.720 --> 00:12:29.970 align:middle line:84% policies do to equilibrium output and interest rate, 00:12:29.970 --> 00:12:30.720 align:middle line:90% and so on. 00:12:30.720 --> 00:12:32.970 align:middle line:84% And so that's what we began to do. 00:12:32.970 --> 00:12:36.950 align:middle line:84% And the first experiment was one of fiscal policy. 00:12:36.950 --> 00:12:40.100 align:middle line:84% So that's an example of a contractionary fiscal policy. 00:12:40.100 --> 00:12:42.890 align:middle line:84% That could happen as a-- contractionary fiscal policy 00:12:42.890 --> 00:12:46.040 align:middle line:84% is essentially increasing taxes, like we 00:12:46.040 --> 00:12:48.530 align:middle line:84% illustrated before, or a reduction in government 00:12:48.530 --> 00:12:49.350 align:middle line:90% expenditure. 00:12:49.350 --> 00:12:54.740 align:middle line:84% Either of those will lead to a shift in the IS to the left. 00:12:54.740 --> 00:13:00.080 align:middle line:84% Remember from lecture three, if I increase taxes or reduce 00:13:00.080 --> 00:13:03.150 align:middle line:84% government expenditure, equilibrium output will fall. 00:13:03.150 --> 00:13:04.395 align:middle line:90% Thus, lecture three. 00:13:04.395 --> 00:13:04.895 align:middle line:90% Remember? 00:13:04.895 --> 00:13:07.920 align:middle line:90% 00:13:07.920 --> 00:13:09.120 align:middle line:90% And so I can trace-- 00:13:09.120 --> 00:13:12.390 align:middle line:84% using lecture three, I can tell you, well, the IS 00:13:12.390 --> 00:13:14.220 align:middle line:90% will shift to the left. 00:13:14.220 --> 00:13:16.200 align:middle line:90% No, we just did that. 00:13:16.200 --> 00:13:18.300 align:middle line:84% But now we know more because we know 00:13:18.300 --> 00:13:21.040 align:middle line:84% that the central bank is also pinning down the interest rate. 00:13:21.040 --> 00:13:23.550 align:middle line:84% And in this particular example here, the central bank 00:13:23.550 --> 00:13:25.825 align:middle line:84% did not go along with the Treasury Department 00:13:25.825 --> 00:13:28.200 align:middle line:84% and say, OK, I'm going to keep the interest rate wherever 00:13:28.200 --> 00:13:28.700 align:middle line:90% it is. 00:13:28.700 --> 00:13:33.580 align:middle line:84% You do whatever you want with the fiscal policy. 00:13:33.580 --> 00:13:36.150 align:middle line:84% So this is an example of a situation where 00:13:36.150 --> 00:13:41.130 align:middle line:84% fiscal policy is contractionary and the central bank remains 00:13:41.130 --> 00:13:44.140 align:middle line:84% with its previous target, interest rate target. 00:13:44.140 --> 00:13:48.580 align:middle line:84% So as a result of that, a contractionary fiscal policy, 00:13:48.580 --> 00:13:51.460 align:middle line:84% as the word says then, is a contraction 00:13:51.460 --> 00:13:55.120 align:middle line:84% in aggregate demand policy ends up also 00:13:55.120 --> 00:13:58.680 align:middle line:84% leading to a lower equilibrium output. 00:13:58.680 --> 00:14:04.840 align:middle line:84% And then I ask, I already told you two things, T up or G down. 00:14:04.840 --> 00:14:07.630 align:middle line:84% But what else would do something similar to this, 00:14:07.630 --> 00:14:08.585 align:middle line:90% which is not policy? 00:14:08.585 --> 00:14:21.305 align:middle line:90% 00:14:21.305 --> 00:14:23.790 align:middle line:84% AUDIENCE: Just any shock of aggregate demand, right? 00:14:23.790 --> 00:14:24.330 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:14:24.330 --> 00:14:26.280 align:middle line:84% I want anything that is a shock to aggregate demand 00:14:26.280 --> 00:14:28.405 align:middle line:84% different from interest rate or anything like that. 00:14:28.405 --> 00:14:30.930 align:middle line:84% So, for example, consumer confidence, 00:14:30.930 --> 00:14:32.700 align:middle line:90% that thing that we put in C0. 00:14:32.700 --> 00:14:34.980 align:middle line:84% Or wealth, something that wasn't in the model 00:14:34.980 --> 00:14:37.710 align:middle line:84% but clearly what is behind C0, that 00:14:37.710 --> 00:14:40.710 align:middle line:84% would lead to a shock like that, and that's contractionary. 00:14:40.710 --> 00:14:44.370 align:middle line:84% That's the reason central banks and financial markets 00:14:44.370 --> 00:14:47.550 align:middle line:84% are all the time looking at the releases of surveys of consumer 00:14:47.550 --> 00:14:49.890 align:middle line:84% confidence and things of that kind 00:14:49.890 --> 00:14:54.630 align:middle line:84% because these are the implications of shocks 00:14:54.630 --> 00:14:57.360 align:middle line:84% to consumer confidence and so on. 00:14:57.360 --> 00:14:58.390 align:middle line:90% OK, good. 00:14:58.390 --> 00:15:02.460 align:middle line:84% So what is the mechanism here, well, we 00:15:02.460 --> 00:15:05.820 align:middle line:84% have discussed it multiple times. 00:15:05.820 --> 00:15:09.560 align:middle line:84% The contraction in fiscal policy lowers the aggregate demand 00:15:09.560 --> 00:15:10.060 align:middle line:90% down. 00:15:10.060 --> 00:15:14.070 align:middle line:84% Then, we multiply and you end up lowering output a lot more. 00:15:14.070 --> 00:15:15.935 align:middle line:84% And this happens for a given interest rate. 00:15:15.935 --> 00:15:17.310 align:middle line:84% I'm having the same interest rate 00:15:17.310 --> 00:15:22.410 align:middle line:84% here and there because I'm looking at two points 00:15:22.410 --> 00:15:28.230 align:middle line:84% along for a fixed LM, for a fixed interest rate. 00:15:28.230 --> 00:15:30.280 align:middle line:90% Good. 00:15:30.280 --> 00:15:32.840 align:middle line:84% So that's the contractionary monetary policy. 00:15:32.840 --> 00:15:37.990 align:middle line:84% Needless to say, an expansionary fiscal policy 00:15:37.990 --> 00:15:39.880 align:middle line:84% is just a shift in the opposite direction. 00:15:39.880 --> 00:15:42.820 align:middle line:84% So what will an expansionary fiscal policy 00:15:42.820 --> 00:15:44.025 align:middle line:90% do to equilibrium output? 00:15:44.025 --> 00:15:47.970 align:middle line:90% 00:15:47.970 --> 00:15:49.840 align:middle line:90% Expansionary. 00:15:49.840 --> 00:15:52.380 align:middle line:84% It will increase output, again, contractionary 00:15:52.380 --> 00:15:55.132 align:middle line:84% fiscal policy reduce output or will it do the opposite? 00:15:55.132 --> 00:15:56.590 align:middle line:84% Obviously, it will increase output. 00:15:56.590 --> 00:15:58.140 align:middle line:84% So that's expansionary fiscal policy. 00:15:58.140 --> 00:16:01.050 align:middle line:84% And it's a very important tool to move output 00:16:01.050 --> 00:16:03.630 align:middle line:84% around when the economy's in a recession, 00:16:03.630 --> 00:16:06.340 align:middle line:90% or so on and so forth. 00:16:06.340 --> 00:16:08.560 align:middle line:84% The other canonical macroeconomic policy 00:16:08.560 --> 00:16:09.770 align:middle line:90% is monetary policy. 00:16:09.770 --> 00:16:13.630 align:middle line:84% And that's an example of an expansionary monetary policy. 00:16:13.630 --> 00:16:17.530 align:middle line:84% So an expansionary monetary policy cuts the interest rate. 00:16:17.530 --> 00:16:18.940 align:middle line:90% Why is that expansionary? 00:16:18.940 --> 00:16:23.050 align:middle line:90% Well, look, it is expansionary-- 00:16:23.050 --> 00:16:25.015 align:middle line:90% let me take this as-- 00:16:25.015 --> 00:16:26.390 align:middle line:84% I'm going to do things in a step. 00:16:26.390 --> 00:16:29.080 align:middle line:90% So claim first. 00:16:29.080 --> 00:16:31.575 align:middle line:84% An expansionary monetary policy is a reduction 00:16:31.575 --> 00:16:32.450 align:middle line:90% in the interest rate. 00:16:32.450 --> 00:16:35.200 align:middle line:84% So the central bank now decides to set a lower interest 00:16:35.200 --> 00:16:37.030 align:middle line:90% rate than it used to. 00:16:37.030 --> 00:16:39.010 align:middle line:90% As a result of that-- 00:16:39.010 --> 00:16:41.140 align:middle line:84% if output didn't change, what would 00:16:41.140 --> 00:16:43.840 align:middle line:90% happen in the goods market? 00:16:43.840 --> 00:16:47.230 align:middle line:84% So suppose that the Fed cuts the interest rate and output doesn't 00:16:47.230 --> 00:16:48.670 align:middle line:90% change. 00:16:48.670 --> 00:16:50.535 align:middle line:84% Is there an equilibrium in the goods market? 00:16:50.535 --> 00:16:57.787 align:middle line:90% 00:16:57.787 --> 00:16:59.620 align:middle line:84% Is there an equilibrium in the goods market? 00:16:59.620 --> 00:17:03.890 align:middle line:84% Suppose that the Fed cuts the interest rate and now we say, 00:17:03.890 --> 00:17:05.510 align:middle line:84% OK, well, nothing will happen here. 00:17:05.510 --> 00:17:07.190 align:middle line:90% Output will stay where it is. 00:17:07.190 --> 00:17:10.560 align:middle line:84% We will have a lower interest rate, that's nice. 00:17:10.560 --> 00:17:15.050 align:middle line:84% Why is that not the final outcome of the monetary policy 00:17:15.050 --> 00:17:17.936 align:middle line:90% expansion? 00:17:17.936 --> 00:17:20.062 align:middle line:84% AUDIENCE: Because then the [INAUDIBLE] market 00:17:20.062 --> 00:17:21.770 align:middle line:84% reacts and aggregate demand [INAUDIBLE].. 00:17:21.770 --> 00:17:23.210 align:middle line:84% RICARDO J. CABALLERO: Exactly, this is an imbalance. 00:17:23.210 --> 00:17:25.760 align:middle line:84% No, because aggregate demand now, at low interest rate, 00:17:25.760 --> 00:17:27.530 align:middle line:90% investment will go up. 00:17:27.530 --> 00:17:29.390 align:middle line:84% This fiscal investment, remember, 00:17:29.390 --> 00:17:31.110 align:middle line:84% purchases of goods and services by firms 00:17:31.110 --> 00:17:33.110 align:middle line:84% for the purpose of building capital, structures, 00:17:33.110 --> 00:17:33.985 align:middle line:90% and things like that. 00:17:33.985 --> 00:17:37.853 align:middle line:84% So aggregate demand went up, so now we 00:17:37.853 --> 00:17:39.020 align:middle line:90% have a disequilibrium there. 00:17:39.020 --> 00:17:40.400 align:middle line:84% Output is less than aggregate demand. 00:17:40.400 --> 00:17:42.817 align:middle line:84% And we know that output is determined by aggregate demand, 00:17:42.817 --> 00:17:45.500 align:middle line:84% and then we go on through all the mechanism. 00:17:45.500 --> 00:17:47.690 align:middle line:84% So at this point, it's not at equilibrium. 00:17:47.690 --> 00:17:50.420 align:middle line:84% We're going to end up with a higher level of output. 00:17:50.420 --> 00:17:53.390 align:middle line:84% At that lower interest rate, we have a lower level of output. 00:17:53.390 --> 00:17:55.430 align:middle line:84% Therefore, it's not surprising that we 00:17:55.430 --> 00:17:57.900 align:middle line:84% call this an expansionary monetary policy. 00:17:57.900 --> 00:17:59.660 align:middle line:84% So when the Fed cuts the interest rate, 00:17:59.660 --> 00:18:02.450 align:middle line:84% that's an expansionary monetary policy. 00:18:02.450 --> 00:18:07.810 align:middle line:84% This will expand aggregate demand. 00:18:07.810 --> 00:18:10.810 align:middle line:84% So how does the Fed implement this? 00:18:10.810 --> 00:18:11.350 align:middle line:90% Sorry. 00:18:11.350 --> 00:18:13.420 align:middle line:84% AUDIENCE: They can do expansionary open market 00:18:13.420 --> 00:18:13.990 align:middle line:90% operations. 00:18:13.990 --> 00:18:15.740 align:middle line:84% RICARDO J. CABALLERO: Yeah, there you are. 00:18:15.740 --> 00:18:16.360 align:middle line:90% Perfect. 00:18:16.360 --> 00:18:22.090 align:middle line:84% So what they need to do is do some expansionary monetary open 00:18:22.090 --> 00:18:23.350 align:middle line:90% market operation. 00:18:23.350 --> 00:18:25.940 align:middle line:84% Again, now it's a little more sophisticated than that, 00:18:25.940 --> 00:18:28.240 align:middle line:90% but let's stick with this. 00:18:28.240 --> 00:18:30.430 align:middle line:84% That is the first thing they'll do 00:18:30.430 --> 00:18:33.250 align:middle line:90% is they'll shift money supply. 00:18:33.250 --> 00:18:36.250 align:middle line:84% They'll go out there and they start buying bonds and giving 00:18:36.250 --> 00:18:38.110 align:middle line:90% money to-- 00:18:38.110 --> 00:18:42.100 align:middle line:84% injecting money into the system, particularly through the banks. 00:18:42.100 --> 00:18:43.670 align:middle line:90% So that's the initial response. 00:18:43.670 --> 00:18:46.380 align:middle line:84% That's what will cut the interest rate. 00:18:46.380 --> 00:18:47.300 align:middle line:90% What happens next? 00:18:47.300 --> 00:18:54.625 align:middle line:90% 00:18:54.625 --> 00:18:57.940 align:middle line:84% This will allow me to illustrate the modern IS. 00:18:57.940 --> 00:19:02.050 align:middle line:84% Remember, the Fed's decision was not 00:19:02.050 --> 00:19:07.360 align:middle line:84% to increase the money supply by 35%. 00:19:07.360 --> 00:19:09.460 align:middle line:84% What the Fed communicated to the market 00:19:09.460 --> 00:19:12.070 align:middle line:84% was that it was going to cut interest rates by 50 basis 00:19:12.070 --> 00:19:12.660 align:middle line:90% points. 00:19:12.660 --> 00:19:14.080 align:middle line:90% That's the communication. 00:19:14.080 --> 00:19:18.670 align:middle line:84% So initially, the way it does that overnight is it 00:19:18.670 --> 00:19:20.350 align:middle line:90% goes out and does exactly that. 00:19:20.350 --> 00:19:24.990 align:middle line:90% 00:19:24.990 --> 00:19:30.570 align:middle line:84% So what it did is what we have there. 00:19:30.570 --> 00:19:32.910 align:middle line:90% We had some interest rate, I0. 00:19:32.910 --> 00:19:37.630 align:middle line:90% 00:19:37.630 --> 00:19:39.960 align:middle line:90% The Fed now wants to go to I1. 00:19:39.960 --> 00:19:44.954 align:middle line:90% 00:19:44.954 --> 00:19:46.890 align:middle line:84% So in order to do that, well, you 00:19:46.890 --> 00:19:52.920 align:middle line:84% have to look at this money demand and increase money supply 00:19:52.920 --> 00:19:54.580 align:middle line:84% to achieve the lower interest rate. 00:19:54.580 --> 00:19:57.275 align:middle line:84% The question I'm asking you now, does it stop there? 00:19:57.275 --> 00:19:59.850 align:middle line:90% 00:19:59.850 --> 00:20:02.760 align:middle line:84% So the Fed says, OK, I did my job, 00:20:02.760 --> 00:20:04.630 align:middle line:84% I want to lower the interest rate. 00:20:04.630 --> 00:20:06.690 align:middle line:84% I'm going to increase M. I increase M. 00:20:06.690 --> 00:20:09.150 align:middle line:84% And now, I manage to bring the interest rate down 00:20:09.150 --> 00:20:10.180 align:middle line:90% to that point. 00:20:10.180 --> 00:20:12.940 align:middle line:84% And that-- they're intervening overnight market, 00:20:12.940 --> 00:20:15.290 align:middle line:90% so that happens very quickly. 00:20:15.290 --> 00:20:18.160 align:middle line:84% Do you think that the Fed now can sleep for a while? 00:20:18.160 --> 00:20:22.690 align:middle line:90% 00:20:22.690 --> 00:20:23.250 align:middle line:90% Why not? 00:20:23.250 --> 00:20:30.962 align:middle line:90% 00:20:30.962 --> 00:20:33.420 align:middle line:84% There are many reasons why the feds cannot sleep for a long 00:20:33.420 --> 00:20:35.675 align:middle line:84% time, but in this particular case. 00:20:35.675 --> 00:20:38.370 align:middle line:90% 00:20:38.370 --> 00:20:40.700 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:20:40.700 --> 00:20:42.110 align:middle line:90% 00:20:42.110 --> 00:20:43.410 align:middle line:90% RICARDO J. CABALLERO: OK, yes. 00:20:43.410 --> 00:20:45.380 align:middle line:90% Money demand will increase. 00:20:45.380 --> 00:20:46.790 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:20:46.790 --> 00:20:47.980 align:middle line:90% RICARDO J. CABALLERO: Why? 00:20:47.980 --> 00:20:52.023 align:middle line:84% AUDIENCE: Because now, [INAUDIBLE] increasing? 00:20:52.023 --> 00:20:53.065 align:middle line:90% RICARDO J. CABALLERO: No. 00:20:53.065 --> 00:20:57.190 align:middle line:84% So the first shock was an increase in money supply. 00:20:57.190 --> 00:21:00.810 align:middle line:84% The point-- the thing you want to say 00:21:00.810 --> 00:21:03.990 align:middle line:84% is that because now the interest rate is lower, 00:21:03.990 --> 00:21:06.620 align:middle line:90% equilibrium output will go up. 00:21:06.620 --> 00:21:09.080 align:middle line:84% But if equilibrium-- output goes up, 00:21:09.080 --> 00:21:11.130 align:middle line:84% then what happens in this diagram? 00:21:11.130 --> 00:21:14.300 align:middle line:90% Well, the money demand goes up. 00:21:14.300 --> 00:21:16.820 align:middle line:84% Because remember, one of the parameters in this curve 00:21:16.820 --> 00:21:18.410 align:middle line:90% was output. 00:21:18.410 --> 00:21:19.130 align:middle line:90% Remember? 00:21:19.130 --> 00:21:24.020 align:middle line:84% This was output times LI That's that curve there. 00:21:24.020 --> 00:21:28.250 align:middle line:84% In this money demand, I had output fixed at Y0. 00:21:28.250 --> 00:21:30.470 align:middle line:84% But now equilibrium output is higher, 00:21:30.470 --> 00:21:34.820 align:middle line:84% so this curve will also shift out. 00:21:34.820 --> 00:21:39.160 align:middle line:84% Now you're going to have Y1 LI there. 00:21:39.160 --> 00:21:43.390 align:middle line:90% So what will the Fed do? 00:21:43.390 --> 00:21:46.280 align:middle line:84% See, the Fed doesn't do anything and it stops here, 00:21:46.280 --> 00:21:49.000 align:middle line:84% then the interest rate goes back up, not necessarily 00:21:49.000 --> 00:21:50.920 align:middle line:84% to the old level, but it will go up. 00:21:50.920 --> 00:21:55.480 align:middle line:84% So what the Fed will have to do is keep expanding money. 00:21:55.480 --> 00:21:56.890 align:middle line:90% Sorry, it's an ugly diagram. 00:21:56.890 --> 00:22:00.050 align:middle line:84% But it will keep expanding money up to-- 00:22:00.050 --> 00:22:02.800 align:middle line:84% so it can preserve the interest rate. 00:22:02.800 --> 00:22:05.928 align:middle line:84% In the old analysis, you would have stopped in the first shot, 00:22:05.928 --> 00:22:06.970 align:middle line:90% but nowadays, that's not. 00:22:06.970 --> 00:22:09.280 align:middle line:84% The Fed says, look, I'm going to provide money, 00:22:09.280 --> 00:22:12.140 align:middle line:84% and I know it takes time for output to expand and all that, 00:22:12.140 --> 00:22:14.960 align:middle line:84% so I will accommodate all that comes. 00:22:14.960 --> 00:22:17.900 align:middle line:84% It will not come overnight, all this extra demand for money, 00:22:17.900 --> 00:22:20.440 align:middle line:84% but I know there will be more demand coming along 00:22:20.440 --> 00:22:24.580 align:middle line:84% if I'm successful at expanding economic activity. 00:22:24.580 --> 00:22:30.310 align:middle line:84% So the central bank knows that if this ends up happening, then 00:22:30.310 --> 00:22:34.240 align:middle line:84% that it will have to provide more money than initially just 00:22:34.240 --> 00:22:37.060 align:middle line:84% to preserve the interest rate at the lower rate level. 00:22:37.060 --> 00:22:40.210 align:middle line:84% Again, we don't have any concept of time in this course. 00:22:40.210 --> 00:22:43.670 align:middle line:84% And I don't think that-- well, we'll do a little bit later. 00:22:43.670 --> 00:22:46.300 align:middle line:84% But things happen in reality-- in the financial markets, 00:22:46.300 --> 00:22:49.550 align:middle line:84% they happen very quickly and then they take time. 00:22:49.550 --> 00:22:51.200 align:middle line:90% The real side is much slower. 00:22:51.200 --> 00:22:54.410 align:middle line:84% I mean, this expansion in output takes a couple of years, 00:22:54.410 --> 00:22:55.330 align:middle line:90% for example. 00:22:55.330 --> 00:22:56.380 align:middle line:90% It's slower. 00:22:56.380 --> 00:22:59.050 align:middle line:84% The reaction of interest rate, asset prices, and so on 00:22:59.050 --> 00:23:01.210 align:middle line:90% happens over night, instantly. 00:23:01.210 --> 00:23:04.630 align:middle line:84% When people do analysis of the impact of monetary policy 00:23:04.630 --> 00:23:09.640 align:middle line:84% on financial asset prices, you look at the small windows, 00:23:09.640 --> 00:23:12.520 align:middle line:84% minutes around an announcement or something like that 00:23:12.520 --> 00:23:14.020 align:middle line:84% to understand what is the impact. 00:23:14.020 --> 00:23:18.040 align:middle line:84% When you look at the impact of monetary policy or prices 00:23:18.040 --> 00:23:21.100 align:middle line:84% on real activity, you look over the span of quarters. 00:23:21.100 --> 00:23:23.530 align:middle line:84% That's your unit of-- and you begin 00:23:23.530 --> 00:23:25.750 align:middle line:90% to see effects a quarter later. 00:23:25.750 --> 00:23:30.250 align:middle line:84% And you keep seeing effects, you know eight quarters later. 00:23:30.250 --> 00:23:31.490 align:middle line:90% So different time scale. 00:23:31.490 --> 00:23:33.460 align:middle line:84% In this course, we're not worrying about that. 00:23:33.460 --> 00:23:35.930 align:middle line:90% But everything happens at once. 00:23:35.930 --> 00:23:38.260 align:middle line:84% So really, what will happen in this course 00:23:38.260 --> 00:23:40.450 align:middle line:84% is that it won't be enough to increase 00:23:40.450 --> 00:23:42.010 align:middle line:90% money supply to this point. 00:23:42.010 --> 00:23:45.020 align:middle line:84% In order to have an interest rate at the final equilibrium 00:23:45.020 --> 00:23:47.270 align:middle line:84% level of output, at this level, I'm 00:23:47.270 --> 00:23:50.300 align:middle line:84% going to have to expand money supply a lot more. 00:23:50.300 --> 00:23:51.765 align:middle line:90% That's what I'm saying. 00:23:51.765 --> 00:23:52.265 align:middle line:90% Good. 00:23:52.265 --> 00:23:58.460 align:middle line:90% 00:23:58.460 --> 00:24:04.820 align:middle line:84% So again, I can always go back to my lecture three. 00:24:04.820 --> 00:24:07.670 align:middle line:84% Remember, I always-- I told you that that diagram 00:24:07.670 --> 00:24:09.760 align:middle line:84% in lecture three was going to be very important. 00:24:09.760 --> 00:24:12.860 align:middle line:84% The expansionary effects of an expansionary monetary policy 00:24:12.860 --> 00:24:15.920 align:middle line:84% can be analyzed in the lecture three diagram, 00:24:15.920 --> 00:24:18.420 align:middle line:84% because there, we take as given an interest rate. 00:24:18.420 --> 00:24:21.800 align:middle line:84% And now, we know that when we have a higher interest rate, 00:24:21.800 --> 00:24:24.710 align:middle line:84% a lower interest rate will bring this aggregate demand up, 00:24:24.710 --> 00:24:27.168 align:middle line:84% and then we get the multiplier, and blah, blah, blah, blah, 00:24:27.168 --> 00:24:28.070 align:middle line:90% blah, blah. 00:24:28.070 --> 00:24:30.000 align:middle line:90% That's what happened. 00:24:30.000 --> 00:24:33.525 align:middle line:90% So this is a movement in the-- 00:24:33.525 --> 00:24:35.508 align:middle line:90% when monetary policy changes-- 00:24:35.508 --> 00:24:37.300 align:middle line:84% that's another thing that is very important 00:24:37.300 --> 00:24:38.550 align:middle line:90% when you do IS-LM analysis. 00:24:38.550 --> 00:24:41.190 align:middle line:84% Whenever you ask a question, the first thing 00:24:41.190 --> 00:24:42.930 align:middle line:84% you need to think about is, which 00:24:42.930 --> 00:24:45.330 align:middle line:84% curve is this policy moving or which 00:24:45.330 --> 00:24:47.850 align:middle line:90% curve is this shock moving? 00:24:47.850 --> 00:24:52.170 align:middle line:84% And what I know is that monetary policy-- 00:24:52.170 --> 00:24:54.540 align:middle line:84% fiscal policy will always move the IS. 00:24:54.540 --> 00:24:58.252 align:middle line:90% Will it move the LM? 00:24:58.252 --> 00:24:59.960 align:middle line:84% No, it has nothing to do with things that 00:24:59.960 --> 00:25:01.380 align:middle line:90% happen in financial markets. 00:25:01.380 --> 00:25:03.410 align:middle line:84% That doesn't mean that the Fed may not 00:25:03.410 --> 00:25:07.810 align:middle line:84% wish to respond to the fiscal expansion or whatever, 00:25:07.810 --> 00:25:09.830 align:middle line:84% but that's a response that the Fed decides. 00:25:09.830 --> 00:25:13.220 align:middle line:84% It's not a direct consequence of the fiscal policy. 00:25:13.220 --> 00:25:16.340 align:middle line:84% Fiscal policy is not bundled with interventions 00:25:16.340 --> 00:25:18.590 align:middle line:90% in the financial market. 00:25:18.590 --> 00:25:21.500 align:middle line:84% Contrary to that is monetary policy. 00:25:21.500 --> 00:25:25.600 align:middle line:84% I tell you the Fed decides to cut interest rate, that's 00:25:25.600 --> 00:25:26.770 align:middle line:90% a movement of the LM. 00:25:26.770 --> 00:25:28.810 align:middle line:84% It has nothing to do with the IS. 00:25:28.810 --> 00:25:30.910 align:middle line:84% So anything that happens in the IS 00:25:30.910 --> 00:25:34.930 align:middle line:84% is going to be a movement along the IS, not a shift of the IS. 00:25:34.930 --> 00:25:38.140 align:middle line:90% So that's what we saw here. 00:25:38.140 --> 00:25:41.690 align:middle line:84% When the Fed cut interest rate, we end up with higher output, 00:25:41.690 --> 00:25:45.740 align:middle line:84% but that was a result of a shift along the IS. 00:25:45.740 --> 00:25:48.270 align:middle line:84% Because monetary policy is not an IS policy. 00:25:48.270 --> 00:25:50.880 align:middle line:90% It's an LM policy. 00:25:50.880 --> 00:25:53.500 align:middle line:90% Fiscal policy is an IS policy. 00:25:53.500 --> 00:25:57.710 align:middle line:84% That is something that shifts the IS and not the LM. 00:25:57.710 --> 00:26:01.500 align:middle line:84% So that very important to understand, 00:26:01.500 --> 00:26:04.310 align:middle line:90% again, what moves what. 00:26:04.310 --> 00:26:07.370 align:middle line:90% OK, so let's look at the-- 00:26:07.370 --> 00:26:08.750 align:middle line:90% anyways, so let me pause here. 00:26:08.750 --> 00:26:12.950 align:middle line:84% Because if you understand what I just said, 00:26:12.950 --> 00:26:15.900 align:middle line:90% it's 2/3 of your quiz. 00:26:15.900 --> 00:26:19.358 align:middle line:84% So make sure that you understand it. 00:26:19.358 --> 00:26:20.900 align:middle line:84% I mean, if you really understand it-- 00:26:20.900 --> 00:26:22.983 align:middle line:84% obviously we're not going to ask you exactly this, 00:26:22.983 --> 00:26:29.562 align:middle line:84% but small perturbations around what I just said. 00:26:29.562 --> 00:26:31.580 align:middle line:84% So now, we can use this stuff even more. 00:26:31.580 --> 00:26:34.090 align:middle line:84% Now we understand what the basic monetary policy does. 00:26:34.090 --> 00:26:37.630 align:middle line:84% We're going to understand what basic fiscal policy does 00:26:37.630 --> 00:26:40.160 align:middle line:90% to the economy. 00:26:40.160 --> 00:26:43.340 align:middle line:90% Let's look at some scenarios. 00:26:43.340 --> 00:26:46.100 align:middle line:90% This, I'm calling all in. 00:26:46.100 --> 00:26:47.490 align:middle line:90% What am I representing there? 00:26:47.490 --> 00:26:54.860 align:middle line:90% 00:26:54.860 --> 00:26:55.795 align:middle line:90% In that diagram? 00:26:55.795 --> 00:27:02.370 align:middle line:90% 00:27:02.370 --> 00:27:04.110 align:middle line:84% So I'm saying all that you see in 00:27:04.110 --> 00:27:06.600 align:middle line:84% that diagram is a result of policy decisions, 00:27:06.600 --> 00:27:08.927 align:middle line:90% macroeconomic policy decisions. 00:27:08.927 --> 00:27:11.010 align:middle line:84% AUDIENCE: Expansionary fiscal and monetary policy? 00:27:11.010 --> 00:27:11.910 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:27:11.910 --> 00:27:13.920 align:middle line:84% That's the reason I'm calling it all in. 00:27:13.920 --> 00:27:17.880 align:middle line:84% That's the case in which both want to be very expansionary. 00:27:17.880 --> 00:27:21.540 align:middle line:84% And so you see that the expansionary monetary policy 00:27:21.540 --> 00:27:23.970 align:middle line:84% already sort of increases equilibrium output. 00:27:23.970 --> 00:27:26.490 align:middle line:84% But then you add to it expansionary fiscal policy, 00:27:26.490 --> 00:27:31.480 align:middle line:84% which moves the IS to the right, and you further increase output. 00:27:31.480 --> 00:27:32.980 align:middle line:84% So you end up with a big increase 00:27:32.980 --> 00:27:37.150 align:middle line:84% in output as a result of this powerful policy package. 00:27:37.150 --> 00:27:41.295 align:middle line:84% When do you think you may see situations like that? 00:27:41.295 --> 00:27:48.080 align:middle line:90% 00:27:48.080 --> 00:27:52.130 align:middle line:84% Sometimes you see it out of pure irresponsibility. 00:27:52.130 --> 00:27:55.453 align:middle line:84% I mean, people go to Argentina, this happens all the time 00:27:55.453 --> 00:27:56.370 align:middle line:90% for the wrong reasons. 00:27:56.370 --> 00:28:01.490 align:middle line:84% But if in normal times, normal environments, 00:28:01.490 --> 00:28:02.798 align:middle line:90% when do you think that-- 00:28:02.798 --> 00:28:04.340 align:middle line:84% I shouldn't have said "normal times." 00:28:04.340 --> 00:28:09.590 align:middle line:84% In normal environments, sort of with sound macroeconomic policy, 00:28:09.590 --> 00:28:12.010 align:middle line:84% when do you think you would see something like this? 00:28:12.010 --> 00:28:14.705 align:middle line:90% 00:28:14.705 --> 00:28:16.055 align:middle line:90% AUDIENCE: Recessions? 00:28:16.055 --> 00:28:17.430 align:middle line:84% RICARDO J. CABALLERO: Recessions. 00:28:17.430 --> 00:28:19.690 align:middle line:84% And the biggest-- during recessions, 00:28:19.690 --> 00:28:22.530 align:middle line:84% you need to get the economy out of the hole. 00:28:22.530 --> 00:28:25.433 align:middle line:84% And then you probably-- you first 00:28:25.433 --> 00:28:26.850 align:middle line:84% try monetary policy because that's 00:28:26.850 --> 00:28:28.540 align:middle line:90% the most direct and quick. 00:28:28.540 --> 00:28:32.040 align:middle line:84% I mean, that's a decision that can be made overnight. 00:28:32.040 --> 00:28:34.410 align:middle line:84% But often, when the recession is sufficiently deep, 00:28:34.410 --> 00:28:37.610 align:middle line:84% that's not enough and you need more. 00:28:37.610 --> 00:28:39.405 align:middle line:84% And that's what you do with fiscal policy. 00:28:39.405 --> 00:28:41.180 align:middle line:84% There are other reasons-- there are other differences 00:28:41.180 --> 00:28:42.222 align:middle line:90% between the two policies. 00:28:42.222 --> 00:28:44.670 align:middle line:84% Because we're not looking under the hood here. 00:28:44.670 --> 00:28:47.510 align:middle line:84% But, for example, in COVID, it was very-- 00:28:47.510 --> 00:28:50.130 align:middle line:84% a certain group of people were much more affected than others. 00:28:50.130 --> 00:28:51.350 align:middle line:84% I mean, people that work in restaurants, 00:28:51.350 --> 00:28:52.730 align:middle line:84% those guys just lost their jobs and there 00:28:52.730 --> 00:28:53.960 align:middle line:90% was nothing they could do. 00:28:53.960 --> 00:28:57.560 align:middle line:84% So there was a reason to target the transfers-- when 00:28:57.560 --> 00:29:01.620 align:middle line:84% you use interest rate, it's a very blunt policy to everyone. 00:29:01.620 --> 00:29:04.670 align:middle line:84% When you use fiscal policy, you can also-- 00:29:04.670 --> 00:29:06.410 align:middle line:84% it's not only the amount you spend, 00:29:06.410 --> 00:29:08.060 align:middle line:84% but you can also target the expenditure 00:29:08.060 --> 00:29:09.210 align:middle line:90% in certain directions. 00:29:09.210 --> 00:29:11.960 align:middle line:84% And so there are other reasons why you 00:29:11.960 --> 00:29:13.740 align:middle line:90% may want to use the two tools. 00:29:13.740 --> 00:29:15.600 align:middle line:84% But the main one is-- the first order 00:29:15.600 --> 00:29:17.840 align:middle line:84% one is if you're in a deep recession, 00:29:17.840 --> 00:29:21.330 align:middle line:84% you need everything to try to lift the economy out of that. 00:29:21.330 --> 00:29:22.940 align:middle line:84% And so that's the kind of packages 00:29:22.940 --> 00:29:26.730 align:middle line:90% you see in big recessions. 00:29:26.730 --> 00:29:32.230 align:middle line:84% Now, there's a slide that I think 00:29:32.230 --> 00:29:34.880 align:middle line:84% I have pending from two lectures ago. 00:29:34.880 --> 00:29:37.697 align:middle line:84% And this is a good opportunity to bring it back. 00:29:37.697 --> 00:29:39.280 align:middle line:84% Remember when we looked at equilibrium 00:29:39.280 --> 00:29:42.280 align:middle line:84% in financial markets, we came up with 00:29:42.280 --> 00:29:46.078 align:middle line:84% this downward-sloping demand, money demand. 00:29:46.078 --> 00:29:48.370 align:middle line:84% And then we said, well, if you lower the interest rate, 00:29:48.370 --> 00:29:50.960 align:middle line:84% there's more money demand, and so on, and so forth. 00:29:50.960 --> 00:29:52.540 align:middle line:84% And then we said, therefore, the way 00:29:52.540 --> 00:29:54.700 align:middle line:84% the Fed lowers interest rate, or the central bank 00:29:54.700 --> 00:29:58.450 align:middle line:84% lowers the interest rate is by increasing money supply. 00:29:58.450 --> 00:30:02.960 align:middle line:84% The point of this picture is that there is a limit to that. 00:30:02.960 --> 00:30:06.740 align:middle line:84% And the limit is, more or less, when 00:30:06.740 --> 00:30:09.050 align:middle line:90% the interest rate reaches zero. 00:30:09.050 --> 00:30:10.970 align:middle line:84% Because when the interest rate reaches-- 00:30:10.970 --> 00:30:14.880 align:middle line:84% the nominal interest rate reaches zero, then 00:30:14.880 --> 00:30:18.270 align:middle line:84% there is no cost in holding bonds-- 00:30:18.270 --> 00:30:20.340 align:middle line:90% in holding money, sorry. 00:30:20.340 --> 00:30:22.577 align:middle line:84% The only reason for you not to hold all your wealth 00:30:22.577 --> 00:30:24.660 align:middle line:84% in the form of money is because you were giving up 00:30:24.660 --> 00:30:28.560 align:middle line:84% some opportunity cost of investing in bonds, which 00:30:28.560 --> 00:30:30.870 align:middle line:84% were inconvenient financial assets because you couldn't 00:30:30.870 --> 00:30:33.390 align:middle line:84% transact with them, but they pay you higher interest rates. 00:30:33.390 --> 00:30:35.070 align:middle line:84% That's the reason you want to go there. 00:30:35.070 --> 00:30:38.190 align:middle line:84% But once you reach zero interest rate, then you're indifferent 00:30:38.190 --> 00:30:39.550 align:middle line:90% and you might as well hold. 00:30:39.550 --> 00:30:42.210 align:middle line:84% If the central bank goes out there and does an open market 00:30:42.210 --> 00:30:44.670 align:middle line:84% operation, you don't need to be compensated for that 00:30:44.670 --> 00:30:47.610 align:middle line:84% because you're totally willing to hold your wealth 00:30:47.610 --> 00:30:48.930 align:middle line:90% in the form of money. 00:30:48.930 --> 00:30:52.420 align:middle line:84% And so monetary policy is no longer effective 00:30:52.420 --> 00:30:56.130 align:middle line:84% when you reach what is called the zero lower bound. 00:30:56.130 --> 00:31:00.261 align:middle line:84% And that's what we call the liquidity trap. 00:31:00.261 --> 00:31:01.810 align:middle line:90% It's called the liquidity trap. 00:31:01.810 --> 00:31:03.220 align:middle line:90% Let me not get into why. 00:31:03.220 --> 00:31:05.960 align:middle line:90% But essentially, it's that. 00:31:05.960 --> 00:31:07.710 align:middle line:84% So you can inject more and more liquidity, 00:31:07.710 --> 00:31:11.430 align:middle line:84% but you cannot move the interest rate, so you lost a policy tool. 00:31:11.430 --> 00:31:15.115 align:middle line:84% This was the tragedy of Japan for many decades. 00:31:15.115 --> 00:31:19.880 align:middle line:84% They were stuck against the zero lower bound, the liquidity trap. 00:31:19.880 --> 00:31:23.380 align:middle line:84% And so they had to go through massive fiscal expansions 00:31:23.380 --> 00:31:25.600 align:middle line:84% because they didn't have-- they were in recession, 00:31:25.600 --> 00:31:28.390 align:middle line:84% chronic recessions, and they didn't have a very powerful 00:31:28.390 --> 00:31:30.490 align:middle line:84% monetary policy tool because they were 00:31:30.490 --> 00:31:32.020 align:middle line:90% against the zero lower bound. 00:31:32.020 --> 00:31:36.740 align:middle line:84% So why did I use this opportunity to bring this about? 00:31:36.740 --> 00:31:39.550 align:middle line:84% Because that's, for the reason I just described, in the case 00:31:39.550 --> 00:31:40.100 align:middle line:90% of Japan. 00:31:40.100 --> 00:31:44.180 align:middle line:84% But I asked the question, what would you 00:31:44.180 --> 00:31:45.660 align:middle line:90% advise the government to do? 00:31:45.660 --> 00:31:47.330 align:middle line:84% Well, I already told you the answer. 00:31:47.330 --> 00:31:50.360 align:middle line:84% If you have an economy in a recession, 00:31:50.360 --> 00:31:54.380 align:middle line:84% and this means you use all the monetary policy that you had, 00:31:54.380 --> 00:31:57.290 align:middle line:84% conventional monetary policy that you have-- now 00:31:57.290 --> 00:31:59.010 align:middle line:84% we have unconventional monetary policy, 00:31:59.010 --> 00:32:01.250 align:middle line:84% but I'll tell you a little bit more about that later. 00:32:01.250 --> 00:32:04.325 align:middle line:84% But once you run out of this and you're still 00:32:04.325 --> 00:32:06.700 align:middle line:84% in a recession, what would you tell the government to do? 00:32:06.700 --> 00:32:10.413 align:middle line:90% 00:32:10.413 --> 00:32:11.580 align:middle line:90% AUDIENCE: Use fiscal policy? 00:32:11.580 --> 00:32:12.880 align:middle line:84% RICARDO J. CABALLERO: You use fiscal policy. 00:32:12.880 --> 00:32:14.380 align:middle line:84% That's the other tool that you have. 00:32:14.380 --> 00:32:16.200 align:middle line:84% So that's a typical situation you see. 00:32:16.200 --> 00:32:19.260 align:middle line:84% When countries-- the interest rates are already very low, 00:32:19.260 --> 00:32:21.547 align:middle line:84% they tend to use much more actively fiscal policy 00:32:21.547 --> 00:32:23.380 align:middle line:84% because it's the only policy they have left. 00:32:23.380 --> 00:32:25.620 align:middle line:84% And that has been the case of Japan, again, 00:32:25.620 --> 00:32:29.520 align:middle line:84% since the crash of their financial bubble in the late 00:32:29.520 --> 00:32:32.850 align:middle line:90% '80s, early '90s. 00:32:32.850 --> 00:32:36.020 align:middle line:84% So look at the COVID-19 response. 00:32:36.020 --> 00:32:38.320 align:middle line:84% Something happened to my figure here. 00:32:38.320 --> 00:32:40.650 align:middle line:84% But anyways, this is zero, essentially. 00:32:40.650 --> 00:32:44.670 align:middle line:90% So this is COVID. 00:32:44.670 --> 00:32:46.240 align:middle line:90% The COVID shock happened. 00:32:46.240 --> 00:32:49.140 align:middle line:84% Clearly, the economy was imploding into a recession. 00:32:49.140 --> 00:32:52.080 align:middle line:84% The Fed immediately reacted and cut interest rates very, 00:32:52.080 --> 00:32:54.720 align:middle line:90% very aggressively to zero. 00:32:54.720 --> 00:32:56.210 align:middle line:90% And then, we were stuck there. 00:32:56.210 --> 00:32:57.270 align:middle line:90% This is effectively zero. 00:32:57.270 --> 00:32:58.770 align:middle line:84% I mean, there are technical things-- 00:32:58.770 --> 00:33:02.960 align:middle line:84% the thing moves a little, but this is effectively zero. 00:33:02.960 --> 00:33:05.150 align:middle line:84% So the US was, during that period, 00:33:05.150 --> 00:33:08.240 align:middle line:90% against really a liquid-- 00:33:08.240 --> 00:33:09.660 align:middle line:90% against the zero lower bound. 00:33:09.660 --> 00:33:13.040 align:middle line:84% There was no more power for the kind of monetary policy 00:33:13.040 --> 00:33:16.140 align:middle line:90% that we have described here. 00:33:16.140 --> 00:33:20.942 align:middle line:84% So let me-- so that tells you that there's 00:33:20.942 --> 00:33:22.650 align:middle line:84% going to have to be lots of fiscal policy 00:33:22.650 --> 00:33:23.920 align:middle line:90% if you want to get out of that. 00:33:23.920 --> 00:33:25.150 align:middle line:90% And I'll show you that later. 00:33:25.150 --> 00:33:27.150 align:middle line:84% There was a lot of fiscal policy. 00:33:27.150 --> 00:33:29.332 align:middle line:84% But before getting there, I'm going 00:33:29.332 --> 00:33:31.665 align:middle line:84% to show you something that you don't need to really know 00:33:31.665 --> 00:33:34.380 align:middle line:84% for the quiz, but so you can understand 00:33:34.380 --> 00:33:38.250 align:middle line:84% what is going on in the newspapers a little better. 00:33:38.250 --> 00:33:41.220 align:middle line:84% The Fed-- that was not the only-- precisely 00:33:41.220 --> 00:33:46.800 align:middle line:84% because the situation with Japan was so chronic, people began 00:33:46.800 --> 00:33:49.170 align:middle line:84% to develop lots of tools, alternative tools 00:33:49.170 --> 00:33:52.560 align:middle line:84% for central banks to use when your interest rate-- 00:33:52.560 --> 00:33:55.800 align:middle line:84% the main interest rate you use is stuck against zero, 00:33:55.800 --> 00:33:57.190 align:middle line:90% against the zero lower bound. 00:33:57.190 --> 00:33:58.690 align:middle line:84% And that's what you may have heard-- 00:33:58.690 --> 00:34:01.560 align:middle line:84% it's called sometimes unconventional monetary policy, 00:34:01.560 --> 00:34:03.750 align:middle line:90% QE, quantitative easing. 00:34:03.750 --> 00:34:07.020 align:middle line:84% All those kinds of things, they represent essentially policies 00:34:07.020 --> 00:34:10.110 align:middle line:84% that are like monetary policy, but they are not 00:34:10.110 --> 00:34:12.389 align:middle line:84% exactly the way we have-- because they are not 00:34:12.389 --> 00:34:14.260 align:middle line:84% interventions in the very short-term bonds. 00:34:14.260 --> 00:34:16.940 align:middle line:84% They are interventions in other assets out there. 00:34:16.940 --> 00:34:19.010 align:middle line:84% In this course, we have it very simple. 00:34:19.010 --> 00:34:20.600 align:middle line:90% We have only one interest rate. 00:34:20.600 --> 00:34:22.420 align:middle line:84% In reality, there are multiple bonds. 00:34:22.420 --> 00:34:23.540 align:middle line:90% There are risky bonds. 00:34:23.540 --> 00:34:24.170 align:middle line:90% They're spread. 00:34:24.170 --> 00:34:26.679 align:middle line:84% Somebody asks about risky bonds in a few lectures ago. 00:34:26.679 --> 00:34:27.530 align:middle line:90% They are spreads. 00:34:27.530 --> 00:34:29.600 align:middle line:84% There are lots of interest rates floating around. 00:34:29.600 --> 00:34:31.690 align:middle line:84% So in principle, a central bank could intervene 00:34:31.690 --> 00:34:33.170 align:middle line:90% in those other rates as well. 00:34:33.170 --> 00:34:34.780 align:middle line:84% In fact, in Japan, they have even 00:34:34.780 --> 00:34:37.480 align:middle line:84% intervened in the stock market, and that tells you 00:34:37.480 --> 00:34:39.360 align:middle line:90% how far they can go. 00:34:39.360 --> 00:34:42.280 align:middle line:84% So in a richer environment with more financial assets, 00:34:42.280 --> 00:34:46.030 align:middle line:84% in principle, the Fed could go beyond the standard short-term 00:34:46.030 --> 00:34:49.190 align:middle line:84% bonds that they go for their open market operation. 00:34:49.190 --> 00:34:52.620 align:middle line:84% And that's exactly what they have been doing. 00:34:52.620 --> 00:34:54.370 align:middle line:84% A way of thinking about that is, remember, 00:34:54.370 --> 00:34:56.409 align:middle line:84% when we look at the monetary-- expansion 00:34:56.409 --> 00:34:58.930 align:middle line:84% in conventional monetary policy, we 00:34:58.930 --> 00:35:00.530 align:middle line:84% start with a balance sheet like that. 00:35:00.530 --> 00:35:03.940 align:middle line:84% Remember, we said the central bank has bonds and the money. 00:35:03.940 --> 00:35:06.140 align:middle line:84% If it wants to have an expansionary monetary policy, 00:35:06.140 --> 00:35:08.830 align:middle line:84% it goes out there, it buys more bonds 00:35:08.830 --> 00:35:12.370 align:middle line:84% and gives them the-- it gives the bank's money. 00:35:12.370 --> 00:35:15.153 align:middle line:84% And that expands the balance sheet. 00:35:15.153 --> 00:35:16.570 align:middle line:84% You end up with more-- the balance 00:35:16.570 --> 00:35:19.180 align:middle line:84% sheet of the central bank ends up with more bonds 00:35:19.180 --> 00:35:21.430 align:middle line:84% and also with more liabilities because it 00:35:21.430 --> 00:35:24.140 align:middle line:84% gave more money to people, banks, and so on, 00:35:24.140 --> 00:35:25.870 align:middle line:90% so it owes more money. 00:35:25.870 --> 00:35:29.770 align:middle line:84% So monetary policy naturally-- expansionary monetary policy 00:35:29.770 --> 00:35:32.720 align:middle line:84% naturally leads to an expansion of the balance sheet. 00:35:32.720 --> 00:35:35.950 align:middle line:84% Now, for years, outside of Japan, 00:35:35.950 --> 00:35:37.890 align:middle line:84% nobody really cared too much about that 00:35:37.890 --> 00:35:40.560 align:middle line:84% because this effect, relative to what you saw in the interest 00:35:40.560 --> 00:35:41.437 align:middle line:90% rate, was very small. 00:35:41.437 --> 00:35:43.770 align:middle line:84% I mean, yeah, the balance sheet was moving a little bit, 00:35:43.770 --> 00:35:45.720 align:middle line:90% but it was mild. 00:35:45.720 --> 00:35:46.860 align:middle line:90% And also here. 00:35:46.860 --> 00:35:49.340 align:middle line:90% We hit the zero lower bound. 00:35:49.340 --> 00:35:50.810 align:middle line:84% And essentially, the Fed went out 00:35:50.810 --> 00:35:53.120 align:middle line:90% and bought all sorts of things. 00:35:53.120 --> 00:35:58.370 align:middle line:84% First of all, when you hear QE, quantitative easing, that 00:35:58.370 --> 00:36:01.760 align:middle line:84% means mostly that the Fed goes out there and buys 00:36:01.760 --> 00:36:07.548 align:middle line:84% not only short-term US Treasury bonds, but long-term bonds. 00:36:07.548 --> 00:36:09.590 align:middle line:84% Because there's something called the term spread. 00:36:09.590 --> 00:36:12.920 align:middle line:84% Typically, interest rates in the long run are higher than 00:36:12.920 --> 00:36:16.310 align:middle line:84% the interest rates in the short run, typically, 00:36:16.310 --> 00:36:18.080 align:middle line:84% controlling for a bunch of things, 00:36:18.080 --> 00:36:19.770 align:middle line:84% and that's called the term "premium." 00:36:19.770 --> 00:36:23.100 align:middle line:84% Well, they went and bought those kind of bonds. 00:36:23.100 --> 00:36:26.720 align:middle line:84% They also bought bonds issued by Fannie and Freddie-- 00:36:26.720 --> 00:36:29.750 align:middle line:90% 00:36:29.750 --> 00:36:34.130 align:middle line:84% Freddie Mac-- no, Freddie and Fannie, 00:36:34.130 --> 00:36:37.130 align:middle line:84% mortgage-backed securities, a bunch of stuff, even loans. 00:36:37.130 --> 00:36:41.390 align:middle line:84% In fact, they created a facility to buy corporate bonds. 00:36:41.390 --> 00:36:43.140 align:middle line:84% And at some point, they created a facility 00:36:43.140 --> 00:36:45.660 align:middle line:90% to buy fallen angels bonds. 00:36:45.660 --> 00:36:48.000 align:middle line:84% Initially, it was only investment grade bonds, so 00:36:48.000 --> 00:36:50.730 align:middle line:84% all the companies that have the best possible rating. 00:36:50.730 --> 00:36:54.300 align:middle line:84% But that wasn't enough, so they went out there and created 00:36:54.300 --> 00:36:57.193 align:middle line:84% a facility to buy fallen angels bonds. 00:36:57.193 --> 00:36:58.860 align:middle line:84% Fallen angels were essentially companies 00:36:58.860 --> 00:37:02.700 align:middle line:84% that were prime companies before COVID, 00:37:02.700 --> 00:37:07.170 align:middle line:84% but after COVID, they didn't look so good; airlines, cruises, 00:37:07.170 --> 00:37:10.050 align:middle line:84% and stuff like that, hotels, and so on. 00:37:10.050 --> 00:37:12.610 align:middle line:84% So that was a massive expansion of the balance sheet. 00:37:12.610 --> 00:37:17.470 align:middle line:84% So in terms of this, this guy grew a lot. 00:37:17.470 --> 00:37:19.762 align:middle line:84% But the purpose, that's like monetary policy. 00:37:19.762 --> 00:37:21.220 align:middle line:84% That's what we call unconventional. 00:37:21.220 --> 00:37:22.762 align:middle line:84% It's different from the standard one, 00:37:22.762 --> 00:37:25.900 align:middle line:84% but they were doing-- trying to operate very much 00:37:25.900 --> 00:37:27.860 align:middle line:90% like monetary policy operates. 00:37:27.860 --> 00:37:30.070 align:middle line:84% Here, you see the balance sheet of the Fed. 00:37:30.070 --> 00:37:33.790 align:middle line:84% You see, before the global financial crisis 00:37:33.790 --> 00:37:39.660 align:middle line:84% or the Great Recession of 2008, 2009, 00:37:39.660 --> 00:37:41.567 align:middle line:84% the balance sheet wasn't an interesting thing 00:37:41.567 --> 00:37:42.900 align:middle line:90% to look at for the central bank. 00:37:42.900 --> 00:37:46.740 align:middle line:84% Because, yeah, they did their regular open market operations 00:37:46.740 --> 00:37:50.322 align:middle line:84% and for anti-cyclical policy, but you would see small wiggles 00:37:50.322 --> 00:37:52.530 align:middle line:84% in the size of the balance sheet relative to the size 00:37:52.530 --> 00:37:53.610 align:middle line:90% of the balance sheet. 00:37:53.610 --> 00:37:55.230 align:middle line:84% In the global financial crisis, they 00:37:55.230 --> 00:37:58.620 align:middle line:84% hit the zero lower bound for the first time, the US. 00:37:58.620 --> 00:38:02.560 align:middle line:84% And so there, you saw a massive expansion of the balance sheet. 00:38:02.560 --> 00:38:03.930 align:middle line:90% This is the number of assets. 00:38:03.930 --> 00:38:05.140 align:middle line:84% The same happened to liabilities. 00:38:05.140 --> 00:38:07.515 align:middle line:84% The other side of it is they're injecting massive amounts 00:38:07.515 --> 00:38:10.006 align:middle line:90% of money into the economy. 00:38:10.006 --> 00:38:12.465 align:middle line:84% So there, you saw a big expansion. 00:38:12.465 --> 00:38:14.340 align:middle line:84% The recovery from the global financial crisis 00:38:14.340 --> 00:38:17.950 align:middle line:84% was hard because the financial sector was very compromised, 00:38:17.950 --> 00:38:19.350 align:middle line:90% so it took them a while. 00:38:19.350 --> 00:38:21.130 align:middle line:84% And they kept doing this kind of policies. 00:38:21.130 --> 00:38:23.730 align:middle line:84% Then they began to unwind the balance sheet. 00:38:23.730 --> 00:38:26.790 align:middle line:84% And then COVID came, and that's what I was showing you before. 00:38:26.790 --> 00:38:27.910 align:middle line:90% Massive expansion. 00:38:27.910 --> 00:38:30.795 align:middle line:84% They sent the interest rate to zero. 00:38:30.795 --> 00:38:32.050 align:middle line:90% That wasn't enough. 00:38:32.050 --> 00:38:33.630 align:middle line:84% And then they went out and bought 00:38:33.630 --> 00:38:37.020 align:middle line:84% lots of other financial assets, which work 00:38:37.020 --> 00:38:38.890 align:middle line:90% very much like monetary policy. 00:38:38.890 --> 00:38:39.940 align:middle line:90% Big thing. 00:38:39.940 --> 00:38:41.620 align:middle line:84% And now, they're unwinding the thing. 00:38:41.620 --> 00:38:43.090 align:middle line:84% Now we're in the opposite process. 00:38:43.090 --> 00:38:43.840 align:middle line:90% We have inflation. 00:38:43.840 --> 00:38:46.360 align:middle line:84% We want to get out of this situation, so they're unwinding. 00:38:46.360 --> 00:38:48.060 align:middle line:84% But you can see the size of that. 00:38:48.060 --> 00:38:49.750 align:middle line:90% It's huge. 00:38:49.750 --> 00:38:51.760 align:middle line:90% Huge. 00:38:51.760 --> 00:38:53.680 align:middle line:90% I mean, this is-- 00:38:53.680 --> 00:38:55.660 align:middle line:84% the balance sheet a couple of decades 00:38:55.660 --> 00:38:58.343 align:middle line:84% ago was of the order of $1 trillion, 00:38:58.343 --> 00:39:00.010 align:middle line:84% which was more or less of the money that 00:39:00.010 --> 00:39:02.320 align:middle line:90% is circulating around. 00:39:02.320 --> 00:39:04.210 align:middle line:90% Now it's $9 trillion. 00:39:04.210 --> 00:39:06.850 align:middle line:90% Massive intervention. 00:39:06.850 --> 00:39:09.530 align:middle line:84% And all central banks, major central banks look like this. 00:39:09.530 --> 00:39:13.210 align:middle line:84% I mean, the ECB also looks like this. 00:39:13.210 --> 00:39:16.490 align:middle line:84% The Bank of Japan looks like this. 00:39:16.490 --> 00:39:18.160 align:middle line:84% But actually, you don't see these blips 00:39:18.160 --> 00:39:21.250 align:middle line:84% as much because they began to do them here. 00:39:21.250 --> 00:39:23.952 align:middle line:84% So they have been accumulating for a long time. 00:39:23.952 --> 00:39:25.785 align:middle line:84% They have been using these kind of policies. 00:39:25.785 --> 00:39:28.330 align:middle line:90% 00:39:28.330 --> 00:39:30.340 align:middle line:84% So coming back now to the course. 00:39:30.340 --> 00:39:32.200 align:middle line:90% What about fiscal policy? 00:39:32.200 --> 00:39:34.720 align:middle line:84% Well, I'm showing you different countries around the world. 00:39:34.720 --> 00:39:38.800 align:middle line:84% Massive fiscal expansions during the COVID episode. 00:39:38.800 --> 00:39:39.340 align:middle line:90% Massive. 00:39:39.340 --> 00:39:40.990 align:middle line:90% I mean, this is-- 00:39:40.990 --> 00:39:44.080 align:middle line:84% the US, the fiscal expansion, if you combine all the packages, 00:39:44.080 --> 00:39:47.050 align:middle line:90% it's of the order of 20% of GDP. 00:39:47.050 --> 00:39:48.490 align:middle line:90% That's huge for fiscal-- 00:39:48.490 --> 00:39:50.180 align:middle line:84% you don't see things like this, and this 00:39:50.180 --> 00:39:52.730 align:middle line:90% happened almost everywhere. 00:39:52.730 --> 00:39:56.510 align:middle line:84% Now, you don't see things like that outside of wars. 00:39:56.510 --> 00:39:59.610 align:middle line:84% This was really like a war, there's no doubt of that. 00:39:59.610 --> 00:40:02.930 align:middle line:84% The amount of expansionary fiscal policy we saw 00:40:02.930 --> 00:40:04.940 align:middle line:84% was comparable to what you see in a war. 00:40:04.940 --> 00:40:07.755 align:middle line:90% 00:40:07.755 --> 00:40:09.310 align:middle line:90% So there you have it. 00:40:09.310 --> 00:40:12.810 align:middle line:84% Big recession, huge recession, massive policy response, 00:40:12.810 --> 00:40:16.590 align:middle line:84% both monetary of the conventional and unconventional 00:40:16.590 --> 00:40:19.060 align:middle line:90% kind and fiscal. 00:40:19.060 --> 00:40:20.980 align:middle line:84% And again, this was not unique to the US. 00:40:20.980 --> 00:40:23.290 align:middle line:84% It happened essentially everywhere. 00:40:23.290 --> 00:40:25.560 align:middle line:84% China is a little different for reasons 00:40:25.560 --> 00:40:28.140 align:middle line:84% I think I mentioned in the first lecture. 00:40:28.140 --> 00:40:33.400 align:middle line:84% But I may talk more about that later. 00:40:33.400 --> 00:40:35.090 align:middle line:90% Good. 00:40:35.090 --> 00:40:37.550 align:middle line:90% OK, so another policy mix. 00:40:37.550 --> 00:40:38.550 align:middle line:90% This is different. 00:40:38.550 --> 00:40:41.000 align:middle line:90% So what do we have there? 00:40:41.000 --> 00:40:46.330 align:middle line:84% That's another policy mix that we see fairly frequently. 00:40:46.330 --> 00:40:48.520 align:middle line:90% So what is that? 00:40:48.520 --> 00:40:52.480 align:middle line:84% LM going down, that's expansionary monetary policy. 00:40:52.480 --> 00:40:57.427 align:middle line:84% IS is going to the left, that's contractionary fiscal policy. 00:40:57.427 --> 00:40:59.385 align:middle line:84% So when do you think you would do such a thing? 00:40:59.385 --> 00:41:04.110 align:middle line:90% 00:41:04.110 --> 00:41:06.370 align:middle line:84% Or countries would engage in things like this? 00:41:06.370 --> 00:41:07.000 align:middle line:90% Yeah? 00:41:07.000 --> 00:41:09.070 align:middle line:84% AUDIENCE: What if you wanted to reduce government spending 00:41:09.070 --> 00:41:10.810 align:middle line:84% but you wanted to ward off a recession? 00:41:10.810 --> 00:41:12.060 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:41:12.060 --> 00:41:16.460 align:middle line:84% That's exactly the conditions when you want to do this. 00:41:16.460 --> 00:41:19.100 align:middle line:84% It's called consolidation of the fiscal deficit. 00:41:19.100 --> 00:41:21.880 align:middle line:84% Sometimes, you have a large fiscal deficit 00:41:21.880 --> 00:41:24.640 align:middle line:84% that's leading to accumulation of public debt, that 00:41:24.640 --> 00:41:26.060 align:middle line:90% doesn't look so good. 00:41:26.060 --> 00:41:34.810 align:middle line:84% So the government-- the Treasury, in the case of the US, 00:41:34.810 --> 00:41:38.560 align:middle line:84% may decide that it wants to reduce fiscal policy 00:41:38.560 --> 00:41:41.470 align:middle line:84% but is afraid because in doing so, 00:41:41.470 --> 00:41:42.970 align:middle line:90% it's going to cause a recession. 00:41:42.970 --> 00:41:46.000 align:middle line:84% And the purpose-- and there is no problem of output being over 00:41:46.000 --> 00:41:46.520 align:middle line:90% [INAUDIBLE]. 00:41:46.520 --> 00:41:51.100 align:middle line:84% It's just that the fiscal accounts look very weak. 00:41:51.100 --> 00:41:55.780 align:middle line:84% So if that's the situation, that is if the economy is not going-- 00:41:55.780 --> 00:41:58.270 align:middle line:84% is not going through an overheating period and so on, 00:41:58.270 --> 00:42:03.140 align:middle line:84% and you want to reduce the fiscal deficit, in some places, 00:42:03.140 --> 00:42:05.550 align:middle line:84% it will be explicit, in some places, implicit. 00:42:05.550 --> 00:42:07.960 align:middle line:84% But the central-- because the central bank 00:42:07.960 --> 00:42:12.220 align:middle line:84% has a goal to keep prices stable and output 00:42:12.220 --> 00:42:14.440 align:middle line:90% close to the potential output. 00:42:14.440 --> 00:42:18.760 align:middle line:84% So even if there is no explicit coordination, if the government 00:42:18.760 --> 00:42:21.550 align:middle line:84% announced a massive fiscal consolidation package, 00:42:21.550 --> 00:42:24.220 align:middle line:84% say it reduces government expenditure by 10%, 00:42:24.220 --> 00:42:26.050 align:middle line:84% the central bank knows that that's 00:42:26.050 --> 00:42:27.400 align:middle line:90% going to cause a recession. 00:42:27.400 --> 00:42:29.110 align:middle line:84% And so the central bank naturally 00:42:29.110 --> 00:42:31.630 align:middle line:84% will respond by cutting interest rate to that 00:42:31.630 --> 00:42:35.230 align:middle line:84% because the recession is not needed. 00:42:35.230 --> 00:42:39.170 align:middle line:84% If the US announced today a fiscal contraction of 5%, 00:42:39.170 --> 00:42:40.795 align:middle line:84% I'm not sure the Fed would do anything. 00:42:40.795 --> 00:42:45.250 align:middle line:84% It will just stay there, put, because we have 00:42:45.250 --> 00:42:47.160 align:middle line:90% an economy that's overheating. 00:42:47.160 --> 00:42:51.070 align:middle line:84% So that's what you would do in a situation in which you want 00:42:51.070 --> 00:42:53.530 align:middle line:84% to fix the fiscal account and the economy is 00:42:53.530 --> 00:42:56.360 align:middle line:90% more or less at a normal time. 00:42:56.360 --> 00:42:57.890 align:middle line:90% It's not overheating. 00:42:57.890 --> 00:43:01.370 align:middle line:90% 00:43:01.370 --> 00:43:03.030 align:middle line:90% When will you do the opposite? 00:43:03.030 --> 00:43:10.860 align:middle line:90% 00:43:10.860 --> 00:43:12.670 align:middle line:84% It's not, when would you do the opposite? 00:43:12.670 --> 00:43:15.340 align:middle line:84% It's, when are you likely to see the opposite? 00:43:15.340 --> 00:43:20.600 align:middle line:90% 00:43:20.600 --> 00:43:22.530 align:middle line:84% So first of all, what is the opposite? 00:43:22.530 --> 00:43:26.390 align:middle line:84% The opposite is a combination of a fiscal expansion 00:43:26.390 --> 00:43:28.260 align:middle line:90% with a monetary contraction. 00:43:28.260 --> 00:43:31.250 align:middle line:90% 00:43:31.250 --> 00:43:33.125 align:middle line:84% When do you think you would see such a thing? 00:43:33.125 --> 00:43:38.010 align:middle line:90% 00:43:38.010 --> 00:43:40.980 align:middle line:84% AUDIENCE: Either maybe when the government has a budget 00:43:40.980 --> 00:43:42.990 align:middle line:84% [INAUDIBLE] and wants to increase spending, 00:43:42.990 --> 00:43:44.526 align:middle line:90% or maybe when they-- 00:43:44.526 --> 00:43:46.030 align:middle line:90% the interest rates are too high. 00:43:46.030 --> 00:43:48.360 align:middle line:84% They want to reduce interest rates. 00:43:48.360 --> 00:43:50.850 align:middle line:90% RICARDO J. CABALLERO: Yeah. 00:43:50.850 --> 00:43:54.690 align:middle line:90% OK, that's true. 00:43:54.690 --> 00:43:56.710 align:middle line:90% But I'm not sure that that's-- 00:43:56.710 --> 00:44:01.050 align:middle line:84% yeah, but that requires a concerted decision and so on. 00:44:01.050 --> 00:44:01.900 align:middle line:90% It's true. 00:44:01.900 --> 00:44:03.037 align:middle line:90% Yeah, valid question. 00:44:03.037 --> 00:44:04.120 align:middle line:90% It's not the one I wanted. 00:44:04.120 --> 00:44:07.780 align:middle line:84% I wanted something more interesting, more exciting, 00:44:07.780 --> 00:44:13.896 align:middle line:90% but those are valid answers. 00:44:13.896 --> 00:44:16.187 align:middle line:90% AUDIENCE: War. 00:44:16.187 --> 00:44:17.270 align:middle line:90% RICARDO J. CABALLERO: War? 00:44:17.270 --> 00:44:19.210 align:middle line:90% No, war typically is all in. 00:44:19.210 --> 00:44:24.170 align:middle line:90% 00:44:24.170 --> 00:44:25.070 align:middle line:90% No. 00:44:25.070 --> 00:44:29.780 align:middle line:84% OK, let me note, I know it's a strange question, 00:44:29.780 --> 00:44:33.050 align:middle line:90% but I know where I'm heading. 00:44:33.050 --> 00:44:34.760 align:middle line:84% Suppose that the government decides 00:44:34.760 --> 00:44:39.340 align:middle line:90% to spend, for whatever reason. 00:44:39.340 --> 00:44:41.110 align:middle line:84% And the central bank says, whoa, we don't 00:44:41.110 --> 00:44:43.990 align:middle line:90% need that expenditure now. 00:44:43.990 --> 00:44:46.360 align:middle line:84% We don't need this fiscal expansion now 00:44:46.360 --> 00:44:48.400 align:middle line:84% because we're on the margin of overheating, 00:44:48.400 --> 00:44:51.190 align:middle line:84% and now we're going to get this big fiscal expansion. 00:44:51.190 --> 00:44:53.410 align:middle line:84% Then, the Fed, the central bank, is 00:44:53.410 --> 00:44:56.440 align:middle line:84% likely to react to that and hike interest rate. 00:44:56.440 --> 00:44:59.290 align:middle line:84% That will make very upset the government. 00:44:59.290 --> 00:45:00.548 align:middle line:90% It always happens. 00:45:00.548 --> 00:45:01.840 align:middle line:90% The government gets very upset. 00:45:01.840 --> 00:45:03.257 align:middle line:84% And there's a guy that says, look, 00:45:03.257 --> 00:45:05.953 align:middle line:84% I'm trying to expand the economy, and you're fighting me. 00:45:05.953 --> 00:45:07.495 align:middle line:84% But that's the nature of the-- that's 00:45:07.495 --> 00:45:09.860 align:middle line:84% the reason central banks are meant to be independent. 00:45:09.860 --> 00:45:12.460 align:middle line:84% That's where they government-- they can offset that. 00:45:12.460 --> 00:45:14.800 align:middle line:84% And the reason I wanted to highlight that example is I 00:45:14.800 --> 00:45:17.050 align:middle line:84% think some of that-- and somebody asked that question, 00:45:17.050 --> 00:45:20.050 align:middle line:84% I think, in the previous lecture-- 00:45:20.050 --> 00:45:21.680 align:middle line:90% happened to the US economy. 00:45:21.680 --> 00:45:25.210 align:middle line:84% One of the reasons we are in an overheating situation right 00:45:25.210 --> 00:45:31.300 align:middle line:84% now is because the US had a big fiscal expansion early in 2021. 00:45:31.300 --> 00:45:33.310 align:middle line:84% And that fiscal expansion was, at the time, 00:45:33.310 --> 00:45:35.960 align:middle line:84% in which there wasn't much spare capacity in the economy. 00:45:35.960 --> 00:45:37.860 align:middle line:84% So we were very close to full employment. 00:45:37.860 --> 00:45:40.670 align:middle line:84% The supply side was very constrained and so on. 00:45:40.670 --> 00:45:44.030 align:middle line:84% And so there may have been good reasons for the fiscal package, 00:45:44.030 --> 00:45:46.560 align:middle line:84% transfers to people that you need to transfer and so on. 00:45:46.560 --> 00:45:48.230 align:middle line:84% But the macroeconomic consequences 00:45:48.230 --> 00:45:52.560 align:middle line:84% of that very naturally was going to lead to overheating. 00:45:52.560 --> 00:45:55.330 align:middle line:84% And the Fed did not respond to that. 00:45:55.330 --> 00:45:58.300 align:middle line:84% And I think that's one of the reasons people think sometimes 00:45:58.300 --> 00:45:59.050 align:middle line:90% that the Fed-- 00:45:59.050 --> 00:46:01.840 align:middle line:84% well, there's no doubt-- exposed that the Fed 00:46:01.840 --> 00:46:03.170 align:middle line:90% was behind the curve. 00:46:03.170 --> 00:46:05.740 align:middle line:84% But one of the reasons they were behind the curve 00:46:05.740 --> 00:46:10.432 align:middle line:84% is that there was this big fiscal expansion, which 00:46:10.432 --> 00:46:11.890 align:middle line:84% naturally was going to span output, 00:46:11.890 --> 00:46:14.738 align:middle line:90% and they did not react to it. 00:46:14.738 --> 00:46:17.030 align:middle line:84% Eventually, they reacted, but it took them a long time. 00:46:17.030 --> 00:46:19.060 align:middle line:84% And by then, we had inflation and all that. 00:46:19.060 --> 00:46:20.560 align:middle line:84% So that's a situation in which we 00:46:20.560 --> 00:46:22.830 align:middle line:84% should have seen a picture like the opposite of this, 00:46:22.830 --> 00:46:24.080 align:middle line:90% but we didn't see the picture. 00:46:24.080 --> 00:46:26.230 align:middle line:84% We didn't see the monetary part, and that's 00:46:26.230 --> 00:46:30.056 align:middle line:84% the reason we ended up with an economy that is overheating. 00:46:30.056 --> 00:46:32.760 align:middle line:90% 00:46:32.760 --> 00:46:33.610 align:middle line:90% Oh, yeah? 00:46:33.610 --> 00:46:34.600 align:middle line:84% AUDIENCE: Did the Fed ever elaborate on 00:46:34.600 --> 00:46:35.690 align:middle line:90% why they didn't do it? 00:46:35.690 --> 00:46:38.110 align:middle line:90% Or was it just for [INAUDIBLE]? 00:46:38.110 --> 00:46:40.030 align:middle line:84% RICARDO J. CABALLERO: I mean, it's always-- 00:46:40.030 --> 00:46:42.015 align:middle line:84% it's a very uncertain environment here. 00:46:42.015 --> 00:46:43.390 align:middle line:84% Yeah, they thought this was going 00:46:43.390 --> 00:46:45.790 align:middle line:84% to be very transitory, that there 00:46:45.790 --> 00:46:48.520 align:middle line:84% was enough inflationary dynamics, 00:46:48.520 --> 00:46:51.910 align:middle line:84% dis-inflationary dynamics, that would offset all that, 00:46:51.910 --> 00:46:54.358 align:middle line:84% exposed it obviously it was a mistake, but it's exposed. 00:46:54.358 --> 00:46:56.150 align:middle line:84% I mean, there was a lot of noise and so on. 00:46:56.150 --> 00:47:00.790 align:middle line:84% Then, the came the Russian war that sort of increased 00:47:00.790 --> 00:47:04.360 align:middle line:84% the price of oil dramatically, and that sort of created lots 00:47:04.360 --> 00:47:05.870 align:middle line:90% of bad dynamics. 00:47:05.870 --> 00:47:08.380 align:middle line:90% So they were unlucky. 00:47:08.380 --> 00:47:11.895 align:middle line:84% That part is the part that I think that-- 00:47:11.895 --> 00:47:13.270 align:middle line:84% again, they thought we were going 00:47:13.270 --> 00:47:14.910 align:middle line:90% through a temporary situation. 00:47:14.910 --> 00:47:17.243 align:middle line:84% They didn't think that it was going to be strong enough. 00:47:17.243 --> 00:47:19.940 align:middle line:84% They thought the supply side was going to expand a lot faster 00:47:19.940 --> 00:47:22.010 align:middle line:90% than it did. 00:47:22.010 --> 00:47:24.470 align:middle line:84% So they may have been right in not fighting it, 00:47:24.470 --> 00:47:26.400 align:middle line:84% but over a horizon of three years. 00:47:26.400 --> 00:47:29.130 align:middle line:84% And they found everything very compressed into three months, 00:47:29.130 --> 00:47:33.440 align:middle line:90% and that led to a problem. 00:47:33.440 --> 00:47:35.766 align:middle line:84% So the last thing I want to show you 00:47:35.766 --> 00:47:42.312 align:middle line:84% is that this model-- how this model works in practice. 00:47:42.312 --> 00:47:44.270 align:middle line:84% I mean, obviously, you're not going to estimate 00:47:44.270 --> 00:47:46.370 align:middle line:90% exactly the model I show you. 00:47:46.370 --> 00:47:49.010 align:middle line:84% You have a real model, we'll have dynamics and many more 00:47:49.010 --> 00:47:49.790 align:middle line:90% things. 00:47:49.790 --> 00:47:53.420 align:middle line:84% But the more complete version of what I just showed you, 00:47:53.420 --> 00:47:57.500 align:middle line:84% the IS-LM I showed you, many people have estimated sort of-- 00:47:57.500 --> 00:48:00.170 align:middle line:90% 00:48:00.170 --> 00:48:05.300 align:middle line:84% for example, I've estimated the response of the economy 00:48:05.300 --> 00:48:08.730 align:middle line:84% to monetary shocks, or to fiscal expansion, and so on. 00:48:08.730 --> 00:48:13.290 align:middle line:84% And they trace out different dynamics, different variables, 00:48:13.290 --> 00:48:15.390 align:middle line:84% and check whether that's consistent with the IS-LM 00:48:15.390 --> 00:48:16.680 align:middle line:90% framework or not. 00:48:16.680 --> 00:48:18.510 align:middle line:84% And the point of this figure is that it 00:48:18.510 --> 00:48:19.887 align:middle line:90% is very consistent with that. 00:48:19.887 --> 00:48:21.720 align:middle line:84% But let me show you a little bit about time. 00:48:21.720 --> 00:48:24.180 align:middle line:84% So this is the effect on different variables 00:48:24.180 --> 00:48:27.940 align:middle line:84% of a surprise increase in the federal funds rate. 00:48:27.940 --> 00:48:29.490 align:middle line:90% That's the monetary policy rate. 00:48:29.490 --> 00:48:33.720 align:middle line:84% Federal funds rate is the interest rate that the Fed sets. 00:48:33.720 --> 00:48:36.510 align:middle line:84% And where you see that in practice, what you see 00:48:36.510 --> 00:48:40.650 align:middle line:84% is this is the impact on retail sales, on sales output, 00:48:40.650 --> 00:48:42.720 align:middle line:90% really, more or less. 00:48:42.720 --> 00:48:45.763 align:middle line:84% And, yeah, in practice, the output 00:48:45.763 --> 00:48:46.930 align:middle line:90% doesn't respond immediately. 00:48:46.930 --> 00:48:48.480 align:middle line:90% It takes a while. 00:48:48.480 --> 00:48:49.770 align:middle line:90% It takes several quarters. 00:48:49.770 --> 00:48:51.160 align:middle line:90% But eventually, it hits you. 00:48:51.160 --> 00:48:54.390 align:middle line:84% And that's one of the big issues with monetary policy today 00:48:54.390 --> 00:48:57.090 align:middle line:84% is that clearly, inflation is not under control, 00:48:57.090 --> 00:48:58.650 align:middle line:90% but they have done a lot. 00:48:58.650 --> 00:49:03.120 align:middle line:84% And we know that it takes time for the economy 00:49:03.120 --> 00:49:06.818 align:middle line:84% to really perceive the full impact of a monetary policy. 00:49:06.818 --> 00:49:08.985 align:middle line:84% And so that's the tension now because lots of people 00:49:08.985 --> 00:49:11.220 align:middle line:84% are pushing the Fed to do more because we still 00:49:11.220 --> 00:49:14.070 align:middle line:84% have 6% inflation, but they have done a lot. 00:49:14.070 --> 00:49:16.550 align:middle line:84% And they know that monetary policy works with lags. 00:49:16.550 --> 00:49:19.140 align:middle line:84% "With long and variable lags" is a famous sentence. 00:49:19.140 --> 00:49:23.100 align:middle line:84% And so it takes about six quarters to really see the mess, 00:49:23.100 --> 00:49:25.640 align:middle line:90% how much mess has been caused. 00:49:25.640 --> 00:49:27.930 align:middle line:84% It will take a while, so we have to see. 00:49:27.930 --> 00:49:30.140 align:middle line:84% You see, output, well, it's more like sales. 00:49:30.140 --> 00:49:30.980 align:middle line:90% It's the same thing. 00:49:30.980 --> 00:49:33.630 align:middle line:84% Initially, they trend slowly, but it takes a while, 00:49:33.630 --> 00:49:36.130 align:middle line:84% but it does have a very large effect. 00:49:36.130 --> 00:49:37.600 align:middle line:90% This is employment. 00:49:37.600 --> 00:49:38.145 align:middle line:90% Same thing. 00:49:38.145 --> 00:49:40.760 align:middle line:90% 00:49:40.760 --> 00:49:43.350 align:middle line:90% These diagrams, you don't-- 00:49:43.350 --> 00:49:44.600 align:middle line:90% well, this is unemployment. 00:49:44.600 --> 00:49:46.970 align:middle line:84% Naturally, the other side of it is-- 00:49:46.970 --> 00:49:49.500 align:middle line:84% unemployment also will build up slowly. 00:49:49.500 --> 00:49:51.080 align:middle line:90% So unemployment is very low now. 00:49:51.080 --> 00:49:53.270 align:middle line:84% But we don't know when the economy really 00:49:53.270 --> 00:49:55.490 align:middle line:84% feels the impact of all the monetary policy 00:49:55.490 --> 00:49:58.670 align:middle line:84% has been done in the last eight months or so. 00:49:58.670 --> 00:50:01.440 align:middle line:90% Where will unemployment end? 00:50:01.440 --> 00:50:03.843 align:middle line:84% And the big problem for the Fed today 00:50:03.843 --> 00:50:05.760 align:middle line:84% is something that you don't need to understand 00:50:05.760 --> 00:50:07.680 align:middle line:84% until the second part of the course 00:50:07.680 --> 00:50:10.230 align:middle line:84% is that prices do decline eventually, 00:50:10.230 --> 00:50:11.950 align:middle line:90% but it takes a long time. 00:50:11.950 --> 00:50:14.690 align:middle line:84% So to control inflation with monetary policy, 00:50:14.690 --> 00:50:16.540 align:middle line:90% it takes a while, a long time. 00:50:16.540 --> 00:50:19.480 align:middle line:84% Let's see whether the economy, consumers, and so on have 00:50:19.480 --> 00:50:22.690 align:middle line:90% the patience to hang in there. 00:50:22.690 --> 00:50:24.240 align:middle line:90% OK. 00:50:24.240 --> 00:50:35.000 align:middle line:90%