 Good evening. Good afternoon. Good morning, depending on which part of the universe you are Today we're going to talk about the impact of policy on the economy and Specifically we were going to look at the impact of monetary policy and fiscal policy. We're going to use our ISLM framework to understand how can the government affect the Equilibrium output interest rate investment or that so in the case of fiscal policy Let's let's simply take a case where the government is pressed by all kinds of constraints to reduce the deficit Or it could be a situation where in fact the government feels that the economy is overheating and then wants to slow down The matter matter what the cause is they could there could be a reason for why the government would implement what we call a contractually a contractionary fiscal policy, which means to reduce Spending or increasing taxes with the purpose of slowing down economic activity So once again, let's go back to our ISLM framework and see how we can actually Visualize the impact of fiscal policy in on the economy since we're talking about Contractually fiscal policy. Let's take the case where the government chooses to accomplish that by reducing government expenditures remember government expenditures is part of Aggregate demand so for goods and services. So it's in the goods market Which means that our focus Starting point will be the IS curve, which is the Condition for equilibrium in the goods market. So here we have a goods market Shock the shock is on the goods market in the good market So when the government reduces government expenditures, that means that aggregate demand is going to go down We will see a shift in the ISLM to the left and that will give us a new equilibrium for both income and Interest rate. So income will go down interest rate will go down So if government decides to reduce government expenditures, it will be the same if they decide to raise taxes That will result in lower output lower interest rate, but then my most more interesting question is Why does the interest rate Decline when government reduces expenditures and why does Income go down as As we see on this graph on this diagram. So why why does interest rate go down? Remember we are talking about and if first of all the government reduces expenditures, this reduces aggregate demand and It's what gives us a lower interest rate and of course a lower output, but then the question is why does interest rate go down Recall our discussion about Portfolio choice people have the choice in Holding their worth between money and bonds Now in this case, how can we use that relationship to understand why government why interest rate is going down? If government is spending less That means that the government needs to borrow less doesn't need to borrow. So that means that the Supply for bonds Which is the one of the means in which government can borrow is going to go down So government needs to borrow less Supply less the supply of bonds is going to go down supply Goes down which means that the price of bonds Goes up. We implies that Interest rate goes down Remember we always found we said that there is always a negative relationship between price of bond and interest rate So it's the is the decline in government expenditures meaning less needs for the government to borrow That means that the price of bond goes up as the supply goes down Okay, so that that's one way in which we can explain one why government why interest rate goes down Now as interest rate go down What is going to happen to investment? So in equilibrium? We see lower income Higher I mean lower interest rate, which means that the lower interest rate means that investment is going to go up But then the high the lower output means that interest rate Investment is going to go down. So what is the net effect? It all depends on whether you believe that Investment is sensitive enough to interest rate in other words when When you look at investment by firms is the constraints more on the cost of capital in the interest rate or on the availability of funds or demand Which is the which explains the relationship between interest rate. I mean investment and income if you believe if you believe that the the the constraint is on the on the demand side of Investment so that for example firms invest mostly to meet the demand for for their for their products and in which case the In which case income is a key factor in explaining in investment then this effect will be Large if you believe that it's the cost of capital that determines investment Then this effect is going to be large. So the net effect will depend on whether it's the income or Accelerator effect as we call it that is bigger or the cost of capital that is bigger So this you cannot answer this question theoretically You just have to look at the data look at the evidence and see whether at a decline in government expenditures is accompanied by an investment boom or a Decline investment and that's that's that's very important because if you are a central bank governor It all depends on which channel which effect you believe in if you believe that this is a powerful effect And you are a central bank governor You're going to use your monetary policy to keep interest rates low to simulate investment But if you if you believe that this is not strong enough then in fact what you want to in terms of simulating Investment is to accelerate Economic activity and create incomes Which is a source of demand for? Firms output and then as demand goes up output Demand for firms output goes up then firms are going to invest more How about monetary policy? Let's take the case where a government Concerned by the fact that the economy is not growing or the economy is coming out of a recession Wants to simulate the economy through expansionary monetary policy. This means injecting more Cash in the economy or reducing interest rates, whatever it is to stimulate the economy In this case what is happening if the government if the the Fed decides to Inject more more cash in the economy. That means that money supply goes up this curve goes up shift to the right and we have a lower interest rate and higher So increasing money supply led to lower interest rate higher output But then I can ask you Why and also why here? Why does interest rate go up? Go go down when money supply goes up Here again, we're going to look at our portfolio choice So money supply goes up that means that there is excess Cash in people's pockets So people are going to buy bonds This will raise the price of bonds and there you go Meaning interest rate is lower Whereas for this one what's happening is that as money supply goes up and interest rate goes down What is happening? We hope is that the lower interest rate would Would increase cause investment to go up and income to rise So we have here both an Impact on income and an impact on on the investment Interest rate the way we explain the interest rate effect is through the portfolio choice Excess cash in the economy people get rid of excess cash by buying bonds means demand for bond goes up and the price of bonds go up Here as interest rate goes down we We are saying we are assuming that that reduces the cost of capital firms are going to invest more and that creates more That leads to higher income That sums up the impact of an expansionary monetary policy on On the economy which will lead to higher output lower interest rate. Good morning. Good afternoon Good evening depending on where you are