Open course ware

[SQUEAKING] [RUSTLING] [CLICKING] RICARDO J. CABALLERO: OK, so let's continue with this IS-LM model. Remember in the previous lecture, we set up-- we set it up. We built the IS-LM model. And we'll go over that very quickly in this lecture because I think it's very important for you. And then, we're going to use it. And eventually, we're going to talk a little bit about the policy response, the macroeconomic policy response during the COVID-19 shock, or recession, all of the above. So the starting point-- remember, the first thing we did, we constructed the IS relation. And the IS relation was just the same as lecture 3. But we sort of spelled out what is inside that investment that we had taken as a constant there. We said, well, far more realistic is to make investment itself increasing in output because it's increasing in sales. That won't change the analysis that we had in lecture three. All that will do is change the slope of the aggregate ...

[SQUEAKING] [RUSTLING] [CLICKING] RICARDO J. CABALLERO: OK, let's start. So what you have there in that picture is the result of a survey to a bunch of economists on-- which are asked to assess the probability that there is a recession within the next 12 months. Recession means, essentially, a decline in aggregate output. And well, the first thing to notice here is that it's not very good news. There are very high chances that, at least according to these experts, that the US enters a recession within the next 12 months or so-- pretty high probability. You can see that that number typically is very, very low, and it goes very high sort of next to recessions. And now we're not in a recession, but there is a sort of very high perceived probability that we may go into a recession in the near future. So how is it that these people come up with this forecast? Well, at some level, either explicitly or implicitly, they must have some model of the termination of equil...

[SQUEAKING] [RUSTLING] [CLICKING] RICARDO J. CABALLERO: So today, my plan is to finish the open economy part of the course. And we will talk about exchange rate regimes. But before I do that, I need to finish a few things that we didn't in the previous lecture. And that will help as an introduction for the kind of things I want to talk about today. And let me start just reviewing that last slide that we discussed, which is the Mundell-Fleming model. And the Mundell-Fleming model, essentially, is our old IS-LM model, in which the IS a little different because now we have a net export term, which is a function of new things like foreign output, foreign income, and most importantly, the real exchange rate. And the real exchange rate itself, because of the UIP, uncovered interest parity condition, is a function of expected exchange rate, the foreign interest rate. And it also gives yet another reason for why the interest rate affects domestic aggregate demand. There's...