WEBVTT 00:00:00.000 --> 00:00:03.100 Welcome to the deep dive. If you're joining us 00:00:03.100 --> 00:00:06.900 today, you're probably already tracking the complexities 00:00:06.900 --> 00:00:10.259 of macroeconomic policy. Yeah. Or maybe you're 00:00:10.259 --> 00:00:12.640 prepping for an economics class. Right. Or just, 00:00:12.640 --> 00:00:14.460 you know, trying to make sense of the financial 00:00:14.460 --> 00:00:16.339 news when they talk about the Federal Reserve. 00:00:16.660 --> 00:00:19.059 Or you're just insanely curious about how the 00:00:19.059 --> 00:00:21.079 economy actually works behind the scenes. Which 00:00:21.079 --> 00:00:23.260 is a great reason to be here. It is. Because 00:00:23.260 --> 00:00:27.199 today our mission is to thoroughly unpack a single, 00:00:27.440 --> 00:00:30.420 honestly quite dense Wikipedia article. It's 00:00:30.420 --> 00:00:33.159 about the ISMP model. The investment savings 00:00:33.159 --> 00:00:36.600 monetary policy model. Exactly. And we're going 00:00:36.600 --> 00:00:39.579 to build a mental map of the economy using just 00:00:39.579 --> 00:00:42.439 a few key variables. We're talking interest rates, 00:00:42.719 --> 00:00:46.020 inflation, output, consumer spending, and of 00:00:46.020 --> 00:00:48.079 course, the Federal Reserve. And I know that 00:00:48.079 --> 00:00:50.159 sounds like dry academia. A little bit, yeah. 00:00:50.159 --> 00:00:52.320 But it's actually not. It's really the source 00:00:52.320 --> 00:00:54.579 code for how central banks attempt to manage 00:00:54.579 --> 00:00:57.000 our reality. That's how they map out their decisions. 00:00:57.200 --> 00:00:59.539 And we even have a surprising academic rivalry 00:00:59.539 --> 00:01:01.539 to get into later on. Oh yeah, the controversy. 00:01:01.759 --> 00:01:04.359 Right, about whether this model, which is widely 00:01:04.359 --> 00:01:06.459 used, actually hides the most important parts 00:01:06.459 --> 00:01:09.799 of the economy. But let's start with the blueprint. 00:01:10.040 --> 00:01:12.659 What is the ISMP model? Let's lay the foundation. 00:01:13.040 --> 00:01:15.159 So the core definition from the text we're looking 00:01:15.159 --> 00:01:19.299 at says, the ISMP model is a macroeconomic tool 00:01:19.299 --> 00:01:22.879 specifically designed to display short run fluctuations. 00:01:23.299 --> 00:01:24.900 And we really need to emphasize that phrase, 00:01:25.340 --> 00:01:28.120 short run fluctuations. Why is that so critical? 00:01:28.659 --> 00:01:31.000 Because in macroeconomics, the difference between 00:01:31.000 --> 00:01:33.540 the short run and the long run is, well, it changes 00:01:33.540 --> 00:01:35.439 the entire physics of the economy you're looking 00:01:35.439 --> 00:01:38.560 at. OK, so what does short run imply here? It 00:01:38.560 --> 00:01:40.560 implies that certain things in the economy haven't 00:01:40.560 --> 00:01:43.310 had time to adjust yet. Specifically, prices 00:01:43.310 --> 00:01:45.750 and wages. We call them sticky. Sticky prices. 00:01:45.909 --> 00:01:48.209 Right. If the central bank suddenly changes the 00:01:48.209 --> 00:01:51.269 interest rate today, your local coffee shop doesn't 00:01:51.269 --> 00:01:53.790 instantly print new menus with lower prices. 00:01:54.010 --> 00:01:57.069 Yeah, that takes time. Exactly. And your boss 00:01:57.069 --> 00:01:59.269 doesn't immediately call you in to renegotiate 00:01:59.269 --> 00:02:02.049 your salary because those prices are sticky. 00:02:02.650 --> 00:02:06.829 A shift in monetary policy has a very real immediate 00:02:06.829 --> 00:02:10.270 impact on actual economic output and employment. 00:02:10.490 --> 00:02:14.569 Got it. So the ISMP model is mapping that specific 00:02:14.569 --> 00:02:17.389 window of turbulence, the immediate reaction. 00:02:17.469 --> 00:02:19.810 Yeah, the reactive phase before the broader economy 00:02:19.810 --> 00:02:23.110 has time to reach some new long -term equilibrium. 00:02:23.430 --> 00:02:26.509 OK, so in this short run window, the text lists 00:02:26.509 --> 00:02:29.729 three main things this model tracks, the holy 00:02:29.729 --> 00:02:32.310 trinity of variables here, the interest rate, 00:02:32.530 --> 00:02:35.370 inflation, and output. Those three are inherently 00:02:35.370 --> 00:02:37.750 linked in this closed system. It kind of reminds 00:02:37.750 --> 00:02:41.080 me of a dashboard in a car. How so? Like if you 00:02:41.080 --> 00:02:43.460 change one dial, say you tweak the monetary policy 00:02:43.460 --> 00:02:46.020 dial, it automatically forces the needles to 00:02:46.020 --> 00:02:47.879 move on the other gauges, like inflation and 00:02:47.879 --> 00:02:49.939 output. You can't just change one thing in isolation. 00:02:50.180 --> 00:02:52.419 That is a perfect analogy. It's a highly interconnected 00:02:52.419 --> 00:02:54.120 machine. And to understand the whole machine, 00:02:54.240 --> 00:02:55.919 we really have to look at the individual gears 00:02:55.919 --> 00:02:57.680 first. Let's do that. Let's look at the first 00:02:57.680 --> 00:03:00.060 gear, the MP curve. The Federal Reserve's main 00:03:00.060 --> 00:03:02.849 lever. Right. MP stands for monetary policy. 00:03:03.030 --> 00:03:06.110 So I want you, the listener, to visualize a graph 00:03:06.110 --> 00:03:08.629 with us, just a basic two -axis graph. Keep it 00:03:08.629 --> 00:03:10.969 simple in your mind. The vertical axis, the y 00:03:10.969 --> 00:03:13.189 -axis going up and down, is the real interest 00:03:13.189 --> 00:03:16.050 rate. OK. And the horizontal axis, the x -axis 00:03:16.050 --> 00:03:18.610 going left or right, is the inflation rate. Right. 00:03:18.710 --> 00:03:21.789 And the text points out that the MP curve displays 00:03:21.789 --> 00:03:24.270 a positive relationship. It's an upward sloping 00:03:24.270 --> 00:03:27.210 curve. Upward sloping, meaning as inflation moves 00:03:27.210 --> 00:03:30.189 right, meaning it increases. The real interest 00:03:30.189 --> 00:03:32.870 rate moves up. But why? Like physically, what 00:03:32.870 --> 00:03:35.650 is driving that positive relationship? Well, 00:03:35.710 --> 00:03:37.629 the driver of that entire line is the Federal 00:03:37.629 --> 00:03:40.050 Reserve or whichever central bank you're looking 00:03:40.050 --> 00:03:43.030 at. The upward slope isn't some natural law of 00:03:43.030 --> 00:03:46.150 nature. It's a mechanical rule built into the 00:03:46.150 --> 00:03:48.550 model to represent how the Fed behaves. OK, so 00:03:48.550 --> 00:03:51.310 it's mapping human policy decisions. Exactly. 00:03:51.889 --> 00:03:54.050 When inflation starts to heat up, moving to the 00:03:54.050 --> 00:03:56.129 right on your mental graph, the central bank 00:03:56.129 --> 00:03:58.530 reacts by raising the real interest rate to cool 00:03:58.530 --> 00:04:01.099 things down. They hike rates. To make borrowing 00:04:01.099 --> 00:04:04.020 more expensive. Right. And if inflation drops, 00:04:04.780 --> 00:04:09.300 they lower rates to stimulate things. So the 00:04:09.300 --> 00:04:12.240 curve slopes upward because it mathematically 00:04:12.240 --> 00:04:14.919 assumes the central bank is always going to fight 00:04:14.919 --> 00:04:18.300 inflation by raising the cost of borrowing. So 00:04:18.300 --> 00:04:20.860 a movement along that curve is just the Fed doing 00:04:20.860 --> 00:04:23.480 its normal day to day job. Right. Just following 00:04:23.480 --> 00:04:25.839 the standard playbook. But the text gives us 00:04:25.839 --> 00:04:28.860 a specific scenario where the Fed takes a much 00:04:28.860 --> 00:04:31.879 bigger action. It talks about a target decrease 00:04:31.879 --> 00:04:34.079 in the federal funds rate. Now, that is different. 00:04:34.279 --> 00:04:36.560 That is a regime change. And the text says, this 00:04:36.560 --> 00:04:39.740 action shifts the entire MP curve to the right. 00:04:40.060 --> 00:04:41.839 Not just moving along the line, but picking the 00:04:41.839 --> 00:04:43.819 whole line up and shoving it to the right. Right. 00:04:44.079 --> 00:04:46.439 And let's painfully break down the dual outcome 00:04:46.439 --> 00:04:48.740 the text explicitly states here, because this 00:04:48.740 --> 00:04:51.560 is huge. It says, shifting the MP curve right 00:04:51.560 --> 00:04:53.759 results in a decrease in the real interest rate 00:04:53.759 --> 00:04:56.180 and an increase in the inflation rate. And that 00:04:56.180 --> 00:04:58.639 right there is the fundamental trade -off of 00:04:58.639 --> 00:05:01.300 monetary policy. It's the package deal. Exactly. 00:05:01.579 --> 00:05:04.519 When the Fed steps in to artificially lower their 00:05:04.519 --> 00:05:07.439 target rate, they are explicitly accepting a 00:05:07.439 --> 00:05:10.319 trade -off. They are saying, we want lower real 00:05:10.319 --> 00:05:13.160 interest rates to help the economy, but we know 00:05:13.160 --> 00:05:15.480 the mathematical cost of that is higher inflation. 00:05:15.980 --> 00:05:18.079 You can't get one without the other. You really 00:05:18.079 --> 00:05:20.319 can't. And that's why understanding this model 00:05:20.319 --> 00:05:22.699 matters so much for anyone trying to decipher 00:05:22.699 --> 00:05:26.129 policy. It removes the illusion that central 00:05:26.129 --> 00:05:28.490 bankers have magic wands. They just have levers. 00:05:28.709 --> 00:05:31.370 Levers with very strict consequences. OK, let's 00:05:31.370 --> 00:05:32.850 switch gears to the second half of the model. 00:05:33.069 --> 00:05:35.810 We've got the MP curve. Now we need the IS curve. 00:05:36.110 --> 00:05:38.389 Investment savings. Right. And this represents 00:05:38.389 --> 00:05:41.529 basically everyone else. Consumers, the government, 00:05:41.850 --> 00:05:44.430 total output. A real physical economy. So let's 00:05:44.430 --> 00:05:47.209 redraw our mental graph. The vertical axis remains 00:05:47.209 --> 00:05:50.050 the real interest rate. Same as before. But now, 00:05:50.329 --> 00:05:53.449 the horizontal axis is not inflation. It's total 00:05:53.449 --> 00:05:57.129 output, which the text labels as Q. Total output, 00:05:57.310 --> 00:06:00.009 Q. Basically think of it as gross domestic product, 00:06:00.209 --> 00:06:02.870 all the goods and services we produce. Now here 00:06:02.870 --> 00:06:05.529 is a crucial difference. The text highlights 00:06:05.529 --> 00:06:08.110 that the IS curve is a negative relationship. 00:06:08.449 --> 00:06:11.069 It slopes downward. Right. From top left down 00:06:11.069 --> 00:06:13.949 to bottom right. And the core rule from the text 00:06:13.949 --> 00:06:16.490 is that an increase in the interest rate produces 00:06:16.490 --> 00:06:19.970 lower total output, Q. Which makes intuitive 00:06:19.970 --> 00:06:22.550 sense if you think about how normal people and 00:06:22.550 --> 00:06:24.829 businesses operate. Walk us through that. If 00:06:24.829 --> 00:06:27.110 the real interest rate is really high, so you're 00:06:27.110 --> 00:06:29.970 way up on that vertical axis, it means borrowing 00:06:29.970 --> 00:06:32.589 money is incredibly expensive. Mortgages are 00:06:32.589 --> 00:06:35.850 high. Car loans are high. Exactly. So what happens? 00:06:36.209 --> 00:06:39.209 You don't buy the new car. A business decides 00:06:39.209 --> 00:06:41.389 not to build that new warehouse because the loan 00:06:41.389 --> 00:06:42.990 is too expensive. They just save their money 00:06:42.990 --> 00:06:46.089 instead. Right. And because everyone stops borrowing 00:06:46.089 --> 00:06:49.310 and spending, total output Q shrinks, it moves 00:06:49.310 --> 00:06:52.790 to the left. But as interest rates drop, loans 00:06:52.790 --> 00:06:55.649 get cheap, people buy things, businesses expand, 00:06:55.750 --> 00:06:58.410 and output moves to the right. It grows. So if 00:06:58.410 --> 00:07:00.389 we connect this back to the M key curve we just 00:07:00.389 --> 00:07:02.970 talked about, if the Fed fights inflation and 00:07:02.970 --> 00:07:05.930 interest rates go up, that directly crushes total 00:07:05.930 --> 00:07:08.110 output on the IS curve. You're seeing the connection. 00:07:08.470 --> 00:07:11.310 Yes. But who actually moves the IS curve? Because 00:07:11.310 --> 00:07:14.149 the Fed moves the MP curve. Who has the steering 00:07:14.149 --> 00:07:16.959 wheel for IS? The text notes it's the actions 00:07:16.959 --> 00:07:19.540 of the government and consumers. So not the central 00:07:19.540 --> 00:07:23.339 bank? No. The Fed has no direct control over 00:07:23.339 --> 00:07:26.399 the IS curve itself. They only control the interest 00:07:26.399 --> 00:07:29.339 rate on the vertical axis. OK, so the text gives 00:07:29.339 --> 00:07:31.279 another step -by -step scenario for this side 00:07:31.279 --> 00:07:34.819 of the model. The action is an increase in either 00:07:34.819 --> 00:07:37.519 consumer spending or government spending. Like 00:07:37.519 --> 00:07:40.000 a massive stimulus bill. Right, like an infrastructure 00:07:40.000 --> 00:07:42.779 package. The movement from that action, according 00:07:42.779 --> 00:07:46.139 to the text, is the IS curve shifts rightwards. 00:07:46.319 --> 00:07:48.699 The whole line moves right. And the result, and 00:07:48.699 --> 00:07:51.939 this is a key phrase, this results in an increase 00:07:51.939 --> 00:07:54.459 in total output for any level of the interest 00:07:54.459 --> 00:07:57.319 rate. That phrase is everything. For any level 00:07:57.319 --> 00:07:59.040 of the interest rate. Meaning the government 00:07:59.040 --> 00:08:01.759 can just brute force economic growth, even if 00:08:01.759 --> 00:08:04.300 borrowing is expensive. Precisely. If the government 00:08:04.300 --> 00:08:06.660 just dumps a trillion dollars into building roads 00:08:06.660 --> 00:08:09.279 and bridges, that directly injects demand into 00:08:09.279 --> 00:08:11.310 the system. It doesn't matter if the interest 00:08:11.310 --> 00:08:14.410 rate is high or low at that exact moment. That 00:08:14.410 --> 00:08:17.829 sheer volume of spending forces total output, 00:08:18.129 --> 00:08:21.810 Q, to expand outward. So summarizing this, the 00:08:21.810 --> 00:08:25.389 Fed controls the MP curve. You, the consumer, 00:08:25.689 --> 00:08:28.250 and the government, you control the IS curve. 00:08:28.569 --> 00:08:30.350 That's the setup. So let's crash them together. 00:08:30.910 --> 00:08:34.210 Section 4, analyzing the intersection. The chain 00:08:34.210 --> 00:08:36.210 reaction. This is where the model actually comes 00:08:36.210 --> 00:08:39.059 alive. We bring both curves onto the same graph. 00:08:39.299 --> 00:08:41.159 Where they cross is the current state of the 00:08:41.159 --> 00:08:45.299 economy. And the text has a very specific analysis 00:08:45.299 --> 00:08:47.759 example that I want to walk through, like, really 00:08:47.759 --> 00:08:51.320 slowly. Economic dominoes falling. Let's do it. 00:08:51.419 --> 00:08:54.299 OK, domino one, a lowering of the federal funds 00:08:54.299 --> 00:08:56.539 target. The central bankers make their decision. 00:08:56.879 --> 00:08:59.940 Domino two, the MP curve shifts to the right. 00:09:00.039 --> 00:09:02.100 The policy takes effect on the graph. Domino 00:09:02.100 --> 00:09:04.460 three. we get a lower interest rate and higher 00:09:04.460 --> 00:09:06.679 inflation. The mechanical trade -off we discussed. 00:09:07.220 --> 00:09:10.039 The cost of borrowing drops. And here is Domino 00:09:10.039 --> 00:09:13.139 Four, the crossover. The text says this newly 00:09:13.139 --> 00:09:15.360 lowered interest rate causes a downward movement 00:09:15.360 --> 00:09:18.259 along the IS curve. Notice it says a movement 00:09:18.259 --> 00:09:20.899 along the curve, not a shift of the curve. Right. 00:09:21.179 --> 00:09:23.100 And this was kind of an aha moment for me reading 00:09:23.100 --> 00:09:26.139 this, because the output of the MP curve, that 00:09:26.139 --> 00:09:28.879 new lower interest rate, it literally becomes 00:09:28.879 --> 00:09:32.370 the input for the IS curve. Yes. It's a handoff. 00:09:32.870 --> 00:09:34.610 The central bank did their part. They lowered 00:09:34.610 --> 00:09:37.330 the rate. Now the consumers and the businesses 00:09:37.330 --> 00:09:40.830 react to that new low rate. They slide down their 00:09:40.830 --> 00:09:42.909 existing demand curve. Because debt is cheap 00:09:42.909 --> 00:09:46.090 again. Exactly. And that leads to the final domino. 00:09:46.289 --> 00:09:49.889 Domino five. Output increases. The grand finale. 00:09:50.789 --> 00:09:53.909 The elegant machine at work. The Fed pulls a 00:09:53.909 --> 00:09:56.129 lever in a boardroom, which manipulates the MP 00:09:56.129 --> 00:09:58.529 curve, which lowers the interest rate, which 00:09:58.529 --> 00:10:01.590 slides down the consumer and government IS curve, 00:10:02.070 --> 00:10:04.250 ultimately resulting in a boom in total output. 00:10:04.690 --> 00:10:06.649 Cue. It's honestly beautiful when you lay it 00:10:06.649 --> 00:10:09.110 out like that. It's a very satisfying tool for 00:10:09.110 --> 00:10:11.970 economists to use. It maps cause and effect so 00:10:11.970 --> 00:10:14.149 cleanly. But it wasn't always the standard tool, 00:10:14.149 --> 00:10:16.590 was it? No, not at all. Yeah, the text introduces 00:10:16.590 --> 00:10:18.669 an older model, the predecessor. It's called 00:10:18.669 --> 00:10:22.029 the ISLM model. The classic ISLM. OK. If you 00:10:22.029 --> 00:10:24.110 took econ a few decades ago, this is what you 00:10:24.110 --> 00:10:27.190 lived and breathed. So defining ISLM, the text 00:10:27.190 --> 00:10:29.509 notes, it describes equilibrium in two markets, 00:10:29.870 --> 00:10:32.389 the commodity market and the money market. Right. 00:10:32.649 --> 00:10:35.870 The IS part is the exact same. Investment savings, 00:10:36.090 --> 00:10:38.309 the commodity market, the real economy. But the 00:10:38.309 --> 00:10:41.009 LM part is different. LM stands for liquidity 00:10:41.009 --> 00:10:43.769 preference and money supply. So why do we have 00:10:43.769 --> 00:10:47.549 ISMP now? The text specifically calls ISMP an 00:10:47.549 --> 00:10:49.809 upgraded version. What was wrong with the old 00:10:49.809 --> 00:10:52.289 one? Well, the text says the upgrade better reflects 00:10:52.289 --> 00:10:55.110 the impact of monetary policy and the central 00:10:55.110 --> 00:10:57.529 bank's role in managing the economy. Meaning 00:10:57.529 --> 00:10:59.909 the central banks changed how they operate in 00:10:59.909 --> 00:11:03.370 the real world. Exactly. Under the old ISLM model, 00:11:03.529 --> 00:11:05.649 The assumption was that a central bank controlled 00:11:05.649 --> 00:11:08.490 the economy by strictly managing the actual supply 00:11:08.490 --> 00:11:11.210 of physical money, the quantity of dollars out 00:11:11.210 --> 00:11:12.789 there. But they don't really do that anymore. 00:11:13.169 --> 00:11:15.549 Not primarily, no. Modern central banks shifted 00:11:15.549 --> 00:11:18.129 to targeting specific short term interest rates 00:11:18.129 --> 00:11:20.649 instead. They adjust the rates and they let the 00:11:20.649 --> 00:11:22.490 money supply kind of float to whatever level 00:11:22.490 --> 00:11:24.610 is needed to maintain that rate. So the map had 00:11:24.610 --> 00:11:27.350 to change to reflect the new territory. Right. 00:11:27.830 --> 00:11:30.009 And the academic context the text gives for this 00:11:30.009 --> 00:11:31.789 is really interesting. It cites a foundational 00:11:31.789 --> 00:11:34.950 paper from the year 2000. By David Romer. Yes. 00:11:35.610 --> 00:11:38.750 Titled Keynesian macroeconomics without the LM 00:11:38.750 --> 00:11:41.970 curve. Without the LM curve. So Romer just straight 00:11:41.970 --> 00:11:44.309 up deleted the money market from the model. He 00:11:44.309 --> 00:11:46.269 looked at it and said if central banks aren't 00:11:46.269 --> 00:11:48.909 obsessing over the money supply anymore why should 00:11:48.909 --> 00:11:52.149 our baseline model obsess over it. He deleted 00:11:52.149 --> 00:11:54.809 the LM curve and replaced it with the MP curve 00:11:54.809 --> 00:11:57.690 which focuses purely on the central bank's interest 00:11:57.690 --> 00:12:00.490 rate actions. It centers the Fed. Completely. 00:12:00.889 --> 00:12:02.970 It puts their policy lever right in the spotlight. 00:12:03.269 --> 00:12:06.169 OK, but before we get into the pushback on Roemer's 00:12:06.169 --> 00:12:09.250 big deletion, because there is pushback, we need 00:12:09.250 --> 00:12:11.750 to scale up a bit because the text reminds us 00:12:11.750 --> 00:12:14.230 of a major limitation. The short run limitation. 00:12:14.509 --> 00:12:17.629 Right. ISMP only displays short run fluctuations. 00:12:17.769 --> 00:12:20.899 It's the immediate reaction. But obviously economists 00:12:20.899 --> 00:12:23.519 care about what happens next year or five years 00:12:23.519 --> 00:12:25.360 from now. You can't just look at the short run. 00:12:25.480 --> 00:12:27.639 So the text introduces the bigger picture. It 00:12:27.639 --> 00:12:30.019 says the ISMP model is actually used as a foundation 00:12:30.019 --> 00:12:34.120 for the ADAS model. ADAS, aggregate demand and 00:12:34.120 --> 00:12:36.179 aggregate supply. What's the connection there? 00:12:36.419 --> 00:12:39.059 Think of the ISMP model as the engine that powers 00:12:39.059 --> 00:12:42.159 the ADAS model. Okay. The ISMP model tells us, 00:12:42.159 --> 00:12:45.399 hey, the Fed cut rates today, so output is booming 00:12:45.399 --> 00:12:48.629 right now. The ADAS model takes that immediate 00:12:48.629 --> 00:12:51.029 boom and tracks how it ripples out over time. 00:12:51.210 --> 00:12:53.950 When those sticky prices get unstuck. Exactly, 00:12:54.029 --> 00:12:56.289 when the sugar high wears off. Because if output 00:12:56.289 --> 00:12:58.490 is booming, eventually companies have to hire 00:12:58.490 --> 00:13:01.509 more workers, which drives up wages, which increases 00:13:01.509 --> 00:13:04.610 costs, which forces them to finally raise their 00:13:04.610 --> 00:13:07.529 prices. Meaning inflation. Systemic long -term 00:13:07.529 --> 00:13:10.440 inflation. The text specifically says that when 00:13:10.440 --> 00:13:14.100 ISMP is plugged into the ADA framework, economists 00:13:14.100 --> 00:13:16.480 can drive long -term movements in inflation and 00:13:16.480 --> 00:13:18.980 interest rates. It transitioned from the base 00:13:18.980 --> 00:13:21.519 short -run movements to the long -term reality. 00:13:21.840 --> 00:13:24.639 So they nest inside each other. ISMP handles 00:13:24.639 --> 00:13:27.240 the today, ADAS handles the tomorrow. That's 00:13:27.240 --> 00:13:28.620 a great way to put it. Alright, let's get back 00:13:28.620 --> 00:13:30.580 to David Romer deleting the money supply from 00:13:30.580 --> 00:13:32.879 the model, because not everyone loved this upgraded 00:13:32.879 --> 00:13:35.320 version. It was a very bold move, and in economics 00:13:35.320 --> 00:13:38.639 bold moves invite serious critiques. And the 00:13:38.639 --> 00:13:41.799 text introduces a massive critique from economist 00:13:42.159 --> 00:13:45.460 Greg Mankiw. A huge name in the field. And Mankiw 00:13:45.460 --> 00:13:47.940 has this great quote in the text. He says, the 00:13:47.940 --> 00:13:51.539 ISMP model has quirky features. Which is, in 00:13:51.539 --> 00:13:54.379 academic speak, calling a rival's model quirky 00:13:54.379 --> 00:13:56.639 is basically throwing down the gauntlet. It's 00:13:56.639 --> 00:14:00.059 a very polite insult. Mankiw explicitly prefers 00:14:00.059 --> 00:14:04.039 the old ISLM model. He does. And the text gives 00:14:04.039 --> 00:14:07.500 us his core argument for why. It says, ISLM focuses 00:14:07.500 --> 00:14:09.360 on the important connections between the money 00:14:09.360 --> 00:14:11.659 supply, interest rates, and economic activity. 00:14:11.470 --> 00:14:15.269 And here's the kicker, whereas the ISMP model 00:14:15.269 --> 00:14:17.149 leaves some of that in the background. Leaves 00:14:17.149 --> 00:14:18.789 it in the background. That is the fundamental 00:14:18.789 --> 00:14:21.669 blind spot Mankiw is pointing out. So Romer wanted 00:14:21.669 --> 00:14:23.830 to center the Federal Reserve and interest rates 00:14:23.830 --> 00:14:25.330 because that's what they actually talk about 00:14:25.330 --> 00:14:27.590 in their press conferences. Right. But Mankiw 00:14:27.590 --> 00:14:31.350 is arguing that by doing so, by literally erasing 00:14:31.350 --> 00:14:34.590 the money supply curve, you're hiding a massive 00:14:34.590 --> 00:14:37.590 structural force in the economy. Mankiw is basically 00:14:37.590 --> 00:14:39.950 saying, Just because the Fed isn't staring at 00:14:39.950 --> 00:14:41.590 the money supply doesn't mean the money supply 00:14:41.590 --> 00:14:43.649 stopped mattering. It's still there. It's definitely 00:14:43.649 --> 00:14:46.409 still there. And Mankiw argues that the sheer 00:14:46.409 --> 00:14:49.049 quantity of money circulating is a critical driver 00:14:49.049 --> 00:14:52.370 of inflation and economic health. If your model 00:14:52.370 --> 00:14:54.549 just assumes the money supply will magically 00:14:54.549 --> 00:14:56.450 adjust itself in the background without causing 00:14:56.450 --> 00:14:58.710 any weird side effects, you're going to get caught 00:14:58.710 --> 00:15:02.070 off guard. So who is right? Which is more important 00:15:02.070 --> 00:15:04.470 for understanding the economy, the interest rate 00:15:04.470 --> 00:15:07.250 lever, or the actual pool of money? Well, it's 00:15:07.250 --> 00:15:10.080 a trade off, right? Roemer's model is incredibly 00:15:10.080 --> 00:15:13.320 accurate for normal times. When the economy is 00:15:13.320 --> 00:15:15.860 functioning normally, the Fed tweaks the interest 00:15:15.860 --> 00:15:18.899 rate, and the ISMP model predicts the outcome 00:15:18.899 --> 00:15:21.620 beautifully. But what about abnormal times? That's 00:15:21.620 --> 00:15:23.659 exactly when Mankiw's critique hits hardest. 00:15:24.320 --> 00:15:26.460 So we've taken this massive journey today through 00:15:26.460 --> 00:15:29.220 the ISMP model. We really have. We started with 00:15:29.220 --> 00:15:31.259 the basic short -run fluctuations of interest 00:15:31.259 --> 00:15:34.220 rates, inflation, and output. We mapped out the 00:15:34.220 --> 00:15:36.679 Federal Reserve's MP curve and how they trade 00:15:36.679 --> 00:15:38.980 higher inflation for lower rates. And we looked 00:15:38.980 --> 00:15:41.759 at the IS curve, where consumer and government 00:15:41.759 --> 00:15:44.299 spending can drive output regardless of what 00:15:44.299 --> 00:15:46.769 the Fed is doing. Right. And then we brought 00:15:46.769 --> 00:15:48.870 them together to watch the chain reaction from 00:15:48.870 --> 00:15:52.210 the boardroom to the cash register. And we debated 00:15:52.210 --> 00:15:55.049 the evolution of the model itself, from ISLM 00:15:55.049 --> 00:15:58.389 to ISMP, Roemer versus Manki. There's a lot to 00:15:58.389 --> 00:16:01.330 take in. It is. But what is the real listener 00:16:01.330 --> 00:16:04.269 value here? Like, why keep this model in your 00:16:04.269 --> 00:16:06.590 head? The value is that the next time you hear 00:16:06.590 --> 00:16:08.870 a news report saying the central bank is lowering 00:16:08.870 --> 00:16:12.639 interest rates, you aren't just hearing abstract 00:16:12.639 --> 00:16:14.700 financial jargon anymore. Right, you have the 00:16:14.700 --> 00:16:17.179 blueprint. You possess the exact mental blueprint. 00:16:17.360 --> 00:16:20.179 You can visualize the MP curve shifting right. 00:16:20.779 --> 00:16:23.279 You know exactly how that decision is meant to 00:16:23.279 --> 00:16:26.340 cascade down the IS curve, making borrowing cheaper, 00:16:26.700 --> 00:16:29.299 to artificially boost total output in the short 00:16:29.299 --> 00:16:31.480 run. You can see the matrix. You can see the 00:16:31.480 --> 00:16:33.779 matrix. I love that. But I want to leave everyone 00:16:33.779 --> 00:16:36.419 with a final provocative thought built on Mankey's 00:16:36.419 --> 00:16:38.120 critique. Oh, this is a good one. Because if 00:16:38.120 --> 00:16:41.539 the ISMP model became the modern standard by 00:16:41.539 --> 00:16:43.720 placing the central bank's interest rate policy 00:16:43.720 --> 00:16:46.399 in the spotlight and leaving the actual money 00:16:46.399 --> 00:16:49.580 supply in the background, what happens to our 00:16:49.580 --> 00:16:51.980 understanding of the economy when those traditional 00:16:51.980 --> 00:16:54.179 interest rate tools stop working? Like when interest 00:16:54.179 --> 00:16:57.559 rates hit zero? Exactly. When rates hit zero 00:16:57.559 --> 00:16:59.940 and the central bank resorts to just printing 00:16:59.940 --> 00:17:02.899 trillions of dollars quantitative easing, suddenly 00:17:02.899 --> 00:17:05.000 the money supply is the only thing that matters. 00:17:05.240 --> 00:17:07.619 But our modern model left that in the background. 00:17:08.039 --> 00:17:11.119 Right. Are we relying on a map that is fundamentally 00:17:11.119 --> 00:17:14.460 blind to the very money supply we ignored? It 00:17:14.460 --> 00:17:16.400 really makes you wonder if our models are shaping 00:17:16.400 --> 00:17:19.839 our reality or blinding us to it. A great question 00:17:19.839 --> 00:17:22.339 to end on. Thank you for joining this deep dive 00:17:22.339 --> 00:17:24.660 and keep questioning the models that shape our 00:17:24.660 --> 00:17:26.220 world. We'll see you next time.