Advertisement
49:27
Transcript
0:16
today we're going to talk about um
0:19
perhaps the most important model in this
0:21
class the ISL MPC model which puts
0:24
together all that we have done up to now
0:26
but before we do that uh let's talk a
0:30
little bit about the current
0:32
events uh who knows what that
0:37
is is this a exam week or
Advertisement
0:42
what Silicon Valley Bank exactly no so
0:46
Silicon Valley Bank the 16th Bank in
0:49
size asset size in the US ER went
0:54
essentially under last Friday was shut
0:57
down by the FD last last
1:01
Friday so that's the decline in in the
1:04
stock value uh during Thursday Friday
1:09
and uh and then it was shut down and you
1:11
see that it's not being traded anymore
1:14
um so that's a pretty significant event
Advertisement
1:17
and the the weekend was pretty stressful
1:19
for anyone involved in in in this event
1:23
the treasury the FDIC the Federal
1:27
Reserve and so on um
1:30
it's first it was a large I mean it's
1:32
not one of the big systemic Banks if you
1:34
will it's not JP Morgan City Bank of
1:38
America one of those Banks which are
1:41
regulated even differently from these
1:42
Banks but still is a pretty large Bank
1:45
you see by asset size $29
1:48
billion H which is you know comparable
1:51
to Washington Mutual which was the
1:53
largest bank that went under during the
1:55
global financial crisis Great Recession
1:57
at that time there were lots of other
1:59
banks that went under H but the largest
2:03
was comparable to this one and in fact
2:05
all the things that were done over the
2:06
weekend and that still being done today
2:08
is to prevent something like this
2:10
happening here as well okay and so it
2:14
was
2:15
a a pretty significant event now what
2:18
happened to Silicon Valley
2:21
Bank um well in the the immediate cause
2:25
of of of of the failure is what always
2:28
kills a bank which is a r
2:30
by this depositors okay and what you see
2:33
here is is the following this is this
2:35
this Bank actually grew enormously over
2:38
the last two three years essentially
2:39
doubl its asset size
2:43
um but it began to have sort of outflow
2:46
net outflows of
2:48
deposits during 2022 and the reason for
2:51
that is not because the business was
2:54
doing poorly anything it was simply
2:57
because this is a bank that service
2:59
primarily of the high the tech sector
3:02
startups companies and things like that
3:04
and those sectors were having hard time
3:06
raising new capital in an environment
3:09
that was not very friendly towards the
3:11
tech sector so so so they began to
3:14
withdraw on their deposits and and
3:16
that's what led to these flows here now
3:21
eventually
3:23
ER because of this and and something
3:26
I'll explain in a few minutes ER
3:29
this the they decided svb Bank decided
3:32
to issue new Equity ER issue new
3:37
Equity to cover certain losses they had
3:40
incurrent and today in the mod of social
3:42
in the world of social media that
3:45
immediately led to sort of massive
3:46
spread that this bank was in trouble and
3:49
then you saw enormous attempts to
3:51
withdraw deposits now not all of these
3:53
these were fulfilled but there was a
3:55
massive pressure to withdraw deposits
3:58
and and and and that's the end always
4:01
for a bank that doesn't find an
4:02
alternative source of funding and often
4:05
for withdrawals of that size the only
4:07
alternative source of funding is either
4:09
that some other bank buys you or that
4:12
the FED comes in and gives you a
4:16
line anyway so what is the that was
4:19
immediate and it's always whenever you
4:21
ask you hear about the bank run the
4:24
immediate cost of the problem is a run
4:26
from of the depositors from deposits in
4:29
that that bank now why did this happen
4:33
in this in this particular bank again I
4:36
explain why is that you saw those small
4:39
withdrawals of deposits but but what
4:42
happens to this to them is actually
4:44
there as I said before their deposits
4:47
grew very rapidly over the last two
4:49
three years and then rather than being
4:52
very risky lenders rather than investing
4:55
you know sometimes when Banks grow very
4:57
rapidly they do lots of crazy things you
4:59
know they in they make lots of loans
5:01
without going doing the D diligent
5:04
process and all that that's not what
5:06
they did they bought treasury bonds the
5:09
safest as as you can imagine they bought
5:11
10 year treasury bonds lots of them but
5:14
they bought them at the wrong time they
5:16
bought them right before the hike in
5:18
interest rates that we began to see in
5:21
2022 and we already looked at the
5:24
relation between interest rates and
5:25
price of bonds well you have a 10-year
5:28
bond and the interest starts going up
5:30
the price of that Bond starts
5:32
declining now that is not is problematic
5:35
for a bank but not entirely the end of
5:38
the story because that means that the
5:40
the the market value of the bonds you're
5:42
holding among your assets starts
5:44
declining but Banks do not need to
5:47
recognize that
5:48
loss unless they sell the
5:51
bonds because the the the logic is that
5:54
well if the guy just sits on the bond
5:56
the bond hasn't really lost any value in
5:57
the sense that it will get the same
5:59
coupons that he was planning to get and
6:00
so on this is us treasuries us
6:02
treasuries are not going to default in
6:03
the coupons let's hope it's not going to
6:05
happen in a few months from now but but
6:08
typically they don't default on coupons
6:10
so so the logic the regul regulation is
6:14
assigned in such a way perhaps is a
6:15
failure I think there is a problem there
6:17
but that they don't need to
6:20
recognize the losses unless they sell
6:22
the bonds so they look pretty healthy
6:25
because they had massive amount of
6:27
Treasury bonds they did not need to
6:28
recognize that
6:30
problem is that when this small W
6:34
relatively small withdrawals start at
6:36
some point they needed to find a
6:39
substitute for those funds they need to
6:40
honor the deposits that that were being
6:43
withdrawn and at that point they had to
6:45
sell assets and when they sold assets
6:48
they made the loss because at that point
6:49
you have to recognize the loss because
6:51
you're not going to hold the the bond
6:53
until expiration and clip all the
6:55
coupons that come from it so you have to
6:57
recognize the loss that's a loss
7:00
that led the CEO to announce that they
7:03
needed a fundraising to cover a $2.5
7:06
billion hold they had as a result of the
7:08
losses okay now okay so now we have a we
7:14
know why where the losses came from now
7:16
if you notice the losses are not that
7:18
big I mean this is a bank with $200
7:19
billion and and the losses were
7:22
relatively small where is the other leg
7:25
of the problem it's
7:28
here you know in in the US deposits are
7:32
ured up to
7:33
$250,000 that means no matter what
7:35
happens to the bank where you have the
7:37
money if that bank goes under and you
7:41
have deposits for below $250,000 the
7:43
FDIC comes and gives you a check okay so
7:45
there's no risk so if you have deposit
7:48
under $250,000 you don't need to worry
7:51
about this you may go you don't need to
7:53
read the news about this bank
7:55
because you will get your funds in fact
7:57
when when the bank was shut down on
8:00
Friday the FDIC announc immediately
8:03
every depositor under $250,000 can come
8:05
on Monday and get his money okay so
8:08
there's no issue there and most banks
8:10
have a large share of depositors that
8:12
are small depositor that means they are
8:14
covered by this Deposit Insurance
8:17
mechanism which was designed precisely
8:20
to prevent runs because if you don't
8:21
need to worry about where you get your
8:23
money know you don't need to run on the
8:25
bank the problem is that this bank was
8:28
very different in the composition of
8:29
depositors he had primarily business
8:33
deposits meaning it was all these
8:35
startup companies and so on in the tech
8:36
sector they had their their deposits
8:38
there and those deposits were much
8:40
larger than
8:41
$250,000 if you
8:43
see it's about I think it's close to 95%
8:47
of the deposits were not covered by the
8:49
insurance by the fdac insurance okay
8:52
that means it's a very different
8:54
calculation when you have a deposit
8:56
that's not covered by insurance and then
8:58
you start feeling that the bank Mak may
8:59
go under what do you do you take your
9:02
money out you know put it some you send
9:05
it to JP Morgan where there's no risk
9:07
and wait until this thing is
9:10
resolved now in this case and that's
9:12
what typically happens in this case it
9:14
happens even faster than normally why
9:17
because many of the depositors the
9:18
business that were deposited in there
9:20
were were a startups that were being
9:24
seeded by some Venture Capital
9:27
funds and Venture Capital funds as soon
9:29
as they noticed that there was a problem
9:31
here began to call all the startups and
9:33
tell him hey take that money out of
9:35
there because you know they may run into
9:37
travel so it was a venture capital world
9:40
that caused the Run
9:42
effectively and and and and and that's
9:45
what happened
9:46
okay now so that's that's what happened
9:49
that's the reason for the run and and
9:51
and
9:53
the and so there was a a problem the
9:55
problem was not that big but but the
9:57
problem is that the deposits were very
9:59
un safe they were not covered and moving
10:01
deposits out is very easy I mean you
10:03
just you know you just wire your money
10:05
to another bank so so so why wait there
10:09
why risk it and that's that's what
10:11
happened it's called in economics
10:14
coordination failure when I mean if
10:16
everyone freezes and say okay nobody
10:17
takes the money out and so on this stuff
10:19
is when I pass then we're safe but but
10:22
but since we don't call each other and
10:24
we don't trust each other to really
10:25
leave the money there we we we we make
10:27
the call only after we have taken our
10:29
money out and since we all think the
10:31
same way then you get a run on the bank
10:34
now let me start connecting this a
10:35
little bit with uh with the kind of
10:38
things we have done in in this course I
10:41
I I I may actually discuss runs later in
10:44
the course as a as a as a topic crisis
10:47
speculative attacks and things like that
10:48
but for
10:50
now here what you have is an indicator
10:53
of essentially is this is the vix a is a
10:57
is an indicator of Supply volatility
11:00
something is extracted from the price of
11:01
options you don't need to know the
11:03
details but the point is that that is
11:07
one of the main indicators of of fear of
11:09
of how afraid are investors in a moment
11:12
in the market and and uh and what you
11:15
can see here is that that this indicator
11:17
the vixs essentially
11:19
Spike
11:21
Thursday and and Thursday and Friday
11:24
went up Friday went up very very rapidly
11:27
and then it got stabilized a little
11:31
now ER it turned out that it turns out
11:34
that over the weekend ER H you may have
11:38
heard the government the Consolidated
11:41
Government came up with a very massive
11:43
package to to prevent runs on the
11:46
remaining Banks and and also to prevent
11:49
the fact that I mean all of these were
11:51
business deposits of a small companies
11:53
that used even this bank for the payroll
11:57
and so on so so what was done of this
11:59
weakness that all the deposit not only
12:01
the ones under
12:03
$250,000 were guarantee by the FDIC
12:06
there are mechanism under which you can
12:08
activate that so that means now all the
12:11
depositors were made
12:15
whole and but the idea was not it was
12:18
part partly the reason to do that it was
12:20
to prevent a mess in the pay roles of
12:23
the small companies and all that that
12:25
had their account in in in this bank but
12:28
it was also to prevent on other Banks
12:31
you know and uh and so on top of this
12:35
the FED now has a line of
12:38
credit ER for banks to not have to sell
12:42
their assets for small Banks they can
12:44
just pledge the assets to the central
12:46
bank and get an exchange for that the
12:48
cash they need okay and they can do that
12:52
without recognizing the implicit loss so
12:54
without marking to market the price of
12:56
the bonds okay so how this mechanism
12:59
existed before the pl of
13:03
svb we would not have seen anything like
13:05
that but the whole idea was to prevent
13:06
that other Banks run into into that kind
13:09
of trouble now the markets reacted well
13:11
to all that overnight and so on but the
13:14
vi kept going up this morning now it's
13:15
coming down again I mean there's still a
13:17
lot of stress and if you see the shares
13:19
of First Republic Bank for example had
13:21
declined by 60% today and things like
13:23
that so so there's a still Panic going
13:26
on okay and as a result of that ER all
13:30
these indicators of stress sort of are
13:32
very stressed out remember credit
13:35
spreads I told you about that X that we
13:37
had Le several lectures ago the
13:39
probability of the fault of a bone the
13:41
perceived probability of the fault all
13:42
those things went up a lot I mean the
13:44
Riser the bonds the closer you are to
13:47
the financial system particular to small
13:49
Banks the larger those spreads have
13:51
become so X went up a
13:53
lot this picture that comes next I find
13:57
it very interesting from the point of
13:58
view of this
14:00
course what this is is the following
14:03
this is the market
14:06
expectation of the next hike by the
14:11
fed the FED next announcement on policy
14:14
rate happens on the 22nd March 22nd so
14:18
remember what has been happening is that
14:20
that that ER since the US has been
14:23
running sort of very hot with lots of
14:24
inflation interest rate were increased
14:26
very rapidly at clips of 50 basis points
14:29
a CLI that's very large changes in
14:31
policy rate for a country as large as
14:33
the US and and so we had this big 25
14:38
basis points increases and a few
14:40
meetings ago they decided to lower the
14:42
pace of the increases to 25 basis points
14:45
rather than 50 Bas points per meeting
14:46
okay so they said we're going to keep
14:48
raising interest rate but we're going to
14:50
go out to 25 basis points now it turns
14:53
out so this is 25 basis points the data
14:56
has becoming very hot remember we said
14:58
inflation looked to have Peak and now
14:59
it's beginning sort of to turn around
15:01
again it's beginning to rise so what has
15:03
been happening is that the market say
15:05
Okay 25% basis point is the most likely
15:09
next hike but you see the expectation of
15:12
that is it was sort of a steady around
15:14
30 basis points some people expected
15:16
some major players expected the FED to
15:19
hike by 50 basis points not 25 basis
15:21
points by early last week data came very
15:25
hot so there was indication that clearly
15:27
inflation was picking up again the labor
15:28
market Market was very strong and so on
15:30
so look what happened to the bets
15:32
immediately expected value went up this
15:34
is all traded it went up and and the
15:37
expectation was for the next meeting was
15:39
up north of of 40 basis points so
15:42
essentially most of the market thought
15:44
that the next hike would be 50 basis
15:47
points
15:49
okay but look what happened and then the
15:51
problems of this with this Bank began
15:54
and look how this pleted today is 15
15:58
basis point is expected value that means
16:00
very few people are expecting 50 basis
16:02
point A lot of people are thinking 25
16:04
still but about an equal size expecting
16:07
zero so a POS in the interest rate hike
16:11
by the FED okay and all that is a result
16:14
of the events of the last two three
16:17
days
16:18
Y what is there to learn from this I
16:21
guess in like the bigger structure or
16:24
who's at fault is it the people who got
16:27
really scared all these depositors that
16:29
got potentially scared or or fearmonger
16:31
in that capacity is it that the banks
16:34
don't necessarily have I mean I can't
16:36
feel like it's an unre there are many
16:37
good questions and and and you're going
16:39
to see a lot of that and politicians are
16:40
going to talk a lot about that in the
16:42
next few days and so on it's very clear
16:44
that there was some sort of regulatory
16:46
failure here the regulator it was pretty
16:49
obvious that I mean this this bank had
16:51
doubled the asset size in in in a year
16:53
that's already a red flag and and these
16:56
guys are regulated by the Fed so the the
16:58
s Francisco fed should have been worried
17:00
about this Bank ER there is issues
17:05
conventional issues of diversification I
17:07
mean it's pretty crazy to have all your
17:08
savings in One Bank especially if you're
17:11
not
17:12
insure there is issues there's
17:16
also remember after the global financial
17:18
crisis there's there was a bill designed
17:23
to legislation designed to strengthen
17:26
the balance sheet of the banks it made
17:27
them hold a lot more cas Capital they
17:30
are subject see if they're systemic they
17:31
are consider they're subject to stress
17:33
test where sort of regulators go in
17:35
there and check whether portfolios can
17:36
survive major micros shcks and so on H
17:40
and that's that's called The Dot Frank
17:42
Bill okay so that was done in
17:45
2018 that got partially undone and
17:48
partially andone precisely for these
17:50
type of Banks and these guys were
17:52
actually loving for that they said okay
17:54
why don't you because to be sort of
17:56
really stress test and so on by the
17:58
regular you have to be big enough to
18:00
really be able to live a a big mess and
18:03
and and and so what these guys and and
18:06
Banks like them did is they Lobby a lot
18:10
so they got the the the threshold of
18:13
asset that you need to have in order to
18:15
be stress stress tested and so on raise
18:18
dramatically so they were right below
18:21
the level that you need to be really
18:24
sort of monitored very very closely by
18:27
the regulator by the by the FED if
18:29
you're a systemic bank then the FED
18:31
regulates you these guys were lightly
18:33
regulated by the FED because they were
18:35
below that threshold so there regulatory
18:37
failures it's clear that the regulator
18:40
fail what it did
18:44
depositors didn't diversify enough ER
18:48
they didn't diversify enough the bank
18:50
itself didn't diversify enough the the
18:52
source of funding I mean what is very
18:54
special of this bank and that's what
18:55
gives us hope that this stuff is not
18:56
going to spread all around is that their
18:59
funding was very sort of you know was
19:01
all coming from the same sector large
19:04
saver large depositors and so on the
19:07
typical bank doesn't have that they have
19:08
a much broader source of funding which
19:10
is what you need because you know
19:12
otherwise so so there are lots of
19:13
lessons for Bankers for
19:16
Regulators ER for microeconomist as well
19:19
I mean to tell you the truth one of the
19:22
concerns with with the pace at which the
19:24
FED has been hik in interest rates is
19:26
that people were wondering well do we we
19:28
know whe something will break at some
19:30
point and there was a lot of concern
19:32
that something could break well
19:33
something broke now and this broke
19:36
entirely the part of the the loss comes
19:39
entirely from interest rate highs
19:41
essentially they got into a portfolio of
19:43
long that was very long rat when rates
19:45
began to rise so they they had losses
19:48
entirely from that and that's a risk I
19:51
mean when you do monetary policy is that
19:54
some people will be stretch out there
19:56
and and and if you sort of sometimes
19:58
miss one that is important that that's
20:00
very costly and I think was that's one
20:02
of the reasons they wanted to lower the
20:06
the interest R hikes from 50 basis
20:08
points to 25 basis points because they
20:11
knew that something could be fragile out
20:14
there and and and this was one of those
20:17
things so those are those are
20:20
lessons now I was about to connect with
20:23
the things we did in a few lectures ago
20:25
I said look so this is telling you the
20:28
markets when they saw this x going
20:31
up and started betting that the that the
20:34
FED will not hike interest rate as much
20:37
and in fact that they may even pause
20:38
rather than raise the interest rate as
20:40
was planned they may even pause interest
20:42
rates we talked about
20:45
this lecture
20:48
seven remember in lecture seven when we
20:51
talk about the expanded islm model we
20:56
had this x variable and we said look if
20:59
x goes up that measure of riskiness and
21:01
so on that increases the cost of
21:03
borrowing for the private sector that is
21:06
like a shift in the yes to the left for
21:08
any given safe interest rate saved by
21:11
the central bank now all of the sudden
21:13
the cost of borrowing for companies is
21:15
higher and therefore this is
21:18
contractionary okay and then we went on
21:22
remember we went on and said well here
21:24
it is the question what should the
21:26
Central Bank do in this case
21:29
in which X went
21:33
up that's was the next slide inide of
21:35
fact you know lower the interest rate
21:37
because there's one component of cost of
21:39
borrowing that's going up for for ER for
21:44
firms which is the X well the FED can
21:47
offset that by lowering the interest
21:49
rate now here they're not planning yet
21:51
to lower the interest rate they were
21:52
planning to raise interest and now
21:54
they're slowing down that that's a bet
21:56
so the market knows some basic and
21:58
expanded islm model because that's
22:01
that's what you know explains exactly
22:03
what you should anticipate that that's
22:05
what is likely to to
22:08
happen anyways that's where we are at
22:10
this
22:13
moment any questions about this
22:15
otherwise I'm going to move to the
22:17
lecture really but I thought we had to
22:19
talk about
22:22
it well in anyways if it gets a lot
22:25
Messier I'm hoping that it won but if it
22:27
gets a lot Messier then we can another
22:29
section at the end I can replace
22:31
something for for something on banking
22:33
crisis and something like that
22:38
okay which is what I teach in one of my
22:40
graduate courses so would be would be
22:45
fine anyway so now what I want to do is
22:48
start this islm PC model and sort of the
22:52
number the name is not very creative
22:53
it's pretty obvious what we're going to
22:55
do here no is going to combine the aslm
22:59
with with the Philips curve and what
23:02
this this will do for us is it will
23:04
allow us to think not only about the
23:07
impact of a policy or a shock but also
23:09
think about what happens over time with
23:11
that shock okay ER not to the long run
23:14
but we call this analysis sort of the
23:16
short run which is what happens in the
23:18
very few early weeks months and what
23:21
happens in the medium run say a year a
23:24
year and a half from now and so this
23:26
model will allow us to put all of the
23:30
together
23:32
um so and But but so so so you don't get
23:36
lost on this so the analysis of the
23:39
short run essentially will remain
23:40
unchanged it's is our islm mod it's just
23:44
that give it a little time and you start
23:47
seeing other certain effects get undone
23:50
and some others get exacerbated and so
23:51
on okay but but the short one is still
23:54
islm is your basic mod but then we're
23:56
going to see that things happen
23:59
over time so remember the slm model was
24:03
essentially this is equilibrium in the
24:05
Goods Market and then we had an LM which
24:07
said I equal to I bar no and so I'm
24:12
going to replace the LM already inside
24:14
this and I get my islm mod so for any
24:17
given I bar I could solve out for
24:20
equilibrium output
24:22
now here I'm going to do I'm going to
24:25
adopt the the the I didn't want to do it
24:27
before but I think at this point is
24:28
useful because of will simplify the
24:30
diagrams when we draw them to really
24:33
think of the FED as setting the real
24:35
interest rate okay so I'm going to
24:38
assume now and then I'm going to explain
24:40
what
24:41
happens when that's a bad assumption but
24:45
but I'm going to assume for now that
24:46
rather than the FED setting the nominal
24:48
interest rate that the FED is set in the
24:50
real interest rate okay so it's setting
24:54
this and then we're going to talk about
24:57
problems I mean in
24:59
principle if the interest rate is not
25:01
against the zero lower
25:03
bound the FED can always do that say
25:06
okay I'm going to give them them I'm
25:07
going to give you the nominal interest
25:09
rate that given this expected inflation
25:10
gives me the real interest rate I want
25:12
okay that's what the FED is really
25:14
trying to do all the time the FED is not
25:16
trying to figure out what is the
25:18
equilibrium nominal interest rate he's
25:19
always trying to figure out whether the
25:21
real interest rate is at the right level
25:23
or not for the economy now the tool they
25:26
have is a nominal interest rate but they
25:27
are thinking thinking always about the
25:29
real interest rate and and and and
25:32
sometimes there's a problem because it's
25:35
a when you against a zero lower bound
25:37
then you can't affect the real interest
25:38
in the same way but but most of the time
25:41
you can and so I'm going to think I'm
25:43
going to rewrite the slm mo now but I'm
25:46
going to call this our bar and the bar
25:49
is there just to tell you remind you
25:50
that there something that the FED is
25:52
setting
25:54
okay so that's our aslm remember the
25:57
Philips curve part
25:59
the Philips that was our Philips curve
26:01
remember the last once we replace the
26:03
natural rate of unemployment in there we
26:05
had the inflation minus expected
26:07
inflation was a decreasing function of
26:09
the unemployment Gap okay so if
26:11
unemployment was above the natural rate
26:12
of unemployment inflation was lower than
26:15
expected inflation and conversely if the
26:18
unemployment rate was lower than the
26:19
unemployment rate and I said one the
26:21
situation of the US today is that
26:23
everything seems to point towards toward
26:27
a situation where U is below un that's
26:29
the reason we're seeing sort of high
26:31
inflation okay now what I'm going to do
26:34
next is I'm going to go from an
26:35
employment to Output so I can put you
26:37
see I don't have an employment anywhere
26:40
here I have output so what I want to do
26:43
is play with the Philips curve and until
26:46
I write it in the space of inflation and
26:48
output not inflation and unemployment so
26:50
I can put the two curves together that's
26:52
what I want to remember I want to merge
26:55
here the slm with the PC so I want to
26:57
put them in the the same
26:59
variable so remember we have operated
27:03
with a very simple production function
27:04
in which output is equal to employment
27:07
remember that's what we assume
27:09
employment we call it n well I can
27:12
rewrite n employment as the labor force
27:15
times one minus the unemployment rate
27:18
that's employment okay so that's I can
27:21
think of output as that similar I can
27:24
define a what we call we don't call it
27:27
natur output we call it potential
27:30
output no and potential output is
27:32
defined as as the output that you get
27:36
when unemployment is at the natural rate
27:38
of unemployment okay so that's a
27:40
definition three lines the potential
27:43
output is when
27:46
when the output you get which in this
27:49
with this production function is the
27:51
employment you get when you're at the
27:53
unemployment at the natural rate of
27:55
unemployment and now I can construct the
27:57
difference the minus that this is
28:00
something we call the output Gap and you
28:02
may
28:03
hear typically when people talk
28:07
about issues of monetary
28:11
policy often is described in terms of
28:13
this variable More Than This Gap say
28:16
people talk about the output Gap if the
28:17
output Gap is positive that means output
28:20
is above the natural rate of out the
28:22
potential output when the output Gap is
28:24
negative output is below potential
28:26
output so I can re write this you know
28:29
this minus that is just that and now I
28:32
can I can replace uus un n here for H
28:37
minus Yus YN / L and I get the Philips
28:41
curve now written in terms of the output
28:43
Gap and inflation so this says when
28:46
output is above potential output when
28:48
the output Gap is positive then
28:50
inflation exceed expected inflation
28:53
conversely when output is below
28:55
potential output then inflation is below
28:58
expected inflation okay but the logic is
29:01
exactly the same as the logic we had
29:02
here why is that this happens well
29:05
because when output is above the
29:07
potential output that means also
29:09
unemployment is lower than the natural
29:10
rate of unemployment okay so that's a
29:14
that's the logic any question about
29:17
this
29:19
no okay good so anyway so now we have a
29:23
a Philips curve and our aslm model so so
29:28
let's put them together and suppose for
29:31
now and when last example when I carry
29:33
around is that expected inflation is
29:35
equal to lag inflation so this a case in
29:38
which expected inflation is not well
29:39
anchor and then we're want to talk about
29:41
what happens when it's anchor and not
29:42
anchor so suppose that that inflation is
29:45
actually whatever is this year's
29:47
inflation that's what you expect for
29:49
next year okay so here I have an example
29:52
in which here I'm plotting our islm now
29:55
which I'm using remember the real
29:57
interest right here here H and in this
30:00
diagram down here I'm plotting the
30:02
Philips
30:04
curve okay so first thing let's look
30:08
about this Philip SC why is that where
30:10
sloping here is output so this this is a
30:13
parameter Pi n so and and and this is
30:16
the left hand side variable so it's
30:17
obviously increasing in output why is
30:19
that well because if output grows that
30:22
means unemployment goes down that means
30:24
wages go up prices go up and you get
30:28
inflation that's a mechanism okay so in
30:32
this particular
30:33
example we have this is the real
30:36
interest rate that the FED has set at
30:38
this moment that's equilibrium output
30:40
what I'm trying to tell you here is that
30:43
nothing has change in the way you
30:45
calculate equilibrium output you just
30:46
use for that you only need the stop
30:49
diagram in the short
30:50
run I tell you what the real interest
30:52
rate is set by the is which is a
30:56
decision by the Fed
30:58
then I know where my is is I can pin
31:01
down output I don't need this diagram to
31:04
really pin down equilibrium output
31:07
okay nothing is different there
31:11
but and this is an example in this
31:14
particular case we have that inflation
31:17
is rising
31:19
here and the question is why so for this
31:22
what I'm trying to say is that for this
31:25
is which is a function of fiscal policy
31:27
of how confident consumers are and stuff
31:30
like that if the FED chooses this real
31:33
interest rate we end up with this output
31:35
but it turns out that this level of
31:36
output is increasing
31:40
inflation and the increase in inflation
31:42
I can read here I see the change in
31:44
inflation is positive here why is this
31:47
happening um if you're changing the
31:49
alpha that means you have a different
31:51
level ofemployment which changes the um
31:54
expected inflation R yeah well actually
31:57
here I don't need to take take this
32:00
diagram would have also work with
32:01
expected inflation as a constant here
32:04
I'm I'm more looking at what happens to
32:06
inflation I'm saying if output is above
32:09
the natural rate of output then
32:10
inflation is above expected inflation
32:12
but I can take expected inflation as a
32:13
constant in fact here it is a constant
32:15
because constant in the sense that is
32:18
given at time T because it's a previous
32:19
year's inflation but what is important
32:22
is that you have too much aggregate
32:23
demand this economy is running very hot
32:26
if output is positive then that is going
32:31
to lead to inflationary pressures in
32:33
this particular model where expected
32:34
inflation is equal to l inflation this
32:36
is pretty bad because not only you get
32:37
inflation above the target of the FED
32:39
but inflation is rising over
32:42
time so this is a case in which this
32:45
Central Bank is setting the real
32:47
interest rate too
32:49
low okay now you may want Japan is doing
32:52
a little bit of this but they have a
32:54
reason is that they have had inflation
32:56
so low that it makes sense for them to
32:58
build a little a little
33:00
inflation in the US it made less sense
33:02
remember the US got into trouble because
33:04
it was in a situation like this for a
33:05
long period of time I mean the you the
33:07
reason we have today 6% inflation well
33:10
depends which indicator you use is
33:12
because the US experience sort of a year
33:16
with a situation like this a year and a
33:19
half okay and that's what sometimes
33:21
people said the Fed was behind the curve
33:23
they they for for a variety of reasons
33:25
one initially potential output the Cline
33:28
because of all the covid related issues
33:30
they expected that to recover quickly so
33:32
they says well let it go because I'm not
33:34
going to start moving my policy right
33:35
around for something that will recover
33:37
quickly as soon as Co is gone well it
33:39
took longer to recover and then it came
33:41
the sort of the Russian war shock and so
33:43
on and so natural rate of unemployment
33:46
moved to the left to start and second
33:50
because of an enormous policy support
33:52
primarily H and the fact that that
33:55
houses were able to save a lot during
33:58
it there was a lot of pent up demand
34:01
then we had enormous aggregate demand
34:03
when we came out of it and the real
34:05
interestate that we had was just way too
34:07
low for all that agregate demand and
34:09
that
34:10
low potential output so we were in a
34:13
situation like this and inflation began
34:14
to
34:15
climb initially expected inflation was
34:19
very well anchor and then we began to
34:20
lose the anchor then we recover it and
34:22
and now we're losing it again we shall
34:24
see what happens after this current
34:25
episode but that was exactly a situation
34:27
of the US and of most economies around
34:29
the world China is in a different story
34:32
but in most economies around the world
34:34
you certainly Europe all of them the UK
34:38
Continental Europe and the UK Latin
34:40
America when you look the situation was
34:43
like that just real interest were way
34:44
too low for a um um the natural rate the
34:50
potential the level of the potential
34:52
output we had at that time and so we got
34:54
into situation like this
34:57
okay so that's the short run in the
34:59
short run if you have an interest rate
35:01
that is very low I mean again in the
35:03
short run you you know how to determine
35:04
output given a real interest rate and
35:06
then now you can say a little more say
35:08
okay but that's going to put inflation
35:10
it's going to cause inflationary
35:11
pressures up or down depending on
35:13
whether you are to the right or to the
35:14
left of the natural rate of output
35:16
that's a new twist about the short run
35:18
that you know but now let's start moving
35:21
over time so what happens over
35:23
time well first let me Define something
35:26
well potential output we know what it is
35:30
but I'm going to define something which
35:31
is called the natural rate of interest
35:34
rate sometimes called the neutral
35:36
interest rate sometimes called the
35:37
weelian interest rate let me not get
35:39
into that story but I'm going to Define
35:42
implicitly the natural rate of interest
35:45
rate or the neutral rate of interest or
35:48
some people call it rst star you may
35:49
have heard of RS star in the newspapers
35:52
people talk about R star when they are
35:54
talking about RAR they're talking about
35:55
that okay is simply the interest rate
35:58
that that makes the natur the potential
36:01
output the equilibrium of the Goods
36:03
Market okay so I'm solving implicitly I
36:05
say I want to get as a result as an I
36:08
want to get as a result of this
36:10
equilibrium here H the natural rate of
36:13
output what is the interest I need to
36:15
pick so that's the
36:17
case okay so I want to get the natural
36:20
rate of output here the potential output
36:22
I know that there is an interest rate
36:24
real interest rate at which that holds
36:27
no it's a matter looking for the
36:28
interest rate that does that and in this
36:30
particular diagram is this you see at
36:33
this interest
36:34
rate the ASI equilibrium output is
36:38
exactly the natural rate of
36:40
output okay so what I know is that
36:45
eventually the economy will have to go
36:49
there no eventually the economy will
36:52
have to go there so how will this happen
36:55
in practice the way we happen is okay
36:59
this is the point we were at in the
37:01
previous slide
37:03
no so we were
37:06
here well that's building in
37:08
inflationary
37:10
pressure what do you think will happen
37:13
inflation start
37:17
climbing who will react who is in charge
37:21
not letting inflation get get carried
37:25
away Central Bank know the Fed so what
37:28
they'll start doing is hiking interest
37:29
rate which is exactly what they have
37:30
been doing no and as they hike interest
37:33
rate you know they're going to
37:35
keep they take they start increasing the
37:37
real interest rate interest until they
37:39
get to this point okay that's
37:42
idea so the point is that in the medium
37:47
run a a the real interest real variables
37:51
determine real variables not monetary
37:53
policy monetary policy has to follow
37:55
whatever it is that the economy throws
37:56
at them banks have to follow whatever is
37:59
the real interest rate if they made a
38:00
mistake and they set an real interest
38:02
rate which is not consistent with a
38:04
stable inflation they're going to learn
38:06
about it and over time they're going to
38:08
have to fix that and when will the
38:10
problem go away only when H they they
38:14
reach the natural rate of unemployment
38:16
okay and so that's what will happen as
38:19
the real interest start going up from
38:21
here to there then you start seeing the
38:24
change in inflation this particular mole
38:27
ER um declining and declining and when
38:29
you get to an natural rate of output at
38:31
least you get a stable
38:36
inflation is this adjustment
38:39
clear okay good okay so that's what
38:42
happened in the medium run so the medium
38:45
run is described as moving from that
38:47
point here the whole process of going
38:49
back to a situation where we converge to
38:52
the Natural rate of interest rate and
38:55
therefore the natural rate of output and
38:57
the natural rate of unemployment and all
38:59
these kind of things okay so that's the
39:01
short run is whatever his output is
39:03
That's So slm the medium run is whatever
39:07
the the natural rate tells you should be
39:10
the natural rate of unemployment the
39:11
natural rate of output and therefore the
39:13
natural rate of interest rate or weelian
39:15
interest rate or the neutral interest
39:16
rate or our star that's all pinned down
39:19
there in the in the in the medium run
39:21
and the transition is obviously going
39:23
from the short run like pure LS slm to
39:26
the Natural rate
39:27
type analysis
39:30
okay now I assume here and that's
39:33
related to your answer I assume here
39:36
that expected inflation was an anchor
39:40
that is that expected inflation was
39:42
equal to l inflation that's I I told you
39:45
before that's not what Central One banks
39:48
want to be because that means that if
39:51
you mess up inflation is high and and
39:55
then in order to bring it down you also
39:57
have to bring down expected inflation
39:58
you need to cause a recession and you
40:00
can see that here so suppose that the
40:02
Central Bank starts with the level of
40:04
inflation that it like suppose that this
40:06
is the model so what I said before the
40:08
expected inflation is equal to lag
40:09
inflation suppose that the Central Bank
40:12
starts at the level of inflation that it
40:14
likes 2% in the US okay I suppose that
40:18
for whatever reason whatever shock it
40:21
finds itself with an interest rate that
40:23
is too low a real interest rate is too
40:25
low that means in inflation exceeds
40:29
expected inflation which was
40:32
2% well by next year say this suppos
40:35
this Gap is 2% well by next year the G
40:38
inflation is
40:40
4% okay so if your inflation is 4% in
40:45
fact in the US it got to be 9% if you
40:48
are at 9% level of inflation and this is
40:50
the model of expected for expected
40:52
inflation you have then Houston you have
40:55
a problem because it's not enough with
40:57
raising interest rate up to this point
40:59
suppose that the FED says wow I don't
41:01
like 9% I'm going to go back to that
41:04
that clearly tells me that my output is
41:06
way above the natural rate of output I'm
41:08
going to hike interest rate and somebody
41:09
tells the fed this is your natural
41:11
interest rate a very good research
41:14
Department tells him look this is your
41:15
natural interest hike it to there
41:17
suppose the FED hikes the interest rate
41:18
to that point what
41:20
happens so the FED realized here this
41:22
was going really wrong they end up with
41:25
9% inflation so but somebody tells him
41:28
look this is your natural your neutral
41:30
interest rate your R star bring it there
41:32
and the FED immediately reacts and takes
41:35
it there what
41:37
happened is the Fed happy with the final
41:40
outcome and supposed the res Department
41:41
was really good so they got got it right
41:44
so the r star was the right R
41:48
star okay and the FED implemented that
41:51
policy move interest rate suppose that
41:53
the interest rate the real interest rate
41:54
they had was minus 1% I'm telling you
41:56
numbers that are not that different from
41:58
what we had minus 1% and and and the
42:02
research Department tells no your your
42:04
RN is really 1% so they hike interest
42:06
rate by 2%
42:08
immediately and now what
42:19
happens
42:21
so I guess that question is a little
42:23
bague but but I'm saying is the Central
42:25
Bank happy now that it o I got we got
42:28
the right natural rate neutral rate it's
42:31
called neutral
42:33
rate well I'm telling you I wouldn't be
42:36
asking you if the Fed was happy after
42:37
that so why do you think why why are
42:39
they unhappy why is the Fed unhappy
42:42
after that not unhappy with the policy
42:45
but but but when I'm saying the
42:47
adjustment is not completed at that
42:49
point
42:56
why and I'm trying to make the bigger
42:58
point for why central banks are so eager
43:01
to maintain credibility and not have
43:02
this kind of model of expected inflation
43:04
they want the markets to believe them
43:06
that that they have a Target and that
43:08
they're going to go to that Target and
43:10
and that to set their expected inflation
43:12
equal to that constant equal to a Target
43:14
that's what they dream with because if
43:16
they don't get that if they get this
43:18
instead things are
43:20
nasty and I'm trying to describe that
43:22
Nas what what what is happening now so
43:26
what happens here okay so so so we went
43:27
here inflation got to be 9% and now the
43:31
FED boom hike interest rate
43:33
by 200 basis point it got to the Natural
43:36
rate we're back at output equal to
43:38
Natural rate of output what is happening
43:39
to inflation
43:43
here so now we're back at the natural
43:46
what is happening to
43:48
inflation well this diagram tells you
43:51
something very specific it says it's not
43:53
changing so now your inflation at least
43:55
is not changing
43:58
okay so that's
44:00
good at least not Rising here it was
44:03
Rising it's not changing but what is the
44:07
problem inflation not changing when
44:10
you're at 9% is not a good outcome for
44:12
the FED want 2% not
44:15
9% okay so they when you have this
44:18
modification you need to do more than
44:20
that you know because you need to bring
44:22
expected inflation down so you need to
44:24
overshoot a Fed that finds itself with
44:26
9% inflation and has expected inflation
44:29
and anchor needs to be inflation much
44:32
lower so needs to raise interest in the
44:34
short run much higher than the natural
44:35
rate of interest rate so it gets
44:37
negative inflation here so you can bring
44:39
the 9% back to
44:41
2% no so I have to generate a minus 7%
44:45
here and to generate a minus 7% here I
44:48
need to bring output much below the
44:51
natural rate of output I need to cause a
44:52
big recession to do that and that's the
44:55
reason the bank central banks don't want
44:57
to be in this scenario because with this
45:00
of inflation if expected inflation
45:03
becomes an anchor then there's no way
45:05
around that the FED will have to cause a
45:06
big recession to get out of inflationary
45:09
problem
45:11
okay contrast that with a case in which
45:14
the market the expected inflation is not
45:15
equal to lag inflation but is equal to
45:17
whatever the FED tells them is the long
45:19
run average 2% so now suppose that
45:23
therefore rather than having here Pi
45:25
minus one I have that Target Pi Bar
45:28
which is 2% so yeah we got to 9% but for
45:33
the FED to go back to say the FED would
45:36
say whoop I mess up you know clearly set
45:39
a real interest that was way too low and
45:41
so I end up with 9% inflation but if
45:43
credibility is maintained and still
45:45
people expect 2% in the medium run then
45:48
that means that the FED doesn't need to
45:49
cause a recession to bring inflation
45:51
back to the normal level it just needs
45:54
to bring output to a level equal to
45:57
potential out so it just need to raise
46:00
interest to RN to the Natural rate of
46:03
the r star not to our Star Plus
46:06
something in order to have this
46:08
inflation in the short okay and we're
46:12
there at this moment in the verge of
46:13
these two worlds we have been
46:14
alternating between the two worlds still
46:18
more biased towards the good World in
46:20
which really the FED doesn't need to
46:22
cause a the need the FED needs to slow
46:25
down the economy because it still need
46:26
to bring out put down to YN but that's a
46:29
small change in practice all these
46:31
things are growing over time it just
46:33
means that the economy grows at a lower
46:35
pace for a few quarters okay but it's
46:39
very different to have to bring
46:40
temporarily output down here because for
46:42
that you need to sort of bring the
46:45
growth has to become
46:46
negative for some period of time in
46:48
order to bring inflation
46:52
down
46:54
good so
46:58
big lessons from uh this part is that as
47:01
I said before in the M run so so I
47:04
haven't changed at I haven't changed any
47:06
of the two models I told you what was
47:07
the model of the short run the slm
47:09
that's still true here I told you then
47:11
what was the model of the natural rate
47:13
of unemployment and all that and that
47:15
there we didn't have any monetary policy
47:16
or anything like that we we look at what
47:17
happened in the labor market and we
47:19
determin the natural rate of an
47:20
employment and that was it okay so so
47:25
the medium run here is when we are in
47:27
that world which has nothing to do with
47:29
monetary policy it has all to do with
47:32
real variables okay what is a n what is
47:34
a equilibrium long-ter real interest
47:36
rate what is a natural rate of
47:38
unemployment things of that
47:40
kind um but monetary policy what does do
47:45
is certainly determine in the short run
47:48
equilibrium output and but in the medium
47:50
run it's is determines what is the
47:52
nominal interest rate equilibrium
47:54
nominal interest rate and the level of
47:55
inflation because the economy will have
47:58
a real interest rate which is the rst
48:01
star and RN the economy has RN but the
48:05
fed and the FED will not get to pick
48:07
what RN is the only thing that the FED
48:10
will get to pick in the medium run is
48:12
what is a nominal interest rate that is
48:14
consistent with that RN because supposed
48:16
the RN is say
48:19
2% if the if the economy ends up having
48:22
3% inflation on average that means that
48:25
the nominal interest r rate for the long
48:27
run is going to have to be
48:29
5% is instead that economy has 2%
48:32
inflation average then that means that
48:33
the the long run nominal interest rate
48:35
will be 4% so monetary policy affects
48:38
the nominal interest rate nominal
48:40
variables in the M run but not the real
48:42
variables the real variables are
48:43
determined by the real sector and that's
48:45
often refer as the neutrality of money
48:47
in the medium run and the long run money
48:50
tends to be neutral and that's that's
48:52
what it means
48:54
that real variables are determined by
48:56
something entirely different but in the
48:58
short run monetary policy is the main
49:00
game game in town and in the medium run
49:03
it's just about inflation it's not about
49:06
real
49:08
activity
49:11
um Let me let me stop here
— end of transcript —
Advertisement
