[00:16] today we're going to talk about um
[00:19] perhaps the most important model in this
[00:21] class the ISL MPC model which puts
[00:24] together all that we have done up to now
[00:26] but before we do that uh let's talk a
[00:30] little bit about the current
[00:32] events uh who knows what that
[00:37] is is this a exam week or
[00:42] what Silicon Valley Bank exactly no so
[00:46] Silicon Valley Bank the 16th Bank in
[00:49] size asset size in the US ER went
[00:54] essentially under last Friday was shut
[00:57] down by the FD last last
[01:01] Friday so that's the decline in in the
[01:04] stock value uh during Thursday Friday
[01:09] and uh and then it was shut down and you
[01:11] see that it's not being traded anymore
[01:14] um so that's a pretty significant event
[01:17] and the the weekend was pretty stressful
[01:19] for anyone involved in in in this event
[01:23] the treasury the FDIC the Federal
[01:27] Reserve and so on um
[01:30] it's first it was a large I mean it's
[01:32] not one of the big systemic Banks if you
[01:34] will it's not JP Morgan City Bank of
[01:38] America one of those Banks which are
[01:41] regulated even differently from these
[01:42] Banks but still is a pretty large Bank
[01:45] you see by asset size $29
[01:48] billion H which is you know comparable
[01:51] to Washington Mutual which was the
[01:53] largest bank that went under during the
[01:55] global financial crisis Great Recession
[01:57] at that time there were lots of other
[01:59] banks that went under H but the largest
[02:03] was comparable to this one and in fact
[02:05] all the things that were done over the
[02:06] weekend and that still being done today
[02:08] is to prevent something like this
[02:10] happening here as well okay and so it
[02:14] was
[02:15] a a pretty significant event now what
[02:18] happened to Silicon Valley
[02:21] Bank um well in the the immediate cause
[02:25] of of of of the failure is what always
[02:28] kills a bank which is a r
[02:30] by this depositors okay and what you see
[02:33] here is is the following this is this
[02:35] this Bank actually grew enormously over
[02:38] the last two three years essentially
[02:39] doubl its asset size
[02:43] um but it began to have sort of outflow
[02:46] net outflows of
[02:48] deposits during 2022 and the reason for
[02:51] that is not because the business was
[02:54] doing poorly anything it was simply
[02:57] because this is a bank that service
[02:59] primarily of the high the tech sector
[03:02] startups companies and things like that
[03:04] and those sectors were having hard time
[03:06] raising new capital in an environment
[03:09] that was not very friendly towards the
[03:11] tech sector so so so they began to
[03:14] withdraw on their deposits and and
[03:16] that's what led to these flows here now
[03:21] eventually
[03:23] ER because of this and and something
[03:26] I'll explain in a few minutes ER
[03:29] this the they decided svb Bank decided
[03:32] to issue new Equity ER issue new
[03:37] Equity to cover certain losses they had
[03:40] incurrent and today in the mod of social
[03:42] in the world of social media that
[03:45] immediately led to sort of massive
[03:46] spread that this bank was in trouble and
[03:49] then you saw enormous attempts to
[03:51] withdraw deposits now not all of these
[03:53] these were fulfilled but there was a
[03:55] massive pressure to withdraw deposits
[03:58] and and and and that's the end always
[04:01] for a bank that doesn't find an
[04:02] alternative source of funding and often
[04:05] for withdrawals of that size the only
[04:07] alternative source of funding is either
[04:09] that some other bank buys you or that
[04:12] the FED comes in and gives you a
[04:16] line anyway so what is the that was
[04:19] immediate and it's always whenever you
[04:21] ask you hear about the bank run the
[04:24] immediate cost of the problem is a run
[04:26] from of the depositors from deposits in
[04:29] that that bank now why did this happen
[04:33] in this in this particular bank again I
[04:36] explain why is that you saw those small
[04:39] withdrawals of deposits but but what
[04:42] happens to this to them is actually
[04:44] there as I said before their deposits
[04:47] grew very rapidly over the last two
[04:49] three years and then rather than being
[04:52] very risky lenders rather than investing
[04:55] you know sometimes when Banks grow very
[04:57] rapidly they do lots of crazy things you
[04:59] know they in they make lots of loans
[05:01] without going doing the D diligent
[05:04] process and all that that's not what
[05:06] they did they bought treasury bonds the
[05:09] safest as as you can imagine they bought
[05:11] 10 year treasury bonds lots of them but
[05:14] they bought them at the wrong time they
[05:16] bought them right before the hike in
[05:18] interest rates that we began to see in
[05:21] 2022 and we already looked at the
[05:24] relation between interest rates and
[05:25] price of bonds well you have a 10-year
[05:28] bond and the interest starts going up
[05:30] the price of that Bond starts
[05:32] declining now that is not is problematic
[05:35] for a bank but not entirely the end of
[05:38] the story because that means that the
[05:40] the the market value of the bonds you're
[05:42] holding among your assets starts
[05:44] declining but Banks do not need to
[05:47] recognize that
[05:48] loss unless they sell the
[05:51] bonds because the the the logic is that
[05:54] well if the guy just sits on the bond
[05:56] the bond hasn't really lost any value in
[05:57] the sense that it will get the same
[05:59] coupons that he was planning to get and
[06:00] so on this is us treasuries us
[06:02] treasuries are not going to default in
[06:03] the coupons let's hope it's not going to
[06:05] happen in a few months from now but but
[06:08] typically they don't default on coupons
[06:10] so so the logic the regul regulation is
[06:14] assigned in such a way perhaps is a
[06:15] failure I think there is a problem there
[06:17] but that they don't need to
[06:20] recognize the losses unless they sell
[06:22] the bonds so they look pretty healthy
[06:25] because they had massive amount of
[06:27] Treasury bonds they did not need to
[06:28] recognize that
[06:30] problem is that when this small W
[06:34] relatively small withdrawals start at
[06:36] some point they needed to find a
[06:39] substitute for those funds they need to
[06:40] honor the deposits that that were being
[06:43] withdrawn and at that point they had to
[06:45] sell assets and when they sold assets
[06:48] they made the loss because at that point
[06:49] you have to recognize the loss because
[06:51] you're not going to hold the the bond
[06:53] until expiration and clip all the
[06:55] coupons that come from it so you have to
[06:57] recognize the loss that's a loss
[07:00] that led the CEO to announce that they
[07:03] needed a fundraising to cover a $2.5
[07:06] billion hold they had as a result of the
[07:08] losses okay now okay so now we have a we
[07:14] know why where the losses came from now
[07:16] if you notice the losses are not that
[07:18] big I mean this is a bank with $200
[07:19] billion and and the losses were
[07:22] relatively small where is the other leg
[07:25] of the problem it's
[07:28] here you know in in the US deposits are
[07:32] ured up to
[07:33] $250,000 that means no matter what
[07:35] happens to the bank where you have the
[07:37] money if that bank goes under and you
[07:41] have deposits for below $250,000 the
[07:43] FDIC comes and gives you a check okay so
[07:45] there's no risk so if you have deposit
[07:48] under $250,000 you don't need to worry
[07:51] about this you may go you don't need to
[07:53] read the news about this bank
[07:55] because you will get your funds in fact
[07:57] when when the bank was shut down on
[08:00] Friday the FDIC announc immediately
[08:03] every depositor under $250,000 can come
[08:05] on Monday and get his money okay so
[08:08] there's no issue there and most banks
[08:10] have a large share of depositors that
[08:12] are small depositor that means they are
[08:14] covered by this Deposit Insurance
[08:17] mechanism which was designed precisely
[08:20] to prevent runs because if you don't
[08:21] need to worry about where you get your
[08:23] money know you don't need to run on the
[08:25] bank the problem is that this bank was
[08:28] very different in the composition of
[08:29] depositors he had primarily business
[08:33] deposits meaning it was all these
[08:35] startup companies and so on in the tech
[08:36] sector they had their their deposits
[08:38] there and those deposits were much
[08:40] larger than
[08:41] $250,000 if you
[08:43] see it's about I think it's close to 95%
[08:47] of the deposits were not covered by the
[08:49] insurance by the fdac insurance okay
[08:52] that means it's a very different
[08:54] calculation when you have a deposit
[08:56] that's not covered by insurance and then
[08:58] you start feeling that the bank Mak may
[08:59] go under what do you do you take your
[09:02] money out you know put it some you send
[09:05] it to JP Morgan where there's no risk
[09:07] and wait until this thing is
[09:10] resolved now in this case and that's
[09:12] what typically happens in this case it
[09:14] happens even faster than normally why
[09:17] because many of the depositors the
[09:18] business that were deposited in there
[09:20] were were a startups that were being
[09:24] seeded by some Venture Capital
[09:27] funds and Venture Capital funds as soon
[09:29] as they noticed that there was a problem
[09:31] here began to call all the startups and
[09:33] tell him hey take that money out of
[09:35] there because you know they may run into
[09:37] travel so it was a venture capital world
[09:40] that caused the Run
[09:42] effectively and and and and and that's
[09:45] what happened
[09:46] okay now so that's that's what happened
[09:49] that's the reason for the run and and
[09:51] and
[09:53] the and so there was a a problem the
[09:55] problem was not that big but but the
[09:57] problem is that the deposits were very
[09:59] 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