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