WEBVTT 00:00:16.278 --> 00:00:21.399 today we're going to talk about um 00:00:19.640 --> 00:00:24.320 perhaps the most important model in this 00:00:21.399 --> 00:00:26.919 class the ISL MPC model which puts 00:00:24.320 --> 00:00:30.518 together all that we have done up to now 00:00:26.920 --> 00:00:32.559 but before we do that uh let's talk a 00:00:30.518 --> 00:00:36.799 little bit about the current 00:00:32.558 --> 00:00:36.799 events uh who knows what that 00:00:37.119 --> 00:00:42.000 is is this a exam week or 00:00:42.840 --> 00:00:49.640 what Silicon Valley Bank exactly no so 00:00:46.719 --> 00:00:54.799 Silicon Valley Bank the 16th Bank in 00:00:49.640 --> 00:00:57.879 size asset size in the US ER went 00:00:54.799 --> 00:01:01.759 essentially under last Friday was shut 00:00:57.878 --> 00:01:04.280 down by the FD last last 00:01:01.759 --> 00:01:09.079 Friday so that's the decline in in the 00:01:04.280 --> 00:01:11.320 stock value uh during Thursday Friday 00:01:09.079 --> 00:01:14.560 and uh and then it was shut down and you 00:01:11.319 --> 00:01:17.438 see that it's not being traded anymore 00:01:14.560 --> 00:01:19.640 um so that's a pretty significant event 00:01:17.438 --> 00:01:23.279 and the the weekend was pretty stressful 00:01:19.640 --> 00:01:27.040 for anyone involved in in in this event 00:01:23.280 --> 00:01:30.560 the treasury the FDIC the Federal 00:01:27.040 --> 00:01:32.520 Reserve and so on um 00:01:30.560 --> 00:01:34.759 it's first it was a large I mean it's 00:01:32.519 --> 00:01:38.840 not one of the big systemic Banks if you 00:01:34.759 --> 00:01:41.040 will it's not JP Morgan City Bank of 00:01:38.840 --> 00:01:42.759 America one of those Banks which are 00:01:41.040 --> 00:01:45.600 regulated even differently from these 00:01:42.759 --> 00:01:48.519 Banks but still is a pretty large Bank 00:01:45.599 --> 00:01:51.438 you see by asset size $29 00:01:48.519 --> 00:01:53.359 billion H which is you know comparable 00:01:51.438 --> 00:01:55.039 to Washington Mutual which was the 00:01:53.359 --> 00:01:57.519 largest bank that went under during the 00:01:55.040 --> 00:01:59.920 global financial crisis Great Recession 00:01:57.519 --> 00:02:03.078 at that time there were lots of other 00:01:59.920 --> 00:02:05.399 banks that went under H but the largest 00:02:03.078 --> 00:02:06.798 was comparable to this one and in fact 00:02:05.399 --> 00:02:08.840 all the things that were done over the 00:02:06.799 --> 00:02:10.239 weekend and that still being done today 00:02:08.840 --> 00:02:14.159 is to prevent something like this 00:02:10.239 --> 00:02:15.120 happening here as well okay and so it 00:02:14.159 --> 00:02:18.359 was 00:02:15.120 --> 00:02:21.319 a a pretty significant event now what 00:02:18.360 --> 00:02:25.360 happened to Silicon Valley 00:02:21.318 --> 00:02:28.280 Bank um well in the the immediate cause 00:02:25.360 --> 00:02:30.440 of of of of the failure is what always 00:02:28.280 --> 00:02:33.598 kills a bank which is a r 00:02:30.439 --> 00:02:35.318 by this depositors okay and what you see 00:02:33.598 --> 00:02:38.199 here is is the following this is this 00:02:35.318 --> 00:02:39.958 this Bank actually grew enormously over 00:02:38.199 --> 00:02:43.560 the last two three years essentially 00:02:39.959 --> 00:02:46.878 doubl its asset size 00:02:43.560 --> 00:02:48.840 um but it began to have sort of outflow 00:02:46.878 --> 00:02:51.719 net outflows of 00:02:48.840 --> 00:02:54.519 deposits during 2022 and the reason for 00:02:51.719 --> 00:02:57.199 that is not because the business was 00:02:54.519 --> 00:02:59.120 doing poorly anything it was simply 00:02:57.199 --> 00:03:02.039 because this is a bank that service 00:02:59.120 --> 00:03:04.400 primarily of the high the tech sector 00:03:02.039 --> 00:03:06.878 startups companies and things like that 00:03:04.400 --> 00:03:09.039 and those sectors were having hard time 00:03:06.878 --> 00:03:11.359 raising new capital in an environment 00:03:09.039 --> 00:03:14.280 that was not very friendly towards the 00:03:11.360 --> 00:03:16.720 tech sector so so so they began to 00:03:14.280 --> 00:03:21.759 withdraw on their deposits and and 00:03:16.719 --> 00:03:23.280 that's what led to these flows here now 00:03:21.759 --> 00:03:26.359 eventually 00:03:23.280 --> 00:03:29.919 ER because of this and and something 00:03:26.360 --> 00:03:32.959 I'll explain in a few minutes ER 00:03:29.919 --> 00:03:37.238 this the they decided svb Bank decided 00:03:32.959 --> 00:03:40.199 to issue new Equity ER issue new 00:03:37.239 --> 00:03:42.959 Equity to cover certain losses they had 00:03:40.199 --> 00:03:45.119 incurrent and today in the mod of social 00:03:42.959 --> 00:03:46.840 in the world of social media that 00:03:45.120 --> 00:03:49.200 immediately led to sort of massive 00:03:46.840 --> 00:03:51.360 spread that this bank was in trouble and 00:03:49.199 --> 00:03:53.759 then you saw enormous attempts to 00:03:51.360 --> 00:03:55.319 withdraw deposits now not all of these 00:03:53.759 --> 00:03:58.039 these were fulfilled but there was a 00:03:55.318 --> 00:04:01.238 massive pressure to withdraw deposits 00:03:58.039 --> 00:04:02.639 and and and and that's the end always 00:04:01.239 --> 00:04:05.480 for a bank that doesn't find an 00:04:02.639 --> 00:04:07.958 alternative source of funding and often 00:04:05.479 --> 00:04:09.798 for withdrawals of that size the only 00:04:07.959 --> 00:04:12.000 alternative source of funding is either 00:04:09.799 --> 00:04:16.000 that some other bank buys you or that 00:04:12.000 --> 00:04:16.000 the FED comes in and gives you a 00:04:16.079 --> 00:04:21.439 line anyway so what is the that was 00:04:19.720 --> 00:04:24.479 immediate and it's always whenever you 00:04:21.439 --> 00:04:26.519 ask you hear about the bank run the 00:04:24.478 --> 00:04:29.560 immediate cost of the problem is a run 00:04:26.519 --> 00:04:33.799 from of the depositors from deposits in 00:04:29.560 --> 00:04:36.759 that that bank now why did this happen 00:04:33.800 --> 00:04:39.720 in this in this particular bank again I 00:04:36.759 --> 00:04:42.360 explain why is that you saw those small 00:04:39.720 --> 00:04:44.800 withdrawals of deposits but but what 00:04:42.360 --> 00:04:47.000 happens to this to them is actually 00:04:44.800 --> 00:04:49.319 there as I said before their deposits 00:04:47.000 --> 00:04:52.879 grew very rapidly over the last two 00:04:49.319 --> 00:04:55.519 three years and then rather than being 00:04:52.879 --> 00:04:57.319 very risky lenders rather than investing 00:04:55.519 --> 00:04:59.399 you know sometimes when Banks grow very 00:04:57.319 --> 00:05:01.680 rapidly they do lots of crazy things you 00:04:59.399 --> 00:05:04.038 know they in they make lots of loans 00:05:01.680 --> 00:05:06.000 without going doing the D diligent 00:05:04.038 --> 00:05:09.240 process and all that that's not what 00:05:06.000 --> 00:05:11.279 they did they bought treasury bonds the 00:05:09.240 --> 00:05:14.639 safest as as you can imagine they bought 00:05:11.279 --> 00:05:16.839 10 year treasury bonds lots of them but 00:05:14.639 --> 00:05:18.840 they bought them at the wrong time they 00:05:16.839 --> 00:05:21.918 bought them right before the hike in 00:05:18.839 --> 00:05:24.519 interest rates that we began to see in 00:05:21.918 --> 00:05:25.799 2022 and we already looked at the 00:05:24.519 --> 00:05:28.439 relation between interest rates and 00:05:25.800 --> 00:05:30.520 price of bonds well you have a 10-year 00:05:28.439 --> 00:05:32.160 bond and the interest starts going up 00:05:30.519 --> 00:05:35.680 the price of that Bond starts 00:05:32.160 --> 00:05:38.280 declining now that is not is problematic 00:05:35.680 --> 00:05:40.600 for a bank but not entirely the end of 00:05:38.279 --> 00:05:42.599 the story because that means that the 00:05:40.600 --> 00:05:44.560 the the market value of the bonds you're 00:05:42.600 --> 00:05:47.199 holding among your assets starts 00:05:44.560 --> 00:05:48.560 declining but Banks do not need to 00:05:47.199 --> 00:05:51.240 recognize that 00:05:48.560 --> 00:05:54.399 loss unless they sell the 00:05:51.240 --> 00:05:56.079 bonds because the the the logic is that 00:05:54.399 --> 00:05:57.679 well if the guy just sits on the bond 00:05:56.079 --> 00:05:59.038 the bond hasn't really lost any value in 00:05:57.680 --> 00:06:00.519 the sense that it will get the same 00:05:59.038 --> 00:06:02.680 coupons that he was planning to get and 00:06:00.519 --> 00:06:03.879 so on this is us treasuries us 00:06:02.680 --> 00:06:05.519 treasuries are not going to default in 00:06:03.879 --> 00:06:08.319 the coupons let's hope it's not going to 00:06:05.519 --> 00:06:10.799 happen in a few months from now but but 00:06:08.319 --> 00:06:14.319 typically they don't default on coupons 00:06:10.800 --> 00:06:15.759 so so the logic the regul regulation is 00:06:14.319 --> 00:06:17.560 assigned in such a way perhaps is a 00:06:15.759 --> 00:06:20.080 failure I think there is a problem there 00:06:17.560 --> 00:06:22.800 but that they don't need to 00:06:20.079 --> 00:06:25.839 recognize the losses unless they sell 00:06:22.800 --> 00:06:27.079 the bonds so they look pretty healthy 00:06:25.839 --> 00:06:28.918 because they had massive amount of 00:06:27.079 --> 00:06:30.719 Treasury bonds they did not need to 00:06:28.918 --> 00:06:34.079 recognize that 00:06:30.720 --> 00:06:36.720 problem is that when this small W 00:06:34.079 --> 00:06:39.159 relatively small withdrawals start at 00:06:36.720 --> 00:06:40.960 some point they needed to find a 00:06:39.160 --> 00:06:43.199 substitute for those funds they need to 00:06:40.959 --> 00:06:45.000 honor the deposits that that were being 00:06:43.199 --> 00:06:48.080 withdrawn and at that point they had to 00:06:45.000 --> 00:06:49.598 sell assets and when they sold assets 00:06:48.079 --> 00:06:51.279 they made the loss because at that point 00:06:49.598 --> 00:06:53.240 you have to recognize the loss because 00:06:51.279 --> 00:06:55.198 you're not going to hold the the bond 00:06:53.240 --> 00:06:57.160 until expiration and clip all the 00:06:55.199 --> 00:07:00.400 coupons that come from it so you have to 00:06:57.160 --> 00:07:03.560 recognize the loss that's a loss 00:07:00.399 --> 00:07:06.038 that led the CEO to announce that they 00:07:03.560 --> 00:07:08.720 needed a fundraising to cover a $2.5 00:07:06.038 --> 00:07:14.038 billion hold they had as a result of the 00:07:08.720 --> 00:07:16.680 losses okay now okay so now we have a we 00:07:14.038 --> 00:07:18.079 know why where the losses came from now 00:07:16.680 --> 00:07:19.918 if you notice the losses are not that 00:07:18.079 --> 00:07:22.839 big I mean this is a bank with $200 00:07:19.918 --> 00:07:25.758 billion and and the losses were 00:07:22.839 --> 00:07:28.119 relatively small where is the other leg 00:07:25.759 --> 00:07:32.360 of the problem it's 00:07:28.120 --> 00:07:33.598 here you know in in the US deposits are 00:07:32.360 --> 00:07:35.879 ured up to 00:07:33.598 --> 00:07:37.560 $250,000 that means no matter what 00:07:35.879 --> 00:07:41.240 happens to the bank where you have the 00:07:37.560 --> 00:07:43.598 money if that bank goes under and you 00:07:41.240 --> 00:07:45.720 have deposits for below $250,000 the 00:07:43.598 --> 00:07:48.800 FDIC comes and gives you a check okay so 00:07:45.720 --> 00:07:51.120 there's no risk so if you have deposit 00:07:48.800 --> 00:07:53.079 under $250,000 you don't need to worry 00:07:51.120 --> 00:07:55.079 about this you may go you don't need to 00:07:53.079 --> 00:07:57.959 read the news about this bank 00:07:55.079 --> 00:08:00.198 because you will get your funds in fact 00:07:57.959 --> 00:08:03.000 when when the bank was shut down on 00:08:00.199 --> 00:08:05.520 Friday the FDIC announc immediately 00:08:03.000 --> 00:08:08.000 every depositor under $250,000 can come 00:08:05.519 --> 00:08:10.959 on Monday and get his money okay so 00:08:08.000 --> 00:08:12.478 there's no issue there and most banks 00:08:10.959 --> 00:08:14.198 have a large share of depositors that 00:08:12.478 --> 00:08:17.639 are small depositor that means they are 00:08:14.199 --> 00:08:20.319 covered by this Deposit Insurance 00:08:17.639 --> 00:08:21.960 mechanism which was designed precisely 00:08:20.319 --> 00:08:23.319 to prevent runs because if you don't 00:08:21.959 --> 00:08:25.120 need to worry about where you get your 00:08:23.319 --> 00:08:28.120 money know you don't need to run on the 00:08:25.120 --> 00:08:29.639 bank the problem is that this bank was 00:08:28.120 --> 00:08:33.000 very different in the composition of 00:08:29.639 --> 00:08:35.080 depositors he had primarily business 00:08:33.000 --> 00:08:36.879 deposits meaning it was all these 00:08:35.080 --> 00:08:38.599 startup companies and so on in the tech 00:08:36.879 --> 00:08:40.158 sector they had their their deposits 00:08:38.599 --> 00:08:41.519 there and those deposits were much 00:08:40.158 --> 00:08:43.399 larger than 00:08:41.519 --> 00:08:47.200 $250,000 if you 00:08:43.399 --> 00:08:49.240 see it's about I think it's close to 95% 00:08:47.200 --> 00:08:52.759 of the deposits were not covered by the 00:08:49.240 --> 00:08:54.120 insurance by the fdac insurance okay 00:08:52.759 --> 00:08:56.799 that means it's a very different 00:08:54.120 --> 00:08:58.200 calculation when you have a deposit 00:08:56.799 --> 00:08:59.559 that's not covered by insurance and then 00:08:58.200 --> 00:09:02.480 you start feeling that the bank Mak may 00:08:59.559 --> 00:09:05.039 go under what do you do you take your 00:09:02.480 --> 00:09:07.680 money out you know put it some you send 00:09:05.039 --> 00:09:10.199 it to JP Morgan where there's no risk 00:09:07.679 --> 00:09:12.719 and wait until this thing is 00:09:10.200 --> 00:09:14.399 resolved now in this case and that's 00:09:12.720 --> 00:09:17.040 what typically happens in this case it 00:09:14.399 --> 00:09:18.600 happens even faster than normally why 00:09:17.039 --> 00:09:20.399 because many of the depositors the 00:09:18.600 --> 00:09:24.399 business that were deposited in there 00:09:20.399 --> 00:09:27.159 were were a startups that were being 00:09:24.399 --> 00:09:29.759 seeded by some Venture Capital 00:09:27.159 --> 00:09:31.439 funds and Venture Capital funds as soon 00:09:29.759 --> 00:09:33.958 as they noticed that there was a problem 00:09:31.440 --> 00:09:35.640 here began to call all the startups and 00:09:33.958 --> 00:09:37.838 tell him hey take that money out of 00:09:35.639 --> 00:09:40.480 there because you know they may run into 00:09:37.839 --> 00:09:42.680 travel so it was a venture capital world 00:09:40.480 --> 00:09:45.200 that caused the Run 00:09:42.679 --> 00:09:46.719 effectively and and and and and that's 00:09:45.200 --> 00:09:49.600 what happened 00:09:46.720 --> 00:09:51.839 okay now so that's that's what happened 00:09:49.600 --> 00:09:53.000 that's the reason for the run and and 00:09:51.839 --> 00:09:55.959 and 00:09:53.000 --> 00:09:57.679 the and so there was a a problem the 00:09:55.958 --> 00:09:59.559 problem was not that big but but the 00:09:57.679 --> 00:10:01.559 problem is that the deposits were very 00:09:59.559 --> 00:10:03.319 un safe they were not covered and moving 00:10:01.559 --> 00:10:05.679 deposits out is very easy I mean you 00:10:03.320 --> 00:10:09.640 just you know you just wire your money 00:10:05.679 --> 00:10:11.599 to another bank so so so why wait there 00:10:09.639 --> 00:10:14.120 why risk it and that's that's what 00:10:11.600 --> 00:10:16.040 happened it's called in economics 00:10:14.120 --> 00:10:17.959 coordination failure when I mean if 00:10:16.039 --> 00:10:19.480 everyone freezes and say okay nobody 00:10:17.958 --> 00:10:22.599 takes the money out and so on this stuff 00:10:19.480 --> 00:10:24.320 is when I pass then we're safe but but 00:10:22.600 --> 00:10:25.920 but since we don't call each other and 00:10:24.320 --> 00:10:27.959 we don't trust each other to really 00:10:25.919 --> 00:10:29.519 leave the money there we we we we make 00:10:27.958 --> 00:10:31.039 the call only after we have taken our 00:10:29.519 --> 00:10:34.600 money out and since we all think the 00:10:31.039 --> 00:10:35.958 same way then you get a run on the bank 00:10:34.600 --> 00:10:38.399 now let me start connecting this a 00:10:35.958 --> 00:10:41.039 little bit with uh with the kind of 00:10:38.399 --> 00:10:44.480 things we have done in in this course I 00:10:41.039 --> 00:10:47.240 I I I may actually discuss runs later in 00:10:44.480 --> 00:10:48.879 the course as a as a as a topic crisis 00:10:47.240 --> 00:10:50.799 speculative attacks and things like that 00:10:48.879 --> 00:10:53.480 but for 00:10:50.799 --> 00:10:57.679 now here what you have is an indicator 00:10:53.480 --> 00:11:00.039 of essentially is this is the vix a is a 00:10:57.679 --> 00:11:01.799 is an indicator of Supply volatility 00:11:00.039 --> 00:11:03.838 something is extracted from the price of 00:11:01.799 --> 00:11:07.039 options you don't need to know the 00:11:03.839 --> 00:11:09.760 details but the point is that that is 00:11:07.039 --> 00:11:12.159 one of the main indicators of of fear of 00:11:09.759 --> 00:11:15.039 of how afraid are investors in a moment 00:11:12.159 --> 00:11:17.199 in the market and and uh and what you 00:11:15.039 --> 00:11:19.838 can see here is that that this indicator 00:11:17.200 --> 00:11:21.360 the vixs essentially 00:11:19.839 --> 00:11:24.920 Spike 00:11:21.360 --> 00:11:27.480 Thursday and and Thursday and Friday 00:11:24.919 --> 00:11:31.000 went up Friday went up very very rapidly 00:11:27.480 --> 00:11:34.120 and then it got stabilized a little 00:11:31.000 --> 00:11:38.440 now ER it turned out that it turns out 00:11:34.120 --> 00:11:41.240 that over the weekend ER H you may have 00:11:38.440 --> 00:11:43.560 heard the government the Consolidated 00:11:41.240 --> 00:11:46.560 Government came up with a very massive 00:11:43.559 --> 00:11:49.479 package to to prevent runs on the 00:11:46.559 --> 00:11:51.518 remaining Banks and and also to prevent 00:11:49.480 --> 00:11:53.920 the fact that I mean all of these were 00:11:51.519 --> 00:11:57.078 business deposits of a small companies 00:11:53.919 --> 00:11:59.958 that used even this bank for the payroll 00:11:57.078 --> 00:12:01.879 and so on so so what was done of this 00:11:59.958 --> 00:12:03.199 weakness that all the deposit not only 00:12:01.879 --> 00:12:06.799 the ones under 00:12:03.200 --> 00:12:08.600 $250,000 were guarantee by the FDIC 00:12:06.799 --> 00:12:11.399 there are mechanism under which you can 00:12:08.600 --> 00:12:15.159 activate that so that means now all the 00:12:11.399 --> 00:12:15.159 depositors were made 00:12:15.399 --> 00:12:20.958 whole and but the idea was not it was 00:12:18.919 --> 00:12:23.799 part partly the reason to do that it was 00:12:20.958 --> 00:12:25.919 to prevent a mess in the pay roles of 00:12:23.799 --> 00:12:28.039 the small companies and all that that 00:12:25.919 --> 00:12:31.159 had their account in in in this bank but 00:12:28.039 --> 00:12:35.480 it was also to prevent on other Banks 00:12:31.159 --> 00:12:38.480 you know and uh and so on top of this 00:12:35.480 --> 00:12:42.440 the FED now has a line of 00:12:38.480 --> 00:12:44.480 credit ER for banks to not have to sell 00:12:42.440 --> 00:12:46.839 their assets for small Banks they can 00:12:44.480 --> 00:12:48.519 just pledge the assets to the central 00:12:46.839 --> 00:12:52.399 bank and get an exchange for that the 00:12:48.519 --> 00:12:54.320 cash they need okay and they can do that 00:12:52.399 --> 00:12:56.879 without recognizing the implicit loss so 00:12:54.320 --> 00:12:59.839 without marking to market the price of 00:12:56.879 --> 00:13:03.120 the bonds okay so how this mechanism 00:12:59.839 --> 00:13:05.440 existed before the pl of 00:13:03.120 --> 00:13:06.720 svb we would not have seen anything like 00:13:05.440 --> 00:13:09.079 that but the whole idea was to prevent 00:13:06.720 --> 00:13:11.879 that other Banks run into into that kind 00:13:09.078 --> 00:13:14.000 of trouble now the markets reacted well 00:13:11.879 --> 00:13:15.759 to all that overnight and so on but the 00:13:14.000 --> 00:13:17.759 vi kept going up this morning now it's 00:13:15.759 --> 00:13:19.439 coming down again I mean there's still a 00:13:17.759 --> 00:13:21.319 lot of stress and if you see the shares 00:13:19.440 --> 00:13:23.600 of First Republic Bank for example had 00:13:21.320 --> 00:13:26.000 declined by 60% today and things like 00:13:23.600 --> 00:13:30.120 that so so there's a still Panic going 00:13:26.000 --> 00:13:32.958 on okay and as a result of that ER all 00:13:30.120 --> 00:13:35.120 these indicators of stress sort of are 00:13:32.958 --> 00:13:37.799 very stressed out remember credit 00:13:35.120 --> 00:13:39.560 spreads I told you about that X that we 00:13:37.799 --> 00:13:41.000 had Le several lectures ago the 00:13:39.559 --> 00:13:42.679 probability of the fault of a bone the 00:13:41.000 --> 00:13:44.839 perceived probability of the fault all 00:13:42.679 --> 00:13:47.319 those things went up a lot I mean the 00:13:44.839 --> 00:13:49.240 Riser the bonds the closer you are to 00:13:47.320 --> 00:13:51.160 the financial system particular to small 00:13:49.240 --> 00:13:53.399 Banks the larger those spreads have 00:13:51.159 --> 00:13:57.240 become so X went up a 00:13:53.399 --> 00:13:58.879 lot this picture that comes next I find 00:13:57.240 --> 00:14:00.320 it very interesting from the point of 00:13:58.879 --> 00:14:03.439 view of this 00:14:00.320 --> 00:14:06.199 course what this is is the following 00:14:03.440 --> 00:14:11.079 this is the market 00:14:06.198 --> 00:14:14.359 expectation of the next hike by the 00:14:11.078 --> 00:14:18.278 fed the FED next announcement on policy 00:14:14.360 --> 00:14:20.399 rate happens on the 22nd March 22nd so 00:14:18.278 --> 00:14:23.159 remember what has been happening is that 00:14:20.399 --> 00:14:24.919 that that ER since the US has been 00:14:23.159 --> 00:14:26.958 running sort of very hot with lots of 00:14:24.919 --> 00:14:29.599 inflation interest rate were increased 00:14:26.958 --> 00:14:31.919 very rapidly at clips of 50 basis points 00:14:29.600 --> 00:14:33.920 a CLI that's very large changes in 00:14:31.919 --> 00:14:38.278 policy rate for a country as large as 00:14:33.919 --> 00:14:40.078 the US and and so we had this big 25 00:14:38.278 --> 00:14:42.078 basis points increases and a few 00:14:40.078 --> 00:14:45.120 meetings ago they decided to lower the 00:14:42.078 --> 00:14:46.958 pace of the increases to 25 basis points 00:14:45.120 --> 00:14:48.320 rather than 50 Bas points per meeting 00:14:46.958 --> 00:14:50.000 okay so they said we're going to keep 00:14:48.320 --> 00:14:53.560 raising interest rate but we're going to 00:14:50.000 --> 00:14:56.559 go out to 25 basis points now it turns 00:14:53.559 --> 00:14:58.278 out so this is 25 basis points the data 00:14:56.559 --> 00:14:59.879 has becoming very hot remember we said 00:14:58.278 --> 00:15:01.320 inflation looked to have Peak and now 00:14:59.879 --> 00:15:03.919 it's beginning sort of to turn around 00:15:01.320 --> 00:15:05.839 again it's beginning to rise so what has 00:15:03.919 --> 00:15:09.399 been happening is that the market say 00:15:05.839 --> 00:15:12.519 Okay 25% basis point is the most likely 00:15:09.399 --> 00:15:14.360 next hike but you see the expectation of 00:15:12.519 --> 00:15:16.560 that is it was sort of a steady around 00:15:14.360 --> 00:15:19.000 30 basis points some people expected 00:15:16.559 --> 00:15:21.319 some major players expected the FED to 00:15:19.000 --> 00:15:25.078 hike by 50 basis points not 25 basis 00:15:21.320 --> 00:15:27.040 points by early last week data came very 00:15:25.078 --> 00:15:28.758 hot so there was indication that clearly 00:15:27.039 --> 00:15:30.958 inflation was picking up again the labor 00:15:28.759 --> 00:15:32.360 market Market was very strong and so on 00:15:30.958 --> 00:15:34.518 so look what happened to the bets 00:15:32.360 --> 00:15:37.560 immediately expected value went up this 00:15:34.519 --> 00:15:39.360 is all traded it went up and and the 00:15:37.559 --> 00:15:42.439 expectation was for the next meeting was 00:15:39.360 --> 00:15:44.800 up north of of 40 basis points so 00:15:42.440 --> 00:15:47.319 essentially most of the market thought 00:15:44.799 --> 00:15:49.039 that the next hike would be 50 basis 00:15:47.318 --> 00:15:51.278 points 00:15:49.039 --> 00:15:54.078 okay but look what happened and then the 00:15:51.278 --> 00:15:58.519 problems of this with this Bank began 00:15:54.078 --> 00:16:00.439 and look how this pleted today is 15 00:15:58.519 --> 00:16:02.278 basis point is expected value that means 00:16:00.440 --> 00:16:04.839 very few people are expecting 50 basis 00:16:02.278 --> 00:16:07.559 point A lot of people are thinking 25 00:16:04.839 --> 00:16:11.720 still but about an equal size expecting 00:16:07.559 --> 00:16:14.439 zero so a POS in the interest rate hike 00:16:11.720 --> 00:16:17.079 by the FED okay and all that is a result 00:16:14.440 --> 00:16:18.959 of the events of the last two three 00:16:17.078 --> 00:16:21.198 days 00:16:18.958 --> 00:16:24.239 Y what is there to learn from this I 00:16:21.198 --> 00:16:27.159 guess in like the bigger structure or 00:16:24.240 --> 00:16:29.000 who's at fault is it the people who got 00:16:27.159 --> 00:16:31.399 really scared all these depositors that 00:16:29.000 --> 00:16:34.078 got potentially scared or or fearmonger 00:16:31.399 --> 00:16:36.240 in that capacity is it that the banks 00:16:34.078 --> 00:16:37.879 don't necessarily have I mean I can't 00:16:36.240 --> 00:16:39.240 feel like it's an unre there are many 00:16:37.879 --> 00:16:40.958 good questions and and and you're going 00:16:39.240 --> 00:16:42.198 to see a lot of that and politicians are 00:16:40.958 --> 00:16:44.679 going to talk a lot about that in the 00:16:42.198 --> 00:16:46.318 next few days and so on it's very clear 00:16:44.679 --> 00:16:49.159 that there was some sort of regulatory 00:16:46.318 --> 00:16:51.000 failure here the regulator it was pretty 00:16:49.159 --> 00:16:53.399 obvious that I mean this this bank had 00:16:51.000 --> 00:16:56.000 doubled the asset size in in in a year 00:16:53.399 --> 00:16:58.879 that's already a red flag and and these 00:16:56.000 --> 00:17:00.879 guys are regulated by the Fed so the the 00:16:58.879 --> 00:17:05.119 s Francisco fed should have been worried 00:17:00.879 --> 00:17:07.038 about this Bank ER there is issues 00:17:05.119 --> 00:17:08.719 conventional issues of diversification I 00:17:07.038 --> 00:17:11.720 mean it's pretty crazy to have all your 00:17:08.720 --> 00:17:12.919 savings in One Bank especially if you're 00:17:11.720 --> 00:17:16.000 not 00:17:12.919 --> 00:17:18.919 insure there is issues there's 00:17:16.000 --> 00:17:23.279 also remember after the global financial 00:17:18.919 --> 00:17:26.319 crisis there's there was a bill designed 00:17:23.279 --> 00:17:27.639 to legislation designed to strengthen 00:17:26.318 --> 00:17:30.119 the balance sheet of the banks it made 00:17:27.640 --> 00:17:31.759 them hold a lot more cas Capital they 00:17:30.119 --> 00:17:33.439 are subject see if they're systemic they 00:17:31.759 --> 00:17:35.200 are consider they're subject to stress 00:17:33.440 --> 00:17:36.679 test where sort of regulators go in 00:17:35.200 --> 00:17:40.558 there and check whether portfolios can 00:17:36.679 --> 00:17:42.160 survive major micros shcks and so on H 00:17:40.558 --> 00:17:45.558 and that's that's called The Dot Frank 00:17:42.160 --> 00:17:48.840 Bill okay so that was done in 00:17:45.558 --> 00:17:50.639 2018 that got partially undone and 00:17:48.839 --> 00:17:52.000 partially andone precisely for these 00:17:50.640 --> 00:17:54.919 type of Banks and these guys were 00:17:52.000 --> 00:17:56.880 actually loving for that they said okay 00:17:54.919 --> 00:17:58.520 why don't you because to be sort of 00:17:56.880 --> 00:18:00.039 really stress test and so on by the 00:17:58.519 --> 00:18:03.279 regular you have to be big enough to 00:18:00.038 --> 00:18:06.359 really be able to live a a big mess and 00:18:03.279 --> 00:18:10.158 and and and so what these guys and and 00:18:06.359 --> 00:18:13.319 Banks like them did is they Lobby a lot 00:18:10.159 --> 00:18:15.000 so they got the the the threshold of 00:18:13.319 --> 00:18:18.720 asset that you need to have in order to 00:18:15.000 --> 00:18:21.200 be stress stress tested and so on raise 00:18:18.720 --> 00:18:24.000 dramatically so they were right below 00:18:21.200 --> 00:18:27.558 the level that you need to be really 00:18:24.000 --> 00:18:29.480 sort of monitored very very closely by 00:18:27.558 --> 00:18:31.759 the regulator by the by the FED if 00:18:29.480 --> 00:18:33.640 you're a systemic bank then the FED 00:18:31.759 --> 00:18:35.279 regulates you these guys were lightly 00:18:33.640 --> 00:18:37.960 regulated by the FED because they were 00:18:35.279 --> 00:18:40.558 below that threshold so there regulatory 00:18:37.960 --> 00:18:44.079 failures it's clear that the regulator 00:18:40.558 --> 00:18:48.359 fail what it did 00:18:44.079 --> 00:18:50.319 depositors didn't diversify enough ER 00:18:48.359 --> 00:18:52.158 they didn't diversify enough the bank 00:18:50.319 --> 00:18:54.200 itself didn't diversify enough the the 00:18:52.159 --> 00:18:55.480 source of funding I mean what is very 00:18:54.200 --> 00:18:56.720 special of this bank and that's what 00:18:55.480 --> 00:18:59.440 gives us hope that this stuff is not 00:18:56.720 --> 00:19:01.640 going to spread all around is that their 00:18:59.440 --> 00:19:04.600 funding was very sort of you know was 00:19:01.640 --> 00:19:07.200 all coming from the same sector large 00:19:04.599 --> 00:19:08.558 saver large depositors and so on the 00:19:07.200 --> 00:19:10.759 typical bank doesn't have that they have 00:19:08.558 --> 00:19:12.240 a much broader source of funding which 00:19:10.759 --> 00:19:13.960 is what you need because you know 00:19:12.240 --> 00:19:16.839 otherwise so so there are lots of 00:19:13.960 --> 00:19:19.759 lessons for Bankers for 00:19:16.839 --> 00:19:22.038 Regulators ER for microeconomist as well 00:19:19.759 --> 00:19:24.640 I mean to tell you the truth one of the 00:19:22.038 --> 00:19:26.919 concerns with with the pace at which the 00:19:24.640 --> 00:19:28.840 FED has been hik in interest rates is 00:19:26.919 --> 00:19:30.440 that people were wondering well do we we 00:19:28.839 --> 00:19:32.158 know whe something will break at some 00:19:30.440 --> 00:19:33.200 point and there was a lot of concern 00:19:32.159 --> 00:19:36.720 that something could break well 00:19:33.200 --> 00:19:39.679 something broke now and this broke 00:19:36.720 --> 00:19:41.440 entirely the part of the the loss comes 00:19:39.679 --> 00:19:43.559 entirely from interest rate highs 00:19:41.440 --> 00:19:45.960 essentially they got into a portfolio of 00:19:43.558 --> 00:19:48.359 long that was very long rat when rates 00:19:45.960 --> 00:19:51.240 began to rise so they they had losses 00:19:48.359 --> 00:19:54.359 entirely from that and that's a risk I 00:19:51.240 --> 00:19:56.720 mean when you do monetary policy is that 00:19:54.359 --> 00:19:58.959 some people will be stretch out there 00:19:56.720 --> 00:20:00.880 and and and if you sort of sometimes 00:19:58.960 --> 00:20:02.400 miss one that is important that that's 00:20:00.880 --> 00:20:06.240 very costly and I think was that's one 00:20:02.400 --> 00:20:08.600 of the reasons they wanted to lower the 00:20:06.240 --> 00:20:11.240 the interest R hikes from 50 basis 00:20:08.599 --> 00:20:14.480 points to 25 basis points because they 00:20:11.240 --> 00:20:17.480 knew that something could be fragile out 00:20:14.480 --> 00:20:20.400 there and and and this was one of those 00:20:17.480 --> 00:20:23.558 things so those are those are 00:20:20.400 --> 00:20:25.960 lessons now I was about to connect with 00:20:23.558 --> 00:20:28.798 the things we did in a few lectures ago 00:20:25.960 --> 00:20:31.679 I said look so this is telling you the 00:20:28.798 --> 00:20:34.960 markets when they saw this x going 00:20:31.679 --> 00:20:37.000 up and started betting that the that the 00:20:34.960 --> 00:20:38.759 FED will not hike interest rate as much 00:20:37.000 --> 00:20:40.000 and in fact that they may even pause 00:20:38.759 --> 00:20:42.200 rather than raise the interest rate as 00:20:40.000 --> 00:20:45.798 was planned they may even pause interest 00:20:42.200 --> 00:20:45.798 rates we talked about 00:20:45.839 --> 00:20:51.959 this lecture 00:20:48.679 --> 00:20:56.200 seven remember in lecture seven when we 00:20:51.960 --> 00:20:59.200 talk about the expanded islm model we 00:20:56.200 --> 00:21:01.640 had this x variable and we said look if 00:20:59.200 --> 00:21:03.159 x goes up that measure of riskiness and 00:21:01.640 --> 00:21:06.240 so on that increases the cost of 00:21:03.159 --> 00:21:08.480 borrowing for the private sector that is 00:21:06.240 --> 00:21:11.120 like a shift in the yes to the left for 00:21:08.480 --> 00:21:13.798 any given safe interest rate saved by 00:21:11.119 --> 00:21:15.479 the central bank now all of the sudden 00:21:13.798 --> 00:21:18.960 the cost of borrowing for companies is 00:21:15.480 --> 00:21:22.798 higher and therefore this is 00:21:18.960 --> 00:21:24.519 contractionary okay and then we went on 00:21:22.798 --> 00:21:26.079 remember we went on and said well here 00:21:24.519 --> 00:21:29.079 it is the question what should the 00:21:26.079 --> 00:21:32.000 Central Bank do in this case 00:21:29.079 --> 00:21:32.000 in which X went 00:21:33.000 --> 00:21:37.679 up that's was the next slide inide of 00:21:35.679 --> 00:21:39.798 fact you know lower the interest rate 00:21:37.679 --> 00:21:44.000 because there's one component of cost of 00:21:39.798 --> 00:21:47.119 borrowing that's going up for for ER for 00:21:44.000 --> 00:21:49.159 firms which is the X well the FED can 00:21:47.119 --> 00:21:51.199 offset that by lowering the interest 00:21:49.159 --> 00:21:52.559 rate now here they're not planning yet 00:21:51.200 --> 00:21:54.000 to lower the interest rate they were 00:21:52.558 --> 00:21:56.200 planning to raise interest and now 00:21:54.000 --> 00:21:58.640 they're slowing down that that's a bet 00:21:56.200 --> 00:22:01.120 so the market knows some basic and 00:21:58.640 --> 00:22:03.600 expanded islm model because that's 00:22:01.119 --> 00:22:05.798 that's what you know explains exactly 00:22:03.599 --> 00:22:08.519 what you should anticipate that that's 00:22:05.798 --> 00:22:10.720 what is likely to to 00:22:08.519 --> 00:22:12.918 happen anyways that's where we are at 00:22:10.720 --> 00:22:12.919 this 00:22:13.480 --> 00:22:17.319 moment any questions about this 00:22:15.440 --> 00:22:19.919 otherwise I'm going to move to the 00:22:17.319 --> 00:22:22.038 lecture really but I thought we had to 00:22:19.919 --> 00:22:25.159 talk about 00:22:22.038 --> 00:22:27.440 it well in anyways if it gets a lot 00:22:25.159 --> 00:22:29.200 Messier I'm hoping that it won but if it 00:22:27.440 --> 00:22:31.200 gets a lot Messier then we can another 00:22:29.200 --> 00:22:33.919 section at the end I can replace 00:22:31.200 --> 00:22:37.440 something for for something on banking 00:22:33.919 --> 00:22:37.440 crisis and something like that 00:22:38.200 --> 00:22:45.360 okay which is what I teach in one of my 00:22:40.599 --> 00:22:48.158 graduate courses so would be would be 00:22:45.359 --> 00:22:52.199 fine anyway so now what I want to do is 00:22:48.159 --> 00:22:53.919 start this islm PC model and sort of the 00:22:52.200 --> 00:22:55.600 number the name is not very creative 00:22:53.919 --> 00:22:59.759 it's pretty obvious what we're going to 00:22:55.599 --> 00:23:02.319 do here no is going to combine the aslm 00:22:59.759 --> 00:23:04.640 with with the Philips curve and what 00:23:02.319 --> 00:23:07.119 this this will do for us is it will 00:23:04.640 --> 00:23:09.440 allow us to think not only about the 00:23:07.119 --> 00:23:11.239 impact of a policy or a shock but also 00:23:09.440 --> 00:23:14.519 think about what happens over time with 00:23:11.240 --> 00:23:16.798 that shock okay ER not to the long run 00:23:14.519 --> 00:23:18.879 but we call this analysis sort of the 00:23:16.798 --> 00:23:21.359 short run which is what happens in the 00:23:18.880 --> 00:23:24.200 very few early weeks months and what 00:23:21.359 --> 00:23:26.079 happens in the medium run say a year a 00:23:24.200 --> 00:23:30.440 year and a half from now and so this 00:23:26.079 --> 00:23:30.439 model will allow us to put all of the 00:23:30.679 --> 00:23:36.480 together 00:23:32.200 --> 00:23:39.319 um so and But but so so so you don't get 00:23:36.480 --> 00:23:40.798 lost on this so the analysis of the 00:23:39.319 --> 00:23:44.158 short run essentially will remain 00:23:40.798 --> 00:23:47.200 unchanged it's is our islm mod it's just 00:23:44.159 --> 00:23:50.039 that give it a little time and you start 00:23:47.200 --> 00:23:51.840 seeing other certain effects get undone 00:23:50.038 --> 00:23:54.440 and some others get exacerbated and so 00:23:51.839 --> 00:23:56.918 on okay but but the short one is still 00:23:54.440 --> 00:23:59.159 islm is your basic mod but then we're 00:23:56.919 --> 00:24:03.360 going to see that things happen 00:23:59.159 --> 00:24:05.200 over time so remember the slm model was 00:24:03.359 --> 00:24:07.759 essentially this is equilibrium in the 00:24:05.200 --> 00:24:12.080 Goods Market and then we had an LM which 00:24:07.759 --> 00:24:14.919 said I equal to I bar no and so I'm 00:24:12.079 --> 00:24:17.439 going to replace the LM already inside 00:24:14.919 --> 00:24:20.120 this and I get my islm mod so for any 00:24:17.440 --> 00:24:22.519 given I bar I could solve out for 00:24:20.119 --> 00:24:25.119 equilibrium output 00:24:22.519 --> 00:24:27.200 now here I'm going to do I'm going to 00:24:25.119 --> 00:24:28.639 adopt the the the I didn't want to do it 00:24:27.200 --> 00:24:30.880 before but I think at this point is 00:24:28.640 --> 00:24:33.679 useful because of will simplify the 00:24:30.880 --> 00:24:35.559 diagrams when we draw them to really 00:24:33.679 --> 00:24:38.440 think of the FED as setting the real 00:24:35.558 --> 00:24:40.440 interest rate okay so I'm going to 00:24:38.440 --> 00:24:41.640 assume now and then I'm going to explain 00:24:40.440 --> 00:24:45.200 what 00:24:41.640 --> 00:24:46.759 happens when that's a bad assumption but 00:24:45.200 --> 00:24:48.440 but I'm going to assume for now that 00:24:46.759 --> 00:24:50.319 rather than the FED setting the nominal 00:24:48.440 --> 00:24:54.200 interest rate that the FED is set in the 00:24:50.319 --> 00:24:57.398 real interest rate okay so it's setting 00:24:54.200 --> 00:24:59.759 this and then we're going to talk about 00:24:57.398 --> 00:25:01.918 problems I mean in 00:24:59.759 --> 00:25:03.839 principle if the interest rate is not 00:25:01.919 --> 00:25:06.360 against the zero lower 00:25:03.839 --> 00:25:07.839 bound the FED can always do that say 00:25:06.359 --> 00:25:09.119 okay I'm going to give them them I'm 00:25:07.839 --> 00:25:10.839 going to give you the nominal interest 00:25:09.119 --> 00:25:12.959 rate that given this expected inflation 00:25:10.839 --> 00:25:14.558 gives me the real interest rate I want 00:25:12.960 --> 00:25:16.600 okay that's what the FED is really 00:25:14.558 --> 00:25:18.158 trying to do all the time the FED is not 00:25:16.599 --> 00:25:19.959 trying to figure out what is the 00:25:18.159 --> 00:25:21.799 equilibrium nominal interest rate he's 00:25:19.960 --> 00:25:23.480 always trying to figure out whether the 00:25:21.798 --> 00:25:26.038 real interest rate is at the right level 00:25:23.480 --> 00:25:27.880 or not for the economy now the tool they 00:25:26.038 --> 00:25:29.079 have is a nominal interest rate but they 00:25:27.880 --> 00:25:32.600 are thinking thinking always about the 00:25:29.079 --> 00:25:35.000 real interest rate and and and and 00:25:32.599 --> 00:25:37.278 sometimes there's a problem because it's 00:25:35.000 --> 00:25:38.759 a when you against a zero lower bound 00:25:37.278 --> 00:25:41.159 then you can't affect the real interest 00:25:38.759 --> 00:25:43.519 in the same way but but most of the time 00:25:41.159 --> 00:25:46.000 you can and so I'm going to think I'm 00:25:43.519 --> 00:25:49.200 going to rewrite the slm mo now but I'm 00:25:46.000 --> 00:25:50.880 going to call this our bar and the bar 00:25:49.200 --> 00:25:52.519 is there just to tell you remind you 00:25:50.880 --> 00:25:54.600 that there something that the FED is 00:25:52.519 --> 00:25:57.398 setting 00:25:54.599 --> 00:25:59.319 okay so that's our aslm remember the 00:25:57.398 --> 00:26:01.119 Philips curve part 00:25:59.319 --> 00:26:03.200 the Philips that was our Philips curve 00:26:01.119 --> 00:26:05.398 remember the last once we replace the 00:26:03.200 --> 00:26:07.640 natural rate of unemployment in there we 00:26:05.398 --> 00:26:09.319 had the inflation minus expected 00:26:07.640 --> 00:26:11.240 inflation was a decreasing function of 00:26:09.319 --> 00:26:12.798 the unemployment Gap okay so if 00:26:11.240 --> 00:26:15.359 unemployment was above the natural rate 00:26:12.798 --> 00:26:18.000 of unemployment inflation was lower than 00:26:15.359 --> 00:26:19.599 expected inflation and conversely if the 00:26:18.000 --> 00:26:21.398 unemployment rate was lower than the 00:26:19.599 --> 00:26:23.759 unemployment rate and I said one the 00:26:21.398 --> 00:26:27.359 situation of the US today is that 00:26:23.759 --> 00:26:29.879 everything seems to point towards toward 00:26:27.359 --> 00:26:31.079 a situation where U is below un that's 00:26:29.880 --> 00:26:34.278 the reason we're seeing sort of high 00:26:31.079 --> 00:26:35.558 inflation okay now what I'm going to do 00:26:34.278 --> 00:26:37.839 next is I'm going to go from an 00:26:35.558 --> 00:26:40.079 employment to Output so I can put you 00:26:37.839 --> 00:26:43.480 see I don't have an employment anywhere 00:26:40.079 --> 00:26:46.158 here I have output so what I want to do 00:26:43.480 --> 00:26:48.480 is play with the Philips curve and until 00:26:46.159 --> 00:26:50.440 I write it in the space of inflation and 00:26:48.480 --> 00:26:52.079 output not inflation and unemployment so 00:26:50.440 --> 00:26:55.720 I can put the two curves together that's 00:26:52.079 --> 00:26:57.720 what I want to remember I want to merge 00:26:55.720 --> 00:26:59.399 here the slm with the PC so I want to 00:26:57.720 --> 00:27:03.120 put them in the the same 00:26:59.398 --> 00:27:04.678 variable so remember we have operated 00:27:03.119 --> 00:27:07.719 with a very simple production function 00:27:04.679 --> 00:27:09.679 in which output is equal to employment 00:27:07.720 --> 00:27:12.558 remember that's what we assume 00:27:09.679 --> 00:27:15.519 employment we call it n well I can 00:27:12.558 --> 00:27:18.038 rewrite n employment as the labor force 00:27:15.519 --> 00:27:21.359 times one minus the unemployment rate 00:27:18.038 --> 00:27:24.879 that's employment okay so that's I can 00:27:21.359 --> 00:27:27.918 think of output as that similar I can 00:27:24.880 --> 00:27:30.000 define a what we call we don't call it 00:27:27.919 --> 00:27:32.880 natur output we call it potential 00:27:30.000 --> 00:27:36.440 output no and potential output is 00:27:32.880 --> 00:27:38.120 defined as as the output that you get 00:27:36.440 --> 00:27:40.840 when unemployment is at the natural rate 00:27:38.119 --> 00:27:43.119 of unemployment okay so that's a 00:27:40.839 --> 00:27:46.398 definition three lines the potential 00:27:43.119 --> 00:27:49.798 output is when 00:27:46.398 --> 00:27:51.038 when the output you get which in this 00:27:49.798 --> 00:27:53.038 with this production function is the 00:27:51.038 --> 00:27:55.079 employment you get when you're at the 00:27:53.038 --> 00:27:57.319 unemployment at the natural rate of 00:27:55.079 --> 00:28:00.079 unemployment and now I can construct the 00:27:57.319 --> 00:28:02.038 difference the minus that this is 00:28:00.079 --> 00:28:03.759 something we call the output Gap and you 00:28:02.038 --> 00:28:07.519 may 00:28:03.759 --> 00:28:11.158 hear typically when people talk 00:28:07.519 --> 00:28:13.640 about issues of monetary 00:28:11.159 --> 00:28:16.399 policy often is described in terms of 00:28:13.640 --> 00:28:17.919 this variable More Than This Gap say 00:28:16.398 --> 00:28:20.239 people talk about the output Gap if the 00:28:17.919 --> 00:28:22.159 output Gap is positive that means output 00:28:20.240 --> 00:28:24.359 is above the natural rate of out the 00:28:22.159 --> 00:28:26.799 potential output when the output Gap is 00:28:24.359 --> 00:28:29.240 negative output is below potential 00:28:26.798 --> 00:28:32.038 output so I can re write this you know 00:28:29.240 --> 00:28:37.200 this minus that is just that and now I 00:28:32.038 --> 00:28:41.079 can I can replace uus un n here for H 00:28:37.200 --> 00:28:43.519 minus Yus YN / L and I get the Philips 00:28:41.079 --> 00:28:46.000 curve now written in terms of the output 00:28:43.519 --> 00:28:48.880 Gap and inflation so this says when 00:28:46.000 --> 00:28:50.960 output is above potential output when 00:28:48.880 --> 00:28:53.600 the output Gap is positive then 00:28:50.960 --> 00:28:55.558 inflation exceed expected inflation 00:28:53.599 --> 00:28:58.398 conversely when output is below 00:28:55.558 --> 00:29:01.240 potential output then inflation is below 00:28:58.398 --> 00:29:02.918 expected inflation okay but the logic is 00:29:01.240 --> 00:29:05.880 exactly the same as the logic we had 00:29:02.919 --> 00:29:07.480 here why is that this happens well 00:29:05.880 --> 00:29:09.080 because when output is above the 00:29:07.480 --> 00:29:10.839 potential output that means also 00:29:09.079 --> 00:29:14.480 unemployment is lower than the natural 00:29:10.839 --> 00:29:17.398 rate of unemployment okay so that's a 00:29:14.480 --> 00:29:19.440 that's the logic any question about 00:29:17.398 --> 00:29:23.479 this 00:29:19.440 --> 00:29:28.399 no okay good so anyway so now we have a 00:29:23.480 --> 00:29:31.000 a Philips curve and our aslm model so so 00:29:28.398 --> 00:29:33.158 let's put them together and suppose for 00:29:31.000 --> 00:29:35.720 now and when last example when I carry 00:29:33.159 --> 00:29:38.080 around is that expected inflation is 00:29:35.720 --> 00:29:39.519 equal to lag inflation so this a case in 00:29:38.079 --> 00:29:41.000 which expected inflation is not well 00:29:39.519 --> 00:29:42.240 anchor and then we're want to talk about 00:29:41.000 --> 00:29:45.398 what happens when it's anchor and not 00:29:42.240 --> 00:29:47.640 anchor so suppose that that inflation is 00:29:45.398 --> 00:29:49.000 actually whatever is this year's 00:29:47.640 --> 00:29:52.759 inflation that's what you expect for 00:29:49.000 --> 00:29:55.759 next year okay so here I have an example 00:29:52.759 --> 00:29:57.440 in which here I'm plotting our islm now 00:29:55.759 --> 00:30:00.679 which I'm using remember the real 00:29:57.440 --> 00:30:02.320 interest right here here H and in this 00:30:00.679 --> 00:30:04.519 diagram down here I'm plotting the 00:30:02.319 --> 00:30:08.000 Philips 00:30:04.519 --> 00:30:10.519 curve okay so first thing let's look 00:30:08.000 --> 00:30:13.038 about this Philip SC why is that where 00:30:10.519 --> 00:30:16.079 sloping here is output so this this is a 00:30:13.038 --> 00:30:17.319 parameter Pi n so and and and this is 00:30:16.079 --> 00:30:19.879 the left hand side variable so it's 00:30:17.319 --> 00:30:22.639 obviously increasing in output why is 00:30:19.880 --> 00:30:24.760 that well because if output grows that 00:30:22.640 --> 00:30:28.080 means unemployment goes down that means 00:30:24.759 --> 00:30:32.319 wages go up prices go up and you get 00:30:28.079 --> 00:30:33.759 inflation that's a mechanism okay so in 00:30:32.319 --> 00:30:36.319 this particular 00:30:33.759 --> 00:30:38.200 example we have this is the real 00:30:36.319 --> 00:30:40.960 interest rate that the FED has set at 00:30:38.200 --> 00:30:43.360 this moment that's equilibrium output 00:30:40.960 --> 00:30:45.038 what I'm trying to tell you here is that 00:30:43.359 --> 00:30:46.759 nothing has change in the way you 00:30:45.038 --> 00:30:49.038 calculate equilibrium output you just 00:30:46.759 --> 00:30:50.599 use for that you only need the stop 00:30:49.038 --> 00:30:52.798 diagram in the short 00:30:50.599 --> 00:30:56.918 run I tell you what the real interest 00:30:52.798 --> 00:30:58.480 rate is set by the is which is a 00:30:56.919 --> 00:31:01.320 decision by the Fed 00:30:58.480 --> 00:31:04.000 then I know where my is is I can pin 00:31:01.319 --> 00:31:07.359 down output I don't need this diagram to 00:31:04.000 --> 00:31:11.599 really pin down equilibrium output 00:31:07.359 --> 00:31:14.319 okay nothing is different there 00:31:11.599 --> 00:31:17.719 but and this is an example in this 00:31:14.319 --> 00:31:19.000 particular case we have that inflation 00:31:17.720 --> 00:31:22.798 is rising 00:31:19.000 --> 00:31:25.119 here and the question is why so for this 00:31:22.798 --> 00:31:27.679 what I'm trying to say is that for this 00:31:25.119 --> 00:31:30.319 is which is a function of fiscal policy 00:31:27.679 --> 00:31:33.278 of how confident consumers are and stuff 00:31:30.319 --> 00:31:35.519 like that if the FED chooses this real 00:31:33.278 --> 00:31:36.919 interest rate we end up with this output 00:31:35.519 --> 00:31:40.319 but it turns out that this level of 00:31:36.919 --> 00:31:42.559 output is increasing 00:31:40.319 --> 00:31:44.319 inflation and the increase in inflation 00:31:42.558 --> 00:31:47.798 I can read here I see the change in 00:31:44.319 --> 00:31:49.839 inflation is positive here why is this 00:31:47.798 --> 00:31:51.278 happening um if you're changing the 00:31:49.839 --> 00:31:54.000 alpha that means you have a different 00:31:51.278 --> 00:31:57.919 level ofemployment which changes the um 00:31:54.000 --> 00:32:00.119 expected inflation R yeah well actually 00:31:57.919 --> 00:32:01.480 here I don't need to take take this 00:32:00.119 --> 00:32:04.798 diagram would have also work with 00:32:01.480 --> 00:32:06.679 expected inflation as a constant here 00:32:04.798 --> 00:32:09.038 I'm I'm more looking at what happens to 00:32:06.679 --> 00:32:10.320 inflation I'm saying if output is above 00:32:09.038 --> 00:32:12.440 the natural rate of output then 00:32:10.319 --> 00:32:13.759 inflation is above expected inflation 00:32:12.440 --> 00:32:15.960 but I can take expected inflation as a 00:32:13.759 --> 00:32:18.000 constant in fact here it is a constant 00:32:15.960 --> 00:32:19.919 because constant in the sense that is 00:32:18.000 --> 00:32:22.240 given at time T because it's a previous 00:32:19.919 --> 00:32:23.919 year's inflation but what is important 00:32:22.240 --> 00:32:26.798 is that you have too much aggregate 00:32:23.919 --> 00:32:31.080 demand this economy is running very hot 00:32:26.798 --> 00:32:33.038 if output is positive then that is going 00:32:31.079 --> 00:32:34.599 to lead to inflationary pressures in 00:32:33.038 --> 00:32:36.200 this particular model where expected 00:32:34.599 --> 00:32:37.959 inflation is equal to l inflation this 00:32:36.200 --> 00:32:39.880 is pretty bad because not only you get 00:32:37.960 --> 00:32:42.880 inflation above the target of the FED 00:32:39.880 --> 00:32:45.799 but inflation is rising over 00:32:42.880 --> 00:32:47.760 time so this is a case in which this 00:32:45.798 --> 00:32:49.319 Central Bank is setting the real 00:32:47.759 --> 00:32:52.440 interest rate too 00:32:49.319 --> 00:32:54.879 low okay now you may want Japan is doing 00:32:52.440 --> 00:32:56.639 a little bit of this but they have a 00:32:54.880 --> 00:32:58.320 reason is that they have had inflation 00:32:56.638 --> 00:33:00.079 so low that it makes sense for them to 00:32:58.319 --> 00:33:02.599 build a little a little 00:33:00.079 --> 00:33:04.398 inflation in the US it made less sense 00:33:02.599 --> 00:33:05.839 remember the US got into trouble because 00:33:04.398 --> 00:33:07.558 it was in a situation like this for a 00:33:05.839 --> 00:33:10.638 long period of time I mean the you the 00:33:07.558 --> 00:33:12.839 reason we have today 6% inflation well 00:33:10.638 --> 00:33:16.398 depends which indicator you use is 00:33:12.839 --> 00:33:19.119 because the US experience sort of a year 00:33:16.398 --> 00:33:21.079 with a situation like this a year and a 00:33:19.119 --> 00:33:23.319 half okay and that's what sometimes 00:33:21.079 --> 00:33:25.398 people said the Fed was behind the curve 00:33:23.319 --> 00:33:28.079 they they for for a variety of reasons 00:33:25.398 --> 00:33:30.599 one initially potential output the Cline 00:33:28.079 --> 00:33:32.240 because of all the covid related issues 00:33:30.599 --> 00:33:34.199 they expected that to recover quickly so 00:33:32.240 --> 00:33:35.798 they says well let it go because I'm not 00:33:34.200 --> 00:33:37.278 going to start moving my policy right 00:33:35.798 --> 00:33:39.798 around for something that will recover 00:33:37.278 --> 00:33:41.880 quickly as soon as Co is gone well it 00:33:39.798 --> 00:33:43.960 took longer to recover and then it came 00:33:41.880 --> 00:33:46.799 the sort of the Russian war shock and so 00:33:43.960 --> 00:33:50.159 on and so natural rate of unemployment 00:33:46.798 --> 00:33:52.960 moved to the left to start and second 00:33:50.159 --> 00:33:55.880 because of an enormous policy support 00:33:52.960 --> 00:33:58.360 primarily H and the fact that that 00:33:55.880 --> 00:34:01.039 houses were able to save a lot during 00:33:58.359 --> 00:34:03.398 it there was a lot of pent up demand 00:34:01.038 --> 00:34:05.079 then we had enormous aggregate demand 00:34:03.398 --> 00:34:07.199 when we came out of it and the real 00:34:05.079 --> 00:34:09.319 interestate that we had was just way too 00:34:07.200 --> 00:34:10.519 low for all that agregate demand and 00:34:09.320 --> 00:34:13.240 that 00:34:10.519 --> 00:34:14.918 low potential output so we were in a 00:34:13.239 --> 00:34:15.878 situation like this and inflation began 00:34:14.918 --> 00:34:19.000 to 00:34:15.878 --> 00:34:20.838 climb initially expected inflation was 00:34:19.000 --> 00:34:22.519 very well anchor and then we began to 00:34:20.838 --> 00:34:24.119 lose the anchor then we recover it and 00:34:22.519 --> 00:34:25.719 and now we're losing it again we shall 00:34:24.119 --> 00:34:27.838 see what happens after this current 00:34:25.719 --> 00:34:29.678 episode but that was exactly a situation 00:34:27.838 --> 00:34:32.239 of the US and of most economies around 00:34:29.679 --> 00:34:34.918 the world China is in a different story 00:34:32.239 --> 00:34:38.199 but in most economies around the world 00:34:34.918 --> 00:34:40.480 you certainly Europe all of them the UK 00:34:38.199 --> 00:34:43.000 Continental Europe and the UK Latin 00:34:40.480 --> 00:34:44.918 America when you look the situation was 00:34:43.000 --> 00:34:50.639 like that just real interest were way 00:34:44.918 --> 00:34:52.319 too low for a um um the natural rate the 00:34:50.639 --> 00:34:54.440 potential the level of the potential 00:34:52.320 --> 00:34:57.760 output we had at that time and so we got 00:34:54.440 --> 00:34:59.079 into situation like this 00:34:57.760 --> 00:35:01.079 okay so that's the short run in the 00:34:59.079 --> 00:35:03.160 short run if you have an interest rate 00:35:01.079 --> 00:35:04.640 that is very low I mean again in the 00:35:03.159 --> 00:35:06.838 short run you you know how to determine 00:35:04.639 --> 00:35:08.319 output given a real interest rate and 00:35:06.838 --> 00:35:10.000 then now you can say a little more say 00:35:08.320 --> 00:35:11.760 okay but that's going to put inflation 00:35:10.000 --> 00:35:13.440 it's going to cause inflationary 00:35:11.760 --> 00:35:14.720 pressures up or down depending on 00:35:13.440 --> 00:35:16.358 whether you are to the right or to the 00:35:14.719 --> 00:35:18.118 left of the natural rate of output 00:35:16.358 --> 00:35:21.000 that's a new twist about the short run 00:35:18.119 --> 00:35:23.680 that you know but now let's start moving 00:35:21.000 --> 00:35:26.960 over time so what happens over 00:35:23.679 --> 00:35:30.118 time well first let me Define something 00:35:26.960 --> 00:35:31.519 well potential output we know what it is 00:35:30.119 --> 00:35:34.160 but I'm going to define something which 00:35:31.519 --> 00:35:36.079 is called the natural rate of interest 00:35:34.159 --> 00:35:37.440 rate sometimes called the neutral 00:35:36.079 --> 00:35:39.359 interest rate sometimes called the 00:35:37.440 --> 00:35:42.159 weelian interest rate let me not get 00:35:39.358 --> 00:35:45.279 into that story but I'm going to Define 00:35:42.159 --> 00:35:48.118 implicitly the natural rate of interest 00:35:45.280 --> 00:35:49.839 rate or the neutral rate of interest or 00:35:48.119 --> 00:35:52.720 some people call it rst star you may 00:35:49.838 --> 00:35:54.119 have heard of RS star in the newspapers 00:35:52.719 --> 00:35:55.719 people talk about R star when they are 00:35:54.119 --> 00:35:58.760 talking about RAR they're talking about 00:35:55.719 --> 00:36:01.799 that okay is simply the interest rate 00:35:58.760 --> 00:36:03.440 that that makes the natur the potential 00:36:01.800 --> 00:36:05.839 output the equilibrium of the Goods 00:36:03.440 --> 00:36:08.920 Market okay so I'm solving implicitly I 00:36:05.838 --> 00:36:10.199 say I want to get as a result as an I 00:36:08.920 --> 00:36:13.119 want to get as a result of this 00:36:10.199 --> 00:36:15.159 equilibrium here H the natural rate of 00:36:13.119 --> 00:36:17.079 output what is the interest I need to 00:36:15.159 --> 00:36:20.000 pick so that's the 00:36:17.079 --> 00:36:22.599 case okay so I want to get the natural 00:36:20.000 --> 00:36:24.280 rate of output here the potential output 00:36:22.599 --> 00:36:27.000 I know that there is an interest rate 00:36:24.280 --> 00:36:28.240 real interest rate at which that holds 00:36:27.000 --> 00:36:30.960 no it's a matter looking for the 00:36:28.239 --> 00:36:33.078 interest rate that does that and in this 00:36:30.960 --> 00:36:34.800 particular diagram is this you see at 00:36:33.079 --> 00:36:38.480 this interest 00:36:34.800 --> 00:36:40.720 rate the ASI equilibrium output is 00:36:38.480 --> 00:36:45.719 exactly the natural rate of 00:36:40.719 --> 00:36:49.000 output okay so what I know is that 00:36:45.719 --> 00:36:52.318 eventually the economy will have to go 00:36:49.000 --> 00:36:55.480 there no eventually the economy will 00:36:52.318 --> 00:36:59.800 have to go there so how will this happen 00:36:55.480 --> 00:37:01.159 in practice the way we happen is okay 00:36:59.800 --> 00:37:03.760 this is the point we were at in the 00:37:01.159 --> 00:37:06.039 previous slide 00:37:03.760 --> 00:37:08.520 no so we were 00:37:06.039 --> 00:37:10.800 here well that's building in 00:37:08.519 --> 00:37:13.159 inflationary 00:37:10.800 --> 00:37:15.880 pressure what do you think will happen 00:37:13.159 --> 00:37:15.879 inflation start 00:37:17.440 --> 00:37:25.440 climbing who will react who is in charge 00:37:21.280 --> 00:37:25.440 not letting inflation get get carried 00:37:25.679 --> 00:37:29.838 away Central Bank know the Fed so what 00:37:28.318 --> 00:37:30.920 they'll start doing is hiking interest 00:37:29.838 --> 00:37:33.358 rate which is exactly what they have 00:37:30.920 --> 00:37:35.519 been doing no and as they hike interest 00:37:33.358 --> 00:37:37.880 rate you know they're going to 00:37:35.519 --> 00:37:39.599 keep they take they start increasing the 00:37:37.880 --> 00:37:42.519 real interest rate interest until they 00:37:39.599 --> 00:37:47.160 get to this point okay that's 00:37:42.519 --> 00:37:51.639 idea so the point is that in the medium 00:37:47.159 --> 00:37:53.239 run a a the real interest real variables 00:37:51.639 --> 00:37:55.318 determine real variables not monetary 00:37:53.239 --> 00:37:56.719 policy monetary policy has to follow 00:37:55.318 --> 00:37:59.480 whatever it is that the economy throws 00:37:56.719 --> 00:38:00.919 at them banks have to follow whatever is 00:37:59.480 --> 00:38:02.679 the real interest rate if they made a 00:38:00.920 --> 00:38:04.519 mistake and they set an real interest 00:38:02.679 --> 00:38:06.358 rate which is not consistent with a 00:38:04.519 --> 00:38:08.199 stable inflation they're going to learn 00:38:06.358 --> 00:38:10.039 about it and over time they're going to 00:38:08.199 --> 00:38:14.799 have to fix that and when will the 00:38:10.039 --> 00:38:16.960 problem go away only when H they they 00:38:14.800 --> 00:38:19.359 reach the natural rate of unemployment 00:38:16.960 --> 00:38:21.480 okay and so that's what will happen as 00:38:19.358 --> 00:38:24.358 the real interest start going up from 00:38:21.480 --> 00:38:27.079 here to there then you start seeing the 00:38:24.358 --> 00:38:29.880 change in inflation this particular mole 00:38:27.079 --> 00:38:31.519 ER um declining and declining and when 00:38:29.880 --> 00:38:34.480 you get to an natural rate of output at 00:38:31.519 --> 00:38:34.480 least you get a stable 00:38:36.039 --> 00:38:42.440 inflation is this adjustment 00:38:39.838 --> 00:38:45.239 clear okay good okay so that's what 00:38:42.440 --> 00:38:47.440 happened in the medium run so the medium 00:38:45.239 --> 00:38:49.759 run is described as moving from that 00:38:47.440 --> 00:38:52.119 point here the whole process of going 00:38:49.760 --> 00:38:55.800 back to a situation where we converge to 00:38:52.119 --> 00:38:57.559 the Natural rate of interest rate and 00:38:55.800 --> 00:38:59.160 therefore the natural rate of output and 00:38:57.559 --> 00:39:01.920 the natural rate of unemployment and all 00:38:59.159 --> 00:39:03.960 these kind of things okay so that's the 00:39:01.920 --> 00:39:07.358 short run is whatever his output is 00:39:03.960 --> 00:39:10.318 That's So slm the medium run is whatever 00:39:07.358 --> 00:39:11.639 the the natural rate tells you should be 00:39:10.318 --> 00:39:13.039 the natural rate of unemployment the 00:39:11.639 --> 00:39:15.078 natural rate of output and therefore the 00:39:13.039 --> 00:39:16.318 natural rate of interest rate or weelian 00:39:15.079 --> 00:39:19.960 interest rate or the neutral interest 00:39:16.318 --> 00:39:21.960 rate or our star that's all pinned down 00:39:19.960 --> 00:39:23.679 there in the in the in the medium run 00:39:21.960 --> 00:39:26.358 and the transition is obviously going 00:39:23.679 --> 00:39:27.879 from the short run like pure LS slm to 00:39:26.358 --> 00:39:30.199 the Natural rate 00:39:27.880 --> 00:39:33.880 type analysis 00:39:30.199 --> 00:39:36.439 okay now I assume here and that's 00:39:33.880 --> 00:39:40.480 related to your answer I assume here 00:39:36.440 --> 00:39:42.838 that expected inflation was an anchor 00:39:40.480 --> 00:39:45.920 that is that expected inflation was 00:39:42.838 --> 00:39:48.318 equal to l inflation that's I I told you 00:39:45.920 --> 00:39:51.079 before that's not what Central One banks 00:39:48.318 --> 00:39:55.239 want to be because that means that if 00:39:51.079 --> 00:39:57.079 you mess up inflation is high and and 00:39:55.239 --> 00:39:58.679 then in order to bring it down you also 00:39:57.079 --> 00:40:00.440 have to bring down expected inflation 00:39:58.679 --> 00:40:02.598 you need to cause a recession and you 00:40:00.440 --> 00:40:04.800 can see that here so suppose that the 00:40:02.599 --> 00:40:06.160 Central Bank starts with the level of 00:40:04.800 --> 00:40:08.318 inflation that it like suppose that this 00:40:06.159 --> 00:40:09.960 is the model so what I said before the 00:40:08.318 --> 00:40:12.400 expected inflation is equal to lag 00:40:09.960 --> 00:40:14.000 inflation suppose that the Central Bank 00:40:12.400 --> 00:40:18.519 starts at the level of inflation that it 00:40:14.000 --> 00:40:21.960 likes 2% in the US okay I suppose that 00:40:18.519 --> 00:40:23.480 for whatever reason whatever shock it 00:40:21.960 --> 00:40:25.800 finds itself with an interest rate that 00:40:23.480 --> 00:40:29.400 is too low a real interest rate is too 00:40:25.800 --> 00:40:32.359 low that means in inflation exceeds 00:40:29.400 --> 00:40:35.519 expected inflation which was 00:40:32.358 --> 00:40:38.440 2% well by next year say this suppos 00:40:35.519 --> 00:40:40.920 this Gap is 2% well by next year the G 00:40:38.440 --> 00:40:45.559 inflation is 00:40:40.920 --> 00:40:48.400 4% okay so if your inflation is 4% in 00:40:45.559 --> 00:40:50.679 fact in the US it got to be 9% if you 00:40:48.400 --> 00:40:52.920 are at 9% level of inflation and this is 00:40:50.679 --> 00:40:55.679 the model of expected for expected 00:40:52.920 --> 00:40:57.838 inflation you have then Houston you have 00:40:55.679 --> 00:40:59.838 a problem because it's not enough with 00:40:57.838 --> 00:41:01.719 raising interest rate up to this point 00:40:59.838 --> 00:41:04.799 suppose that the FED says wow I don't 00:41:01.719 --> 00:41:06.480 like 9% I'm going to go back to that 00:41:04.800 --> 00:41:08.280 that clearly tells me that my output is 00:41:06.480 --> 00:41:09.800 way above the natural rate of output I'm 00:41:08.280 --> 00:41:11.800 going to hike interest rate and somebody 00:41:09.800 --> 00:41:14.359 tells the fed this is your natural 00:41:11.800 --> 00:41:15.519 interest rate a very good research 00:41:14.358 --> 00:41:17.199 Department tells him look this is your 00:41:15.519 --> 00:41:18.800 natural interest hike it to there 00:41:17.199 --> 00:41:20.399 suppose the FED hikes the interest rate 00:41:18.800 --> 00:41:22.800 to that point what 00:41:20.400 --> 00:41:25.358 happens so the FED realized here this 00:41:22.800 --> 00:41:28.240 was going really wrong they end up with 00:41:25.358 --> 00:41:30.159 9% inflation so but somebody tells him 00:41:28.239 --> 00:41:32.959 look this is your natural your neutral 00:41:30.159 --> 00:41:35.000 interest rate your R star bring it there 00:41:32.960 --> 00:41:37.559 and the FED immediately reacts and takes 00:41:35.000 --> 00:41:40.119 it there what 00:41:37.559 --> 00:41:41.960 happened is the Fed happy with the final 00:41:40.119 --> 00:41:44.760 outcome and supposed the res Department 00:41:41.960 --> 00:41:48.519 was really good so they got got it right 00:41:44.760 --> 00:41:51.280 so the r star was the right R 00:41:48.519 --> 00:41:53.199 star okay and the FED implemented that 00:41:51.280 --> 00:41:54.519 policy move interest rate suppose that 00:41:53.199 --> 00:41:56.719 the interest rate the real interest rate 00:41:54.519 --> 00:41:58.679 they had was minus 1% I'm telling you 00:41:56.719 --> 00:42:02.000 numbers that are not that different from 00:41:58.679 --> 00:42:04.000 what we had minus 1% and and and the 00:42:02.000 --> 00:42:06.880 research Department tells no your your 00:42:04.000 --> 00:42:08.719 RN is really 1% so they hike interest 00:42:06.880 --> 00:42:12.240 rate by 2% 00:42:08.719 --> 00:42:12.239 immediately and now what 00:42:19.838 --> 00:42:23.679 happens 00:42:21.358 --> 00:42:25.598 so I guess that question is a little 00:42:23.679 --> 00:42:28.519 bague but but I'm saying is the Central 00:42:25.599 --> 00:42:31.920 Bank happy now that it o I got we got 00:42:28.519 --> 00:42:33.719 the right natural rate neutral rate it's 00:42:31.920 --> 00:42:36.039 called neutral 00:42:33.719 --> 00:42:37.959 rate well I'm telling you I wouldn't be 00:42:36.039 --> 00:42:39.759 asking you if the Fed was happy after 00:42:37.960 --> 00:42:42.318 that so why do you think why why are 00:42:39.760 --> 00:42:45.680 they unhappy why is the Fed unhappy 00:42:42.318 --> 00:42:47.440 after that not unhappy with the policy 00:42:45.679 --> 00:42:49.039 but but but when I'm saying the 00:42:47.440 --> 00:42:51.838 adjustment is not completed at that 00:42:49.039 --> 00:42:51.838 point 00:42:56.119 --> 00:43:01.119 why and I'm trying to make the bigger 00:42:58.400 --> 00:43:02.720 point for why central banks are so eager 00:43:01.119 --> 00:43:04.640 to maintain credibility and not have 00:43:02.719 --> 00:43:06.838 this kind of model of expected inflation 00:43:04.639 --> 00:43:08.719 they want the markets to believe them 00:43:06.838 --> 00:43:10.838 that that they have a Target and that 00:43:08.719 --> 00:43:12.598 they're going to go to that Target and 00:43:10.838 --> 00:43:14.358 and that to set their expected inflation 00:43:12.599 --> 00:43:16.440 equal to that constant equal to a Target 00:43:14.358 --> 00:43:18.239 that's what they dream with because if 00:43:16.440 --> 00:43:20.280 they don't get that if they get this 00:43:18.239 --> 00:43:22.519 instead things are 00:43:20.280 --> 00:43:26.079 nasty and I'm trying to describe that 00:43:22.519 --> 00:43:27.920 Nas what what what is happening now so 00:43:26.079 --> 00:43:31.039 what happens here okay so so so we went 00:43:27.920 --> 00:43:33.079 here inflation got to be 9% and now the 00:43:31.039 --> 00:43:36.318 FED boom hike interest rate 00:43:33.079 --> 00:43:38.280 by 200 basis point it got to the Natural 00:43:36.318 --> 00:43:39.519 rate we're back at output equal to 00:43:38.280 --> 00:43:42.200 Natural rate of output what is happening 00:43:39.519 --> 00:43:42.199 to inflation 00:43:43.800 --> 00:43:48.720 here so now we're back at the natural 00:43:46.318 --> 00:43:51.239 what is happening to 00:43:48.719 --> 00:43:53.480 inflation well this diagram tells you 00:43:51.239 --> 00:43:55.879 something very specific it says it's not 00:43:53.480 --> 00:43:58.440 changing so now your inflation at least 00:43:55.880 --> 00:44:00.559 is not changing 00:43:58.440 --> 00:44:03.079 okay so that's 00:44:00.559 --> 00:44:07.800 good at least not Rising here it was 00:44:03.079 --> 00:44:10.160 Rising it's not changing but what is the 00:44:07.800 --> 00:44:12.079 problem inflation not changing when 00:44:10.159 --> 00:44:15.480 you're at 9% is not a good outcome for 00:44:12.079 --> 00:44:18.559 the FED want 2% not 00:44:15.480 --> 00:44:20.318 9% okay so they when you have this 00:44:18.559 --> 00:44:22.400 modification you need to do more than 00:44:20.318 --> 00:44:24.639 that you know because you need to bring 00:44:22.400 --> 00:44:26.720 expected inflation down so you need to 00:44:24.639 --> 00:44:29.239 overshoot a Fed that finds itself with 00:44:26.719 --> 00:44:32.118 9% inflation and has expected inflation 00:44:29.239 --> 00:44:34.358 and anchor needs to be inflation much 00:44:32.119 --> 00:44:35.720 lower so needs to raise interest in the 00:44:34.358 --> 00:44:37.519 short run much higher than the natural 00:44:35.719 --> 00:44:39.919 rate of interest rate so it gets 00:44:37.519 --> 00:44:41.440 negative inflation here so you can bring 00:44:39.920 --> 00:44:45.920 the 9% back to 00:44:41.440 --> 00:44:48.880 2% no so I have to generate a minus 7% 00:44:45.920 --> 00:44:51.240 here and to generate a minus 7% here I 00:44:48.880 --> 00:44:52.760 need to bring output much below the 00:44:51.239 --> 00:44:55.519 natural rate of output I need to cause a 00:44:52.760 --> 00:44:57.760 big recession to do that and that's the 00:44:55.519 --> 00:45:00.119 reason the bank central banks don't want 00:44:57.760 --> 00:45:03.240 to be in this scenario because with this 00:45:00.119 --> 00:45:05.280 of inflation if expected inflation 00:45:03.239 --> 00:45:06.959 becomes an anchor then there's no way 00:45:05.280 --> 00:45:09.000 around that the FED will have to cause a 00:45:06.960 --> 00:45:11.079 big recession to get out of inflationary 00:45:09.000 --> 00:45:14.000 problem 00:45:11.079 --> 00:45:15.760 okay contrast that with a case in which 00:45:14.000 --> 00:45:17.838 the market the expected inflation is not 00:45:15.760 --> 00:45:19.839 equal to lag inflation but is equal to 00:45:17.838 --> 00:45:23.119 whatever the FED tells them is the long 00:45:19.838 --> 00:45:25.719 run average 2% so now suppose that 00:45:23.119 --> 00:45:28.800 therefore rather than having here Pi 00:45:25.719 --> 00:45:33.799 minus one I have that Target Pi Bar 00:45:28.800 --> 00:45:36.839 which is 2% so yeah we got to 9% but for 00:45:33.800 --> 00:45:39.440 the FED to go back to say the FED would 00:45:36.838 --> 00:45:41.279 say whoop I mess up you know clearly set 00:45:39.440 --> 00:45:43.599 a real interest that was way too low and 00:45:41.280 --> 00:45:45.519 so I end up with 9% inflation but if 00:45:43.599 --> 00:45:48.280 credibility is maintained and still 00:45:45.519 --> 00:45:49.719 people expect 2% in the medium run then 00:45:48.280 --> 00:45:51.920 that means that the FED doesn't need to 00:45:49.719 --> 00:45:54.439 cause a recession to bring inflation 00:45:51.920 --> 00:45:57.559 back to the normal level it just needs 00:45:54.440 --> 00:46:00.480 to bring output to a level equal to 00:45:57.559 --> 00:46:03.319 potential out so it just need to raise 00:46:00.480 --> 00:46:06.679 interest to RN to the Natural rate of 00:46:03.318 --> 00:46:08.119 the r star not to our Star Plus 00:46:06.679 --> 00:46:12.000 something in order to have this 00:46:08.119 --> 00:46:13.640 inflation in the short okay and we're 00:46:12.000 --> 00:46:14.800 there at this moment in the verge of 00:46:13.639 --> 00:46:18.039 these two worlds we have been 00:46:14.800 --> 00:46:20.960 alternating between the two worlds still 00:46:18.039 --> 00:46:22.679 more biased towards the good World in 00:46:20.960 --> 00:46:25.000 which really the FED doesn't need to 00:46:22.679 --> 00:46:26.399 cause a the need the FED needs to slow 00:46:25.000 --> 00:46:29.199 down the economy because it still need 00:46:26.400 --> 00:46:31.760 to bring out put down to YN but that's a 00:46:29.199 --> 00:46:33.358 small change in practice all these 00:46:31.760 --> 00:46:35.480 things are growing over time it just 00:46:33.358 --> 00:46:39.440 means that the economy grows at a lower 00:46:35.480 --> 00:46:40.519 pace for a few quarters okay but it's 00:46:39.440 --> 00:46:42.559 very different to have to bring 00:46:40.519 --> 00:46:45.000 temporarily output down here because for 00:46:42.559 --> 00:46:46.359 that you need to sort of bring the 00:46:45.000 --> 00:46:48.760 growth has to become 00:46:46.358 --> 00:46:52.440 negative for some period of time in 00:46:48.760 --> 00:46:54.480 order to bring inflation 00:46:52.440 --> 00:46:58.480 down 00:46:54.480 --> 00:46:58.480 good so 00:46:58.599 --> 00:47:04.200 big lessons from uh this part is that as 00:47:01.519 --> 00:47:06.000 I said before in the M run so so I 00:47:04.199 --> 00:47:07.358 haven't changed at I haven't changed any 00:47:06.000 --> 00:47:09.039 of the two models I told you what was 00:47:07.358 --> 00:47:11.838 the model of the short run the slm 00:47:09.039 --> 00:47:13.079 that's still true here I told you then 00:47:11.838 --> 00:47:15.039 what was the model of the natural rate 00:47:13.079 --> 00:47:16.559 of unemployment and all that and that 00:47:15.039 --> 00:47:17.920 there we didn't have any monetary policy 00:47:16.559 --> 00:47:19.760 or anything like that we we look at what 00:47:17.920 --> 00:47:20.960 happened in the labor market and we 00:47:19.760 --> 00:47:25.680 determin the natural rate of an 00:47:20.960 --> 00:47:27.440 employment and that was it okay so so 00:47:25.679 --> 00:47:29.078 the medium run here is when we are in 00:47:27.440 --> 00:47:32.000 that world which has nothing to do with 00:47:29.079 --> 00:47:34.440 monetary policy it has all to do with 00:47:32.000 --> 00:47:36.760 real variables okay what is a n what is 00:47:34.440 --> 00:47:38.240 a equilibrium long-ter real interest 00:47:36.760 --> 00:47:40.839 rate what is a natural rate of 00:47:38.239 --> 00:47:45.399 unemployment things of that 00:47:40.838 --> 00:47:48.119 kind um but monetary policy what does do 00:47:45.400 --> 00:47:50.680 is certainly determine in the short run 00:47:48.119 --> 00:47:52.880 equilibrium output and but in the medium 00:47:50.679 --> 00:47:54.399 run it's is determines what is the 00:47:52.880 --> 00:47:55.720 nominal interest rate equilibrium 00:47:54.400 --> 00:47:58.920 nominal interest rate and the level of 00:47:55.719 --> 00:48:01.639 inflation because the economy will have 00:47:58.920 --> 00:48:05.400 a real interest rate which is the rst 00:48:01.639 --> 00:48:07.598 star and RN the economy has RN but the 00:48:05.400 --> 00:48:10.280 fed and the FED will not get to pick 00:48:07.599 --> 00:48:12.599 what RN is the only thing that the FED 00:48:10.280 --> 00:48:14.280 will get to pick in the medium run is 00:48:12.599 --> 00:48:16.519 what is a nominal interest rate that is 00:48:14.280 --> 00:48:19.440 consistent with that RN because supposed 00:48:16.519 --> 00:48:22.679 the RN is say 00:48:19.440 --> 00:48:25.318 2% if the if the economy ends up having 00:48:22.679 --> 00:48:27.598 3% inflation on average that means that 00:48:25.318 --> 00:48:29.159 the nominal interest r rate for the long 00:48:27.599 --> 00:48:32.280 run is going to have to be 00:48:29.159 --> 00:48:33.759 5% is instead that economy has 2% 00:48:32.280 --> 00:48:35.640 inflation average then that means that 00:48:33.760 --> 00:48:38.720 the the long run nominal interest rate 00:48:35.639 --> 00:48:40.159 will be 4% so monetary policy affects 00:48:38.719 --> 00:48:42.118 the nominal interest rate nominal 00:48:40.159 --> 00:48:43.358 variables in the M run but not the real 00:48:42.119 --> 00:48:45.440 variables the real variables are 00:48:43.358 --> 00:48:47.880 determined by the real sector and that's 00:48:45.440 --> 00:48:50.760 often refer as the neutrality of money 00:48:47.880 --> 00:48:52.798 in the medium run and the long run money 00:48:50.760 --> 00:48:54.400 tends to be neutral and that's that's 00:48:52.798 --> 00:48:56.838 what it means 00:48:54.400 --> 00:48:58.599 that real variables are determined by 00:48:56.838 --> 00:49:00.759 something entirely different but in the 00:48:58.599 --> 00:49:03.359 short run monetary policy is the main 00:49:00.760 --> 00:49:06.040 game game in town and in the medium run 00:49:03.358 --> 00:49:08.400 it's just about inflation it's not about 00:49:06.039 --> 00:49:11.159 real 00:49:08.400 --> 00:49:16.599 activity 00:49:11.159 --> 00:49:16.598 um Let me let me stop here