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46:09
Transcript
0:16
um so we started with the something a
0:20
little boring basic definitions and the
0:22
first thing we had to do is to
0:25
understand how do we measure output at
0:26
the aggregate level it's very easy to
0:28
understand what output is at the level
0:29
of an Factory but but at the AG level is
0:32
a little tricky and so we had an example
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0:36
of a very simple economy with two
0:38
companies one that produces steel and
0:41
the other one that produces cars and in
0:44
this particular example the steel
0:46
company doesn't sell anything to the
0:47
final consumers it sells all its
0:50
production to the car company and we ask
0:52
a question where is the GDP of this
0:54
economy H the simplest answer would have
0:58
been well 300 no I some what the the the
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1:01
output of the two companies and that
1:03
could be one answer but then I show you
1:06
through three different methods that
1:08
that's the wrong answer and um method
1:12
one H was h a definition is um GDP is
1:18
the value of final goods only okay and
1:22
final goods in this simple example is
1:25
well this company is not producing
1:26
anything as a final good because all its
1:29
sales are going to as an input into
1:31
other companies production and so this
1:34
one doesn't count at all in our simple
1:36
example this one counts and then the
1:38
answer is $200 okay not 3300 but
1:42
$200 method two was to count only the
1:46
value added in each company and value
1:48
added is the difference between the
1:50
final
1:51
output that is the revenue from sales
1:55
minus whatever that company spends on
1:57
intermediate inputs in this simple
2:00
example this company the steel company
2:02
is not spending anything on intermediate
2:04
inputs it's a strange production of a
2:05
steel but anyways it is what it is in
2:07
example and so this is entire this $100
2:11
is is value added completely value added
2:13
there's no expenses on intermediate
2:15
inputs for the car company however the
2:18
revenue from C is 200 but the company
2:20
spends 100 on intermediate input
2:23
therefore the value out of this company
2:25
is 200 minus 100 so you get 100 value
2:27
out from this one 100 value out from
2:29
that one total value added 200 so same
2:33
answer and the third method these are
2:35
the two method that I just described are
2:37
production methods no you're measuring
2:39
the production side the alternative is
2:42
to look at the income side okay and the
2:45
income side let's says just let's sum
2:47
all the incomes in the economy and the
2:49
incomes are income to workers wages and
2:52
income to the owners of capital
2:54
profits ER income to way to workers is
2:58
$80 plus 70 is 100 50 income to owners
3:02
of capital is 20 + 30 that's 50 so 150
3:05
plus 50 is again 200 okay so these are
3:08
three equivalent ways of er er measuring
3:11
output and I said
3:15
ER you know and one of the features I I
3:18
I I show you of of of of this method is
3:21
that they are immune to organizational
3:25
structure within the economy so for
3:26
example if these two companies were to
3:28
merge no clearly the sum of incomes
3:31
would not change would still be 100 it
3:34
would be
3:36
200 ER this one would not change because
3:39
if they were to merge then the whole
3:41
production of the revenues from sales of
3:43
the car company would be value added
3:46
everything would be produced in house
3:48
and still the answer would be 200 then
3:50
no because this company would disappear
3:51
it would emerge inside here and you
3:53
would get still get 200 and the same
3:56
happen with h method one because still
4:00
the sales of final goods is only
4:03
200 the naive approach of just summing
4:06
output you know would be terrible
4:09
because once you merge it output would
4:11
collapse from 300 to 200 that tells you
4:13
that's not the right way of doing things
4:16
okay so while the three methods we
4:18
propose do H work are immune to to this
4:22
organiz changes in organization
4:24
structure The Next Step was to H
4:28
highlight that when we say out output
4:30
we're really after real output and
4:32
there's a distinction between nominal
4:34
output and real output nominal output is
4:37
simply the quantity of final goods
4:39
measured at current prices while real
4:43
output is measured at some fixed set of
4:46
prices okay of one fixed year and I
4:49
think I gave you an
4:50
example this is example I gave you and
4:52
then in the in the in the pets you had
4:54
more complicated examples with multiple
4:56
Goods here you have an economy that
4:58
produces only one good
5:00
cars and that PES 10 cars here 12 cars
5:03
here 13 cars here the price of the cars
5:06
is rising so the nominal GDP is rising a
5:09
lot while the real GDP is rising less
5:12
how do we measure real GDP here we use
5:14
to to 12 in this particular example we
5:16
use the prices here 12 10 times the
5:19
price of the car in 2012 is 24,000
5:22
that's
5:23
240 obviously for the base year nominal
5:27
GDP is the same as real GDP and then 12
5:30
13 is 13 not time 26,000 but times
5:33
24,000 and we get that now in this
5:36
particular example of only one e one
5:38
good ER you can pick any any base year
5:42
and you'll get exactly the same rate of
5:43
growth of real output if you have
5:45
multiple Goods that's not true because
5:47
the relative prices of goods are moving
5:49
over time okay but uh but that's the
5:52
basic idea so I mean again you should
5:55
know these things they're not going to
5:57
be tremendously important in the quiz
5:59
but they will show up in your quiz
6:01
[Music]
6:04
okay and then we went some some
6:06
definitions the unemployment rate know
6:09
being the number of unemployed over the
6:11
labor force not population that's
6:14
important H we talked about inflation
6:18
rate as well that's the rate of change
6:21
of prices and there are different prices
6:22
in the economy one of them is the
6:24
deflator the other one is CPI and so on
6:26
so forth that's it so that was the first
6:30
uh lecture relevant for the quiz any
6:32
question about
6:35
that good keep
6:39
moving okay then we move to when then we
6:41
began to really get serious because we
6:43
began to construct sort of a foundation
6:46
for the islm model okay and the first
6:49
thing we did is we look at the Goods
6:52
Market
6:55
uh no and and what we did here is just
6:59
was say we describ the different
7:00
components of of aggregate demand and we
7:03
said in this econ for for now at least
7:06
we're going to make this economy close
7:08
so we we remove exports and imports and
7:10
for your quiz absolutely you not going
7:12
to see anything about exports or Imports
7:15
okay so this is your aggregate demand ER
7:18
we wanted to build a little more so we
7:20
had to have some behavioral assumptions
7:23
H we made it initially very simple we
7:25
assumed this was
7:26
exogenous the Govern expension was
7:28
exogenous taxes were also exogenous t h
7:32
and the only behavioral equation we had
7:35
was this consumption function we said
7:36
consumption is increasing disposable
7:38
income okay so and we we assume
7:42
something linear like this disposable
7:44
income is just income minus taxes and
7:47
remember income remember from the from
7:50
the alternative ways of measuring GDP
7:52
income is the same as output no so when
7:55
I say income because as is relevant for
7:57
the consump consumer well but it's the
7:59
same as output so that's was our
8:03
consumption function it had an upward
8:05
slope it was upward sloping because
8:07
there's a marginal propensity to consume
8:10
C1 H and then then a key Assumption of
8:14
this part of the course is that that H
8:17
output is aggregate demand determined
8:19
prices were completely fixed H and and
8:22
we said well but you know output is
8:24
whatever demand wants that's what output
8:26
is so this is an equilibrium condition
8:30
okay this is the aggregate demand this
8:33
is an equilibrium condition so we can
8:35
solve out because I can say in
8:37
equilibrium Z is equal to Y and I can
8:40
solve for equilibrium output from that
8:41
equation okay and that's exactly what we
8:43
did in this slide and you got to an
8:46
expression like this knowing how to do
8:48
that is very important for you okay so
8:51
you you better be sure that you know how
8:52
to find equilibrium output in in in this
8:56
model I mean it's going to be very
8:58
difficult to do I M if you don't know
9:00
these steps so so you better know this
9:03
stuff H and remember something we call
9:06
this guy here in the simple economy the
9:08
multiplier why the multiplier well
9:11
because given certain sort of something
9:13
we call exogenous expenditure the 1
9:16
minus C1 multiplies that if the marginal
9:20
to consume is very high say it's close
9:23
to one then the multipli is very very
9:25
high if the marginal Pro to consume say
9:28
is 05 then how much is the
9:33
multiplier two okay good so the
9:36
multiplier is two okay good and that was
9:40
our equilibrium now we had the aggregate
9:42
demand the slope was less than the 45
9:44
degree line because C1 is a number less
9:46
than one and so you have some
9:48
equilibrium output there that's
9:50
equilibrium output at this point
9:52
aggregate demand is equal to well agre
9:55
demand is equal to agre supply that's
9:57
that's always true uh but that's
9:59
consistent also with aggregate demand
10:01
okay with the with the function of
10:03
aggregate demand and and the important
10:06
for for this equilibrium output is that
10:08
that equilibrium output is a function of
10:10
a lot of things that we took as
10:11
parameters in this aggregate demand
10:13
curve what did we take as parameters in
10:16
the agregate bank care just give
10:22
examples well investment government
10:26
expenditure and taxes at the very least
10:29
tax also parameters like autonomous
10:31
consumption that c0 were taking as given
10:34
anything if any of those things move
10:36
this the position of this aggregate
10:38
demand curve will shift
10:40
around okay and that was one example
10:43
suppose autonomous consumption C zero
10:46
goes up so suddenly consumers decide to
10:48
spend more okay well then then what we
10:51
had is is that aggregate demand shift up
10:54
and equilibrium output ends up changing
10:56
by more than the initial change in c z
10:59
why is
10:59
that so this is the change in
11:02
c0
11:04
but uh but the change in output and so
11:07
the initial change c0 leads to an
11:10
initial change in output which is equal
11:12
to c0 that's up to here but then we end
11:15
up with final equilibrium output is is
11:17
is higher than the initial response all
11:20
this happens infinitely fast in this
11:21
model why is this change greater than
11:26
c0 there is a multiplier in front
11:28
exactly
11:30
we change c0 by one but then you have to
11:32
multiply by 1/ 1 minus C1 and that's
11:34
what we Illustrated in this picture
11:37
there okay good and so you should move
11:41
anything you you can move here around no
11:43
move G up T up or stuff like that and
11:47
see what
11:50
happens the last thing I did in this
11:52
section is is uh I show you an
11:54
alternative way entirely equivalent way
11:56
of of illustrating equilibrium which was
12:00
saving equal to
12:01
investment H remember and I derive
12:05
this and I got to an expression like
12:07
that that's exactly the same as
12:08
aggregate demand equal to aggregate
12:10
supply no a investment which in this
12:13
particular basic model is fixed is equal
12:16
to saving by the government which is
12:18
also in this basic model is fixed
12:19
because it's G minus t which is fixed H
12:23
sorry it's T minus G which is fixed and
12:26
then private saving and and then I show
12:29
you a an interesting result which is
12:32
called known the Paradox of savings
12:34
which says the following if for whatever
12:37
reason consumers decide to save more say
12:40
for example because c z now comes down
12:43
okay so now out they have certain income
12:46
out of that same income they want to
12:47
save
12:48
more then from this very simple equation
12:51
I know that what happens to Output
13:02
why because savings go up consum Dem
13:06
goes down and then also investment
13:07
suppos to go down and then no investment
13:10
doesn't go down here because it's fixed
13:13
in this this B Bas basic example not
13:17
islm yes but that's that's that's an
13:19
explanation which is is the right
13:21
explanation but it's is it's the
13:24
explanation in the other space output
13:26
and and and and the income
13:29
I want it in the space of saving an
13:31
investment so let me give it to you very
13:33
quickly but your answer is correct but
13:35
but but it's not what I wanted here
13:37
because what I wanted to say is the
13:39
following if for whatever reason for any
13:41
given level of income savings go up then
13:44
we have an imbalance saving total saving
13:46
is greater than
13:47
investment the only variable that can
13:49
adjust here so we restore equilibrium
13:52
investment equal to saving is for output
13:54
to bring come down because if output
13:55
comes down savings come down and that's
13:57
the way you restore equilibrium
14:00
I told you this way of looking at thing
14:01
is entirely equivalent as we had already
14:03
done so I can also do what you wanted to
14:06
do which is represent that in the space
14:08
of output and aggregate demand and and
14:11
output or or income and and the an
14:15
increase in
14:17
c0 a reduction in c0 would lead to a
14:20
decline in aggregate demand and then
14:22
through the multiply larger increase in
14:24
output so this is the way we characteriz
14:25
it before this is a slightly different
14:28
way of of characterizing which is is
14:30
what gives rise to what is called the
14:32
Paradox of saving because suddenly you
14:33
decide to save more supposed to be good
14:36
well in the short run it's not really
14:37
good it causes a recession okay anyway
14:42
it's cute but it may show up in your
14:43
future so I wanted to remind you
15:01
so that was the Goods Market side
15:05
oops then we look at financial markets
15:07
and we we trivialized financial markets
15:09
really we said let's assume the
15:11
financial markets are very very simple
15:13
money and bonds that's it nothing else
15:20
ER and the first sort of behavior the
15:23
the only behavioral equation we really
15:25
had here was money demand and we say
15:27
well money demand is increasing in nomal
15:29
GDP because if nominal GDP is larger
15:31
then you need to do more transactions
15:33
you need more money more cash ER cash or
15:37
deposit but here we're looking only at
15:39
cash but it's decreasing in the interest
15:41
rate money money is decreasing the Reon
15:43
why it's decreasing in interest rate
15:45
interest rate is the return on the bonds
15:48
no why is money demand decreasing in the
15:50
interest
15:55
rate yeah the opportunity cost of
15:57
holding cash in your pocket is higher
15:59
you didn't care about this
16:02
stuff you know a year ago but now you
16:06
know it cost you 5% to hold cash that's
16:09
what you get in a in a one year
16:13
certificate Bond you treasury bond at
16:16
this moment so it's more significant
16:18
maybe it's not that relevant for you but
16:20
Corporation makes a big difference I
16:22
guarantee you right than keeping the
16:23
thing in the checking account now
16:24
they're really buying short-term
16:26
treasuries and stuff like that okay
16:29
um good so so that's the reason this is
16:33
downward sloping um and
16:37
uh and that's the concept here so then
16:40
what the Central Bank controls is money
16:43
how much money it injects in the economy
16:45
that is how much H you know when okay
16:48
how much money it injects into the
16:50
economy how does let me say just that
16:53
for now and so that's like money supply
16:56
so the equilibrium interest rate is
16:58
simply uh the point in which money
17:01
demand is equal to the money exogenous
17:03
money supply and I said in the modern
17:06
world the central banks don't tell you
17:08
Ms they tell you this is the interest
17:10
rate we want and then they provide
17:12
whatever M they need in order to get the
17:15
interest rate they have told you that
17:17
the they want to have okay so that's the
17:20
case of an expansionary monetary policy
17:23
suppose the FED wants to lower the
17:24
interest rate from here to here well
17:26
what it needs to do is increase money
17:30
and increase money means it goes out
17:32
there and open market operation and and
17:36
and the buys bonds from the private
17:38
sector okay buys bonds takes Bonds in
17:42
and gives them Cash Money okay that's an
17:46
expansion in monetary policy an
17:47
expansionary monetary policy will lower
17:50
the interest
17:53
rate that's an open market operation so
17:55
that's what we just saw was exactly that
17:58
the the FED wants to lower the interest
18:00
rate what it does is it goes out there
18:02
it buys bonds from the private sector so
18:04
it's balance sheet on the asset side has
18:06
more bonds now but it has more
18:08
liabilities because it gives cash to
18:10
people and that's the liability of the
18:11
central banks okay so that's that's an
18:14
open market operation that's an
18:15
expansionary open market operation which
18:18
is designed to lower the interest rate
18:22
okay then I talked about the
18:24
relationship between the interest rate
18:25
and the price of the bond okay and
18:28
that's that's a return on a bond no is
18:31
is is the face value of the bond what
18:34
you get in when the bond matures say
18:37
it's 100 it's a B for 100 minus whatever
18:40
you pay divided by whatever you pay so
18:43
say if you pay today $95 for a bond that
18:47
will pay you $100 a year from now that's
18:49
approximately a 5% interest rate no it's
18:52
a little more but but that's about it
18:55
okay H which is also helps in the
18:58
understand a little bit what what what
19:00
happens during an open market operation
19:02
in an open market operation an expansion
19:04
in monetary policy the Central Bank goes
19:06
out there and buys
19:08
bonds what typically happens to a price
19:11
of a good that is a good or an asset
19:13
that is been bought by somebody big that
19:16
has goes up or down now we have a big
19:19
buyer out there that goes and buys Bond
19:20
do you think the price of bonds will go
19:22
up or
19:23
down up no big guy buyer got into the
19:27
market to buy bonds the price of bonds
19:29
go up but if the P price of bonds goes
19:32
up that means the interest rate goes
19:34
down that's an intuitive way of
19:37
understanding how monetary policy lowers
19:38
interest rate it's a big buyer buying
19:41
bonds the price of bonds will go up but
19:43
the interest rate and the price of the
19:44
bond are inversely
19:48
related you you can see that now suppose
19:51
that the initial price of the bond was
19:52
95 and now the price of the bone goes to
19:55
100 the interest rate goes from a little
19:57
more than 5% to
19:59
zero
20:02
good then I we talk about intermediaries
20:05
forget it for
20:09
now so then we got into two lectures
20:11
about the islm about the basic islm
20:14
model and then we did one more on on the
20:16
extended islm model and I told you that
20:19
at least two third of your quiz will be
20:21
about this so and and I I I already know
20:25
what is in the quiz and I guarantee you
20:26
that I honor my my
20:29
commitment okay so so you better
20:31
understand the slm mod very very well
20:35
now understanding the slm mod also me
20:37
understanding the previous two lectures
20:39
because we're building the islm model
20:42
there
20:46
ER so the first thing we did here is
20:49
said well to make this stuff a little
20:50
more interest we already had a model in
20:52
which we could find equilibrium output
20:54
remember that was in in lecture three we
20:58
had that that but we said but but we
21:00
took many things as exogenous there that
21:02
are really not exogenous in practice in
21:04
particular private investment private
21:06
investment certainly something that
21:09
responds to aggregate activity and to
21:11
the cost of borrowing and things of that
21:13
nature so what we did the first thing we
21:15
did here is we we changed the investment
21:18
function for some constant for something
21:20
that was a function of output and the
21:22
interest rate that component here this
21:25
this the fact that was increasing in
21:26
output just increased the multiplier but
21:28
it didn't change anything
21:30
qualitatively in the analysis but the
21:33
fact that it depends on the interest
21:34
rate is important because now we have as
21:38
a parameter in the in in the goods Mar
21:40
in the aggregate demand curve the
21:42
interest rate okay when you solve out
21:45
the whole thing the interest rate is one
21:47
of the things that can move agregate
21:48
demand around and and and that's
21:50
important because now you can begin to
21:52
see the connection between what the
21:53
Central Bank does and how it affects
21:55
aggregate activity because what the
21:57
Central Bank does affect the interest
21:59
rate the Central Bank cannot go out
22:01
there and buy hamburgers as I said it
22:03
can go out there and buy bonds and with
22:05
that it affects the interest rate and
22:08
and for that to matter for the economy
22:10
not only to bond holders it better be
22:12
the case that that interest rate matters
22:14
for the equilibrium level of output and
22:16
it does so by affecting real investment
22:19
okay so that's a mechanism through which
22:21
monetary policy affect real activity is
22:25
through the cost of
22:27
borrowing we simply in in in reality
22:29
consumers are also affected by that by
22:32
interest rate and so on but the but
22:34
let's keep things simple and have only
22:36
investment as a function of the interest
22:38
rate and and very importantly it's a
22:41
decreasing function of the interest rate
22:43
the higher interest rates the lower is
22:45
investment for any given of output
22:46
because it's more costly to borrow to
22:49
fund that investment so that gave us our
22:51
a curve which is a the combinations of
22:55
output and interest rate that are
22:57
consistent with equilibrium in the
22:58
Market that is when output is equal to
23:00
aggregate demand
23:02
okay so I say yes so that point belongs
23:06
to one is for one interest rate here
23:11
okay so how do we construct the is well
23:14
we start moving the interest rate no so
23:18
uh suppose we start from this this is
23:20
one point in the the point I just showed
23:22
you supposing that we now we increase
23:24
the interest rate we look at the new
23:27
equilibrium output well that Al belongs
23:29
to this is okay and you can keep moving
23:31
the interest rate around so you move ZZ
23:33
around only by moving the interest rate
23:34
don't move g t anything else only by
23:37
moving the interest rate and then you
23:39
can trace an is curve okay if you move
23:43
other parameter than the interest rate
23:45
then it's a move it's a shift in the
23:46
curve it's not a movement along the
23:48
curve so if for example if I increase G
23:51
what
23:54
happens with this
23:57
curve the curve shift to the right okay
24:00
because now for any given level of
24:02
interest rate output will be higher
24:05
because aggregate demand moves up and so
24:07
that's a shift to the right of theare
24:11
good that's an example of the opposite
24:13
is an increasing taxes well it will
24:15
shift the yes to the
24:21
left the L relationship is we already
24:23
described it is is no equilibrium in
24:25
financial markets but we said the way
24:28
monetary policies conducted is the Fed
24:31
sets the interest rate and then money is
24:33
whatever the market needs in order for
24:35
that to be the equilibrium interest rate
24:37
so the mod LM if you will is horizontal
24:41
it's like that okay so now we're set
24:43
because once the FED decides to set this
24:45
interest rate we can find not only the
24:48
equilibrium combinations of interest
24:50
rate and output that are consistent with
24:51
equilibrium in the Goods Market but the
24:53
particular equilibrium level of output
24:56
that is consistent with that interest
24:58
rate
24:59
and that's exactly equilibrium out okay
25:01
so given the LM now I looked at
25:05
intersection with my is and that gives
25:07
me equilibrium output for that level of
25:09
the interest rate which has been set by
25:10
the FED
25:14
okay and then you can use this model
25:17
this is a very powerful little model
25:19
because now you can do lots of things
25:20
with it no for example H that's a
25:24
contractionary fiscal policy that's what
25:25
happens when you reduce G or when you
25:28
you increase
25:33
T what happens if you reduce
25:37
G and T by the same
25:44
amount you see what I'm doing and maybe
25:48
if you that that's often done is okay
25:50
you can increase govern expend but then
25:51
you find a source of Revenue or or or
25:53
reduced govern expenditure but
25:56
then you don't need to generate fiscal
25:58
Surplus so on so when I'm saying this is
26:00
a
26:01
Balan Balan budget fiscal policy that's
26:04
what it's called okay what if I move G
26:06
and T by the same amount does that curve
26:14
move
26:16
yeah because the multip next to T is c0
26:20
in the equation original equation so
26:22
c0 C1 okay perfect yeah yeah so in which
26:29
direction does it move so if I reduce
26:32
G and reduce T by the same amount what
26:37
happens to the I moves to the left or to
26:39
the
26:41
right yeah it moves to the left left
26:43
because why is that I can always go back
26:45
to my basic Goods market equilibrium mod
26:48
if I reduce G by one that reduces
26:50
aggregate demand one by one one for one
26:53
and then the multiplier sort of kicks in
26:55
if I REM but the initial change shift
26:58
down is one if I if I reduce
27:03
taxes I increase aggregate demand but by
27:06
C1 times one no and so I had a reduction
27:11
in a demand of one and I had an increas
27:14
in aggre demand of C1 1 minus C1 is
27:18
greater than zero that's the reason you
27:20
have a net a reduction in in agre demand
27:29
hint this is not a random thought I have
27:32
okay so so do understand it okay
27:39
good
27:43
okay that's monetary
27:46
policy ER so um we that's an expansion
27:51
in monetary policy and in equilibrium
27:55
why is spary so cutting interest rate
27:57
course it will increase equilibrium
27:58
output that's a case in
28:01
which the FED probably is unhappy with
28:03
this low level of output maybe it's a
28:04
recession so one of the main policy
28:07
tools we have to fight a recession is to
28:08
lower the interest rate and you can see
28:10
here how lowering the interest rate will
28:12
increase equilibrium output how does it
28:15
happen why is it that this happen why is
28:17
it that equilibrium output
28:22
Rises exactly it's because increasing
28:25
investment that gives us the first kick
28:27
and once equilibrium starts Rising then
28:30
consumption Rises and we get the whole
28:32
the whole multiply but the initial
28:33
impulse is exactly because there
28:36
increase in in in
28:39
investment H how does it Implement that
28:43
open market operation so what the FED
28:44
will do if it wants to cut the interest
28:46
rate it goes out there buys bonds from
28:49
the public and gives him money in
28:52
exchange okay and that's what happens
28:56
here and then I talk about different
28:58
policy mixes no this this is what
29:00
typically when an economy is deep into
29:02
recession you're going to see both
29:05
policies that work at the same time
29:06
that's very powerful that's a case in
29:08
which in
29:10
which you know we have a very we cut we
29:14
have an expansionary monetary policy
29:15
that shift is down and an expansionary
29:17
fiscal policy and uh you know that's
29:20
definitely what we did during covid was
29:22
massive and during the global financial
29:24
crisis so typically big recessions will
29:26
lead to any recession will lead to
29:29
something like that obviously if it is
29:30
Big you're going to have to a bigger
29:32
combination of this kind of
29:35
stuff some problems that that monetary
29:37
policy May face is that you know
29:40
sometimes you hit a Zer lower bound and
29:42
then when you hit a zero lower bound is
29:43
you just can't lower the interest rate
29:45
more you lose monetary policy you need
29:47
to do other stuff and typically fiscal
29:49
policy then becomes very very active
29:52
okay and this is not just a the
29:55
theoretical curiosity I mean we have
29:57
been against zero lower Bound for a
30:00
sustain amount of time during the last
30:02
20 years or
30:06
so oh that's another policy mix as well
30:10
that suppose that you need to do a
30:12
fiscal adjustment I said so you want to
30:15
reduce the deficit reduce G but you
30:18
don't want to have a recession as a
30:20
result of that one way you can do that
30:22
is by you know you have a a contraction
30:25
in G or increase in taxes that's contra
30:27
actionary but you can offset it with an
30:29
expansion in monetary policy I think in
30:32
the quiz somewhere you have a question
30:33
not I don't think there specific to this
30:35
but in which you're asked to compensate
30:37
for something with something and
30:38
something like that okay so some curve
30:41
move and then you are asked to offset
30:44
that effect on output okay so you should
30:47
understand these kind of things The Next
30:49
Step was to extend a little bit our eslm
30:53
model and by extension we said well look
30:57
at this moment we have only a um prices
31:01
are completely fixed but in reality we
31:04
have inflation and so the nominal
31:06
interest rate is not really the
31:08
effective cost of capital for a company
31:09
a company that wants to fund a real
31:11
investment is more concerned with the
31:14
real interest rate is pain not the
31:15
nominal interest rate so with prices
31:17
that are constant There's no distinction
31:19
but if you have positive inflation then
31:21
then then the distinction makes a makes
31:23
a difference that's the reason we wanted
31:25
to talk about that and the second thing
31:27
is that the same firms are are very
31:30
unlikely to pay the same that the
31:32
treasury pays for borrowing pay it's a
31:35
risky proposition to invest in bonds
31:37
issued by a corporation and therefore
31:39
they're going to have to pay a risk
31:40
premium for that okay and so the
31:43
importance of these two things is that
31:47
ER we ended
31:49
up with an islm M that have now had
31:53
something a little more complicated here
31:55
because it didn't have only the nominal
31:57
interest rate but also had expected
31:59
inflation if for any given nominal
32:02
interest rate if if uh we expect a
32:06
higher inflation that means a lower real
32:07
interest rate okay so so for any given
32:12
nominal interest rate if expected
32:13
inflation goes up that's expansionary
32:15
really for firms okay it's like it's
32:17
cheaper in a sense to borrow okay
32:20
conversely if x goes up the great spread
32:23
goes up that's contractionary because
32:25
it's now more expensive for the firms to
32:27
borrow for any given real interest rate
32:32
okay so we can we can this is called
32:38
extended islm model simply because it
32:41
has been extended to incorporate this
32:43
these add additional factors and now you
32:47
have two more parameters in your in your
32:49
model which is expected inflation and
32:51
the credit spreads okay so if you move
32:55
either of
32:56
these you're going to going to move your
32:58
aggregate demand curve in the Goods
33:00
Market no and it's going to move for
33:03
exactly the same reasons that that
33:05
aggregate demand move when you move the
33:07
interest rate it enters symmetrically in
33:10
this model these guys here enter
33:12
completely symmetrically with then the
33:14
interest rate so whatever was the
33:17
comparative Statics you had with respect
33:18
to the nominal interest rate before they
33:21
appli to x minus
33:25
Pi what I'm trying to say is
33:28
if I if you know how what is the change
33:31
in equilibrium output as a response as a
33:34
result of an increase in 100 basis
33:35
points on the nominal interest rate then
33:38
you know what is a response of
33:39
equilibrium output to an increasing
33:41
credit spreads of 100 basis points or to
33:44
a reduction or or to a reduction in
33:46
expected inflation of 100 basis points
33:49
the entire
33:50
symmetric okay because that's a that's a
33:53
channel is the it's the real it's a cost
33:55
of capital Channel you know for the firm
33:59
that's they're all entering exactly
34:01
through the same the same place but the
34:03
but the the FED doesn't control this guy
34:06
it controls only the nominal interest
34:07
rate okay so anyways so these are new
34:11
parameters here so this is an example
34:14
here that's an example in which credit
34:17
spreads or respected inflation went
34:20
up sorry whether CR spreads went down or
34:25
expected inflation went up up okay and
34:29
that's expansionary that will increase
34:31
aggregate demand because for any given
34:33
level of output now there will be more
34:36
investment okay cre spreads are lower or
34:40
expected inflation is higher mean the
34:42
real interest rate is lower for any
34:43
given nominal interest rate so if the if
34:46
if the FED doesn't react to that that's
34:48
going to lead to an expansion in
34:52
output of course the FED could react to
34:55
that suppose the FED is okay with the
34:57
level of output we
34:59
have okay suppose it's a level of output
35:02
and the F seeing credit spreads falling
35:05
so output is expanding but the FED says
35:07
no no no the level of output y z was
35:09
what I needed I don't want y1 what would
35:12
the FED
35:13
do increase the interest rate exactly
35:17
and it's very easy to see in this
35:18
expression here that that if you don't
35:21
want this guy the total sum to move then
35:23
if this guy moves down or or this guy
35:26
moves up then I need to move I exactly
35:30
to offset that and that's it it's very
35:32
easy to calculate I don't need to solve
35:33
my whole model actually you know you
35:35
tell me this thing in net went down by
35:37
100 basis points if I don't want to
35:39
change output then I need to increase
35:41
the interest rate by 100 basis points so
35:42
I don't change the cost of borrowing the
35:45
effective cost of borrowing for
35:46
corporations
35:49
okay in fact this is exactly what is
35:51
going on right now in the US economy you
35:55
know every time markets get very excited
35:57
credit specs are compressed the stock
35:59
market goes up the FED comes out and say
36:01
come on guys I mean we have inflation
36:03
problem I'm going to need to keep hiking
36:05
interest rates
36:07
because I need to offset Your
36:10
Enthusiasm they don't use those words
36:12
but that's exactly what happened I mean
36:14
chairman pow was testifying in Congress
36:16
yesterday and today and that's what he
36:18
said I me just giving you a summary of
36:21
what he said okay
36:29
now a problem that the Central Bank May
36:30
face suppose you have the opposite
36:32
situation is that one in which credit
36:34
spreads are going up a lot and expected
36:36
inflation is declining a lot and the FED
36:39
doesn't want output to the client
36:40
because that combination will lead to
36:42
reduction in output so the FED wants to
36:44
cut interest rate what problem may it
36:49
face it's zero lower bound it may not be
36:52
able to bring interest rate as much as
36:54
because suppose that the the interest
36:56
rate today is is a is a 50 basis point
37:00
it's not the case today but it was two
37:02
years ago 50 basis point 25 basis points
37:06
and cre spreads go up by 200 basis
37:09
points well there's no way the FED can
37:11
upset that no because he has maximum 25
37:14
basis points to lower and cre the spread
37:17
went up by 100 basis points and that's
37:18
when you start seeing all these more
37:20
exotic policies quantitive eing and
37:22
other things to offset the negative
37:25
impact of the of the increase in the
37:26
greater spreads in the
37:29
economy and the last thing we we did was
37:31
to begin a
37:34
a our transitions to medium run issues
37:39
and and the whole thing began from the
37:41
labor market now you're going to get a
37:43
little bit in the quiz of that but it's
37:44
not going to be as important as what I
37:46
just described but a little bit you're
37:47
going to
37:48
have and the basic uh well definitions
37:52
you should should know the basic
37:55
definitions well this was the first a a
37:58
important equation we have a a wage
38:00
setting equation that says essentially
38:02
that wages are increasing in expected
38:05
prices obviously the nominal wage the
38:06
workers are going to demand is going to
38:08
be higher if they expect the price level
38:10
to be higher in the future but important
38:13
is decreasing in unemployment and
38:15
increasing in this in this variable that
38:17
represents sort of their bargaining
38:19
power and so on H then we look at what
38:23
happened on the on the product on the
38:24
price setting side meaning what firms do
38:27
and for that we had to start with the
38:28
production function we had a very simple
38:30
production function which said if you
38:32
want to produce one more unit of the
38:33
good you need to have one more worker
38:36
that means that the marginal cost of
38:37
production is the wage so it's very
38:39
simple and then we said we're going to
38:41
have a very simple model in which the
38:43
the firms charge their marginal cost
38:46
which is the wage times a marup 1 plus M
38:48
so m is a number like say2 okay so if
38:52
the wage is 100 the markup is 20% they
38:54
want the price of they're want to charge
38:57
a price of 120 we can rearrange this in
39:00
terms of wages and you can say well the
39:03
firm the maximum real wage that firms
39:05
collectively are willing to pay is
39:07
really one over one plus the market okay
39:10
that's just from that so then we look at
39:15
a concept that that is important which
39:16
is the natural rate of unemployment and
39:18
we said the natural rate of unemployment
39:20
has nothing of natural it just means
39:24
that is the level of unemployment when
39:26
the price is equal to expected price or
39:29
expected price equal to the price you
39:30
pick okay so all that we did was to
39:34
replacing the weight setting equation
39:35
the expected price for the actual price
39:37
and then we divided both sides and now
39:40
we have this real wage Demand by by
39:42
workers when the price is equal to
39:44
expected price and we also had a price
39:46
set in equation we can and I said when
39:49
we replace P for p then I get the right
39:53
to put an n superscript n there that's
39:56
the natural rate of unemployment because
39:57
that's my definition of the natural rate
39:58
ofemployment what happens when I can
40:01
replace in the weight setting equation H
40:03
the the expected price for the price and
40:07
we look at the at the natural rate of
40:08
unemployment what is equilibrium here of
40:10
the price setting equation has an imply
40:13
real wage of 1 over 1 plus M and that's
40:16
a wage setting equation which is
40:18
obviously decreasing unemployment
40:20
because the higher is unemployment the
40:21
lower the wage Demand by the workers
40:23
okay and that's one natural rate of
40:25
unemployment again nothing natural is a
40:27
function of parameters which parameters
40:30
well it's a function of that markup
40:31
parameter it's a function of this
40:33
institutional variable Z for example
40:36
okay so that's in equations that's an
40:40
example in
40:41
which Z goes up so suppose that somehow
40:45
you know unions go up or something like
40:47
unionization goes up something of that
40:49
kind or an employment benefits go up
40:52
something of that kind which in in
40:54
principle is supportive of workers well
40:56
in this model
40:58
that will immediately lead to an
40:59
increasing wage demand for at this level
41:02
of unemployment there going to be a a
41:04
higher
41:05
demand higher real wage Demand by the
41:08
workers because they have more
41:09
bargaining power now in this particular
41:12
model that that cannot happen because
41:15
the real wage that firms can are willing
41:17
to pay is only this one one plus M so in
41:20
order to restore equilibrium in the in
41:22
the labor market what has to happen is
41:24
unemployment natural rate of
41:26
unemployment will go up
41:27
and and that that will restore
41:29
equilibrium here because well workers
41:31
the the the bargaining power workers
41:33
gain through those benefits in Z they
41:36
end up losing by an increas in the
41:39
equilibrium level of unemployment okay
41:41
so that's the
41:42
reason hear this stuff backfiring as to
41:45
the workers because you know you end up
41:47
with higher natural rate of unemployment
41:49
so Europe for example has much higher
41:51
labor protection than the US well they
41:53
typically have a much higher
41:55
unemployment rate than the US okay so
41:57
that tradeoffs all these
41:59
things that's a case of increaseing the
42:02
markup and increasing the markup means
42:04
effectively that the firms are going
42:07
offering a lower real wage well at this
42:10
level of unemployment workers are not
42:11
going to take that lower real wage so
42:14
what will have to happen for workers to
42:15
take that low lower real wage is for
42:18
unemployment to rise okay so those are
42:20
the two canonical experiments you can
42:21
have here it's what happens when markets
42:23
go up and that can go they can go up for
42:26
for the wrong reason it could be for oil
42:30
shocks and stuff like that it could be
42:31
because the market becomes less
42:33
competitive allistic firms and so on but
42:36
the final outcome here is that we end up
42:38
with a higher natural rate of
42:39
unemployment which again highlights the
42:42
idea that this is not a g given
42:43
unemployment rate so it's not it's not
42:46
good in any sense it's it's just
42:47
whatever it is the
42:51
equilibri okay uh anyway so you should
42:54
understand well what these two type of
42:56
shocks do to the natur rate of
42:59
unemployment I think that's because then
43:02
lecture nine is not for this this
43:06
quiz that's all I want to say any any
43:13
questions
43:21
no
43:25
y this I think so I think is that the
43:28
same a as next to the yeah this is the
43:33
C you you want me to explain this this
43:37
this yeah yeah it is a CR spread I said
43:41
that's the way you calculate this CR
43:42
spread here it's um remember there are
43:45
two reasons why why
43:51
um do you really want to
43:54
know in anyway let me let me say so
43:59
there are two reasons why the credit
44:00
Express really happen one is the actual
44:03
probability of the fault of a bond which
44:06
the treasury has a very low priority def
44:08
fall corporations depending on the
44:09
ratings they may have higher or lower
44:11
and the other one which is very
44:13
significant is how risk averse investors
44:15
are and that risk aversion changes a lot
44:18
over the business cycle H we capture
44:21
everything through just that X spread
44:23
which we we capture it through this
44:25
probability of theault but you can think
44:27
that prity of the fault as being the
44:28
perceived priority of the fault and when
44:30
you're very scared you perceive that
44:31
terrible things can happen so so it's a
44:34
subjective priority of the
44:36
fault so when that priority of the fault
44:39
is different from zero then you start
44:40
getting a positive
44:42
spread how impactful is the actual def I
44:45
know there were some recent defaults in
44:48
at least the European like real estate
44:50
markets yeah um like how I guess is
44:53
there a difference between like a fear
44:55
of a default and like an actual
44:57
implications as oh this is all about
45:00
perceived risk so it's because this is
45:02
this determines the the borrowing that
45:05
firms can do the cost for firms of
45:06
borrowing if you already defaulted you
45:09
cannot borrow so that's that's over that
45:11
that has other consequences it may have
45:12
impact on the balance sheet of the banks
45:14
it's destruction of wealth it may lead
45:17
to other problems but the problem we're
45:19
highlighting here in this model is the
45:20
cost of borrowing and that is something
45:22
that happens only before you default
45:28
yeah I mean actual defaults especially
45:32
typically in developers and stuff like
45:33
that can and that's what happen in the
45:35
Great Recession ER can have consequences
45:39
especially for the
45:40
banks that typically lend to this
45:42
developers and so on but I I may do
45:45
something about financial crisis but
45:47
much later in the course at the end okay
45:51
well good luck enjoy it if you
45:52
understood what I said today you're
45:55
you're in good shape for
— end of transcript —
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