[00:16] um so we started with the something a
[00:20] little boring basic definitions and the
[00:22] first thing we had to do is to
[00:25] understand how do we measure output at
[00:26] the aggregate level it's very easy to
[00:28] understand what output is at the level
[00:29] of an Factory but but at the AG level is
[00:32] a little tricky and so we had an example
[00:36] of a very simple economy with two
[00:38] companies one that produces steel and
[00:41] the other one that produces cars and in
[00:44] this particular example the steel
[00:46] company doesn't sell anything to the
[00:47] final consumers it sells all its
[00:50] production to the car company and we ask
[00:52] a question where is the GDP of this
[00:54] economy H the simplest answer would have
[00:58] been well 300 no I some what the the the
[01:01] output of the two companies and that
[01:03] could be one answer but then I show you
[01:06] through three different methods that
[01:08] that's the wrong answer and um method
[01:12] one H was h a definition is um GDP is
[01:18] the value of final goods only okay and
[01:22] final goods in this simple example is
[01:25] well this company is not producing
[01:26] anything as a final good because all its
[01:29] sales are going to as an input into
[01:31] other companies production and so this
[01:34] one doesn't count at all in our simple
[01:36] example this one counts and then the
[01:38] answer is $200 okay not 3300 but
[01:42] $200 method two was to count only the
[01:46] value added in each company and value
[01:48] added is the difference between the
[01:50] final
[01:51] output that is the revenue from sales
[01:55] minus whatever that company spends on
[01:57] intermediate inputs in this simple
[02:00] example this company the steel company
[02:02] is not spending anything on intermediate
[02:04] inputs it's a strange production of a
[02:05] steel but anyways it is what it is in
[02:07] example and so this is entire this $100
[02:11] is is value added completely value added
[02:13] there's no expenses on intermediate
[02:15] inputs for the car company however the
[02:18] revenue from C is 200 but the company
[02:20] spends 100 on intermediate input
[02:23] therefore the value out of this company
[02:25] is 200 minus 100 so you get 100 value
[02:27] out from this one 100 value out from
[02:29] that one total value added 200 so same
[02:33] answer and the third method these are
[02:35] the two method that I just described are
[02:37] production methods no you're measuring
[02:39] the production side the alternative is
[02:42] to look at the income side okay and the
[02:45] income side let's says just let's sum
[02:47] all the incomes in the economy and the
[02:49] incomes are income to workers wages and
[02:52] income to the owners of capital
[02:54] profits ER income to way to workers is
[02:58] $80 plus 70 is 100 50 income to owners
[03:02] of capital is 20 + 30 that's 50 so 150
[03:05] plus 50 is again 200 okay so these are
[03:08] three equivalent ways of er er measuring
[03:11] output and I said
[03:15] ER you know and one of the features I I
[03:18] I I show you of of of of this method is
[03:21] that they are immune to organizational
[03:25] structure within the economy so for
[03:26] example if these two companies were to
[03:28] merge no clearly the sum of incomes
[03:31] would not change would still be 100 it
[03:34] would be
[03:36] 200 ER this one would not change because
[03:39] if they were to merge then the whole
[03:41] production of the revenues from sales of
[03:43] the car company would be value added
[03:46] everything would be produced in house
[03:48] and still the answer would be 200 then
[03:50] no because this company would disappear
[03:51] it would emerge inside here and you
[03:53] would get still get 200 and the same
[03:56] happen with h method one because still
[04:00] the sales of final goods is only
[04:03] 200 the naive approach of just summing
[04:06] output you know would be terrible
[04:09] because once you merge it output would
[04:11] collapse from 300 to 200 that tells you
[04:13] that's not the right way of doing things
[04:16] okay so while the three methods we
[04:18] propose do H work are immune to to this
[04:22] organiz changes in organization
[04:24] structure The Next Step was to H
[04:28] highlight that when we say out output
[04:30] we're really after real output and
[04:32] there's a distinction between nominal
[04:34] output and real output nominal output is
[04:37] simply the quantity of final goods
[04:39] measured at current prices while real
[04:43] output is measured at some fixed set of
[04:46] prices okay of one fixed year and I
[04:49] think I gave you an
[04:50] example this is example I gave you and
[04:52] then in the in the in the pets you had
[04:54] more complicated examples with multiple
[04:56] Goods here you have an economy that
[04:58] produces only one good
[05:00] cars and that PES 10 cars here 12 cars
[05:03] here 13 cars here the price of the cars
[05:06] is rising so the nominal GDP is rising a
[05:09] lot while the real GDP is rising less
[05:12] how do we measure real GDP here we use
[05:14] to to 12 in this particular example we
[05:16] use the prices here 12 10 times the
[05:19] price of the car in 2012 is 24,000
[05:22] that's
[05:23] 240 obviously for the base year nominal
[05:27] GDP is the same as real GDP and then 12
[05:30] 13 is 13 not time 26,000 but times
[05:33] 24,000 and we get that now in this
[05:36] particular example of only one e one
[05:38] good ER you can pick any any base year
[05:42] and you'll get exactly the same rate of
[05:43] growth of real output if you have
[05:45] multiple Goods that's not true because
[05:47] the relative prices of goods are moving
[05:49] over time okay but uh but that's the
[05:52] basic idea so I mean again you should
[05:55] know these things they're not going to
[05:57] be tremendously important in the quiz
[05:59] but they will show up in your quiz
[06:01] [Music]
[06:04] okay and then we went some some
[06:06] definitions the unemployment rate know
[06:09] being the number of unemployed over the
[06:11] labor force not population that's
[06:14] important H we talked about inflation
[06:18] rate as well that's the rate of change
[06:21] of prices and there are different prices
[06:22] in the economy one of them is the
[06:24] deflator the other one is CPI and so on
[06:26] so forth that's it so that was the first
[06:30] uh lecture relevant for the quiz any
[06:32] question about
[06:35] that good keep
[06:39] moving okay then we move to when then we
[06:41] began to really get serious because we
[06:43] began to construct sort of a foundation
[06:46] for the islm model okay and the first
[06:49] thing we did is we look at the Goods
[06:52] Market
[06:55] uh no and and what we did here is just
[06:59] was say we describ the different
[07:00] components of of aggregate demand and we
[07:03] said in this econ for for now at least
[07:06] we're going to make this economy close
[07:08] so we we remove exports and imports and
[07:10] for your quiz absolutely you not going
[07:12] to see anything about exports or Imports
[07:15] okay so this is your aggregate demand ER
[07:18] we wanted to build a little more so we
[07:20] had to have some behavioral assumptions
[07:23] H we made it initially very simple we
[07:25] assumed this was
[07:26] exogenous the Govern expension was
[07:28] exogenous taxes were also exogenous t h
[07:32] and the only behavioral equation we had
[07:35] was this consumption function we said
[07:36] consumption is increasing disposable
[07:38] income okay so and we we assume
[07:42] something linear like this disposable
[07:44] income is just income minus taxes and
[07:47] remember income remember from the from
[07:50] the alternative ways of measuring GDP
[07:52] income is the same as output no so when
[07:55] I say income because as is relevant for
[07:57] the consump consumer well but it's the
[07:59] same as output so that's was our
[08:03] consumption function it had an upward
[08:05] slope it was upward sloping because
[08:07] there's a marginal propensity to consume
[08:10] C1 H and then then a key Assumption of
[08:14] this part of the course is that that H
[08:17] output is aggregate demand determined
[08:19] prices were completely fixed H and and
[08:22] we said well but you know output is
[08:24] whatever demand wants that's what output
[08:26] is so this is an equilibrium condition
[08:30] okay this is the aggregate demand this
[08:33] is an equilibrium condition so we can
[08:35] solve out because I can say in
[08:37] equilibrium Z is equal to Y and I can
[08:40] solve for equilibrium output from that
[08:41] equation okay and that's exactly what we
[08:43] did in this slide and you got to an
[08:46] expression like this knowing how to do
[08:48] that is very important for you okay so
[08:51] you you better be sure that you know how
[08:52] to find equilibrium output in in in this
[08:56] model I mean it's going to be very
[08:58] difficult to do I M if you don't know
[09:00] these steps so so you better know this
[09:03] stuff H and remember something we call
[09:06] this guy here in the simple economy the
[09:08] multiplier why the multiplier well
[09:11] because given certain sort of something
[09:13] we call exogenous expenditure the 1
[09:16] minus C1 multiplies that if the marginal
[09:20] to consume is very high say it's close
[09:23] to one then the multipli is very very
[09:25] high if the marginal Pro to consume say
[09:28] is 05 then how much is the
[09:33] multiplier two okay good so the
[09:36] multiplier is two okay good and that was
[09:40] our equilibrium now we had the aggregate
[09:42] demand the slope was less than the 45
[09:44] degree line because C1 is a number less
[09:46] than one and so you have some
[09:48] equilibrium output there that's
[09:50] equilibrium output at this point
[09:52] aggregate demand is equal to well agre
[09:55] demand is equal to agre supply that's
[09:57] that's always true uh but that's
[09:59] 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