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