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52:15
Transcript
0:17
all right let's uh let's start um so
0:23
today I want to talk about uh interest
0:26
rates uh you know if you have followed
0:29
the news there's a lot of debate on
0:31
these days on on on where will the
0:35
interest rate in the US end at the end
0:37
of this Titan tiing tightening
0:40
cycle
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0:46
uh and um so I'll show you there has
0:50
been a very aggressive monetary policy
0:52
trying to fight the inflationary episode
0:54
we're going through uh and that's done
0:57
through interest rates and and the
1:00
question that I want to address today is
1:03
H well how is it that the interest rate
1:05
is determined so when a central bank
1:07
decides to hike interest rates how do
1:11
they do that okay and obviously this is
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1:13
about financial markets interest rate
1:15
are set in financial markets and
1:17
financial markets are very very
1:19
complicated so we're going to keep it
1:21
very very simple we're want to make
1:23
introduce more complexity later on in
1:25
the course but still we're going to keep
1:26
it pretty simple because our main
1:28
objective in studying Financial Market
1:31
is really a a to to re to achieve some
1:35
sort of understanding of how the
1:38
interest rate policy that the Central
1:39
Bank H controls is is
1:43
determined so before
1:46
[Music]
1:48
I I get into specifics so let's let's
1:51
see some trivia here who knows who that
1:54
person is
1:56
okay you
2:00
Geron Powell exactly and who's Jeron
2:04
Powell the chair of the Federal Reserve
2:08
uh system in the US which is the Central
2:11
Bank of the US okay so that's that was
2:13
an easy one and and every you know if
2:17
you are into financial markets everyone
2:19
is worried about what this guy is
2:20
thinking and his friends are thinking at
2:22
this moment because they determine the
2:24
interest rate how do they do that well
2:26
that's what we're going to talk about
2:28
later on a little speaker who is
2:34
this no no that's that's
2:38
cheating katsu WEA he is the next ER
2:43
president of the bank of Japan the
2:45
Central Bank of Japan and an interesting
2:49
there are many interesting things of him
2:50
but about him but he's a he's a graduate
2:52
from our program the PHD
2:54
program which actually is an incredibly
2:58
successful program at producing major
3:00
Central Bankers Ben Bernan is our Alum
3:04
Alum that he was
3:06
the the chairman of the Central Bank the
3:09
chair of the Central Bank of the FED
3:11
during the financial crisis Mario dragi
3:14
is a one of our graduates Mario dragi
3:17
was the the most successful ER Central
3:21
Banker in Europe he was the president of
3:24
the ECB European Central Bank for many
3:27
years and in particular during the
3:29
Global Financial crisis and the European
3:32
crisis which followed the global
3:33
financial
3:34
crisis uh I mean but you name it Stan
3:38
Fisher in the past of the Bank of Israel
3:41
and nowadays feel low of the the chair
3:43
of the Reserve Bank of Australia in
3:47
Chile we have had two or three er
3:50
presents and so on so if you if this is
3:52
your career this is a good program you
3:53
should join our program you may end up
3:56
in a in a good place but that's the the
3:58
next one for Japan
4:00
and and Japan is a very interesting
4:02
place from the point of view of monetary
4:04
policy precisely because they they
4:06
haven't had much space to do
4:08
conventional monetary policy so they
4:10
have had to do lots of unconventional
4:12
things from the point of view of what a
4:14
central bank typically does but today
4:17
we're going to study conventional things
4:18
and we'll talk a little bit more about
4:20
unconventional things later in the
4:22
course now some institutional knowledge
4:25
this is the the again in the US the
4:28
Central Bank of the US is called called
4:29
the Federal Reserve System and it's a
4:31
system really H it's a he has a um in um
4:36
the Board of Governors which sits in
4:39
Washington
4:40
DC um and and there are seven Governors
4:43
and the governors are are are nominated
4:46
by the president and and then confirmed
4:48
by by the Senate and the president of
4:51
that board is is H is so the president
4:56
of the FED of the FED will be one of
4:59
those members okay now on in addition to
5:03
that the the US has a Federal Reserve
5:05
Bank system there are seven there are 12
5:08
Regional Banks uh there's one in Boston
5:11
in fact if you look at the skyline near
5:13
the Waterfront there's a building built
5:15
out of recycled aluminum well that's the
5:19
Reserve Bank of Boston and uh and uh and
5:23
of those 12 Regional Banks they
5:27
rotate so so policy the interested is
5:30
set into in a committee which is called
5:32
the fomc Federal Open Market Committee
5:35
um and and the member of that the voting
5:38
members of that committee are the the
5:41
seven Governors plus h four out of the
5:45
12 and they rotate most of them rotate
5:48
the the only one I think does not rotate
5:50
is the is the is the president of the of
5:53
the New York fed because they're so
5:56
important because that's a financial
5:58
heart of the US
6:00
that you certainly want that H ER
6:04
president to be involved in in interest
6:06
rate decisions and it's really the FED
6:09
that is in charge of communication with
6:11
financial Market which is a huge thing
6:12
for the FED okay they are in New York
6:16
and they're crucial for that okay so
6:18
that's that's that's those are the
6:20
people that and in most places around
6:23
the world you're going to have at least
6:26
something equivalent to the the seven
6:28
governors out there okay most places
6:31
obviously the ECB is different because
6:33
it's multiple countries so each country
6:35
sends one member
6:38
no but but but
6:41
otherwise um it tends to be like like
6:44
the US without the the the regional
6:48
Banks so why do we care about monetary
6:51
policy well because I think it's one of
6:53
the main policy tools you have in the
6:54
short run remember in this part of the
6:56
course we're trying to understand output
6:58
in the short ter and one of the main
7:01
policy levels I mean how can you affect
7:03
output is monetary policy which one is
7:06
the other
7:08
one there are two major ones fiscal
7:12
policy exactly and fiscal policy we did
7:14
look at in the previous lecture remember
7:16
we said an expansionary fiscal policies
7:18
an increase in G or a decline in t would
7:20
lead to an expansion in a great demand
7:22
equilibrium output would go out up okay
7:25
so fiscal policy is something you always
7:27
use in in in deep recessions
7:30
uh but monetary policy is much more
7:32
Nimble is I mean it's a it's a bunch of
7:35
people that need to meet and just change
7:36
the interest rate anything that is
7:38
fiscal there are some automatic
7:40
stabilizers by the way so automatically
7:42
fiscal policy becomes more expansionary
7:44
during recessions and stuff like that
7:46
but any deviation from the typical
7:48
automatic stabilizers require Congress
7:50
to approve things it's a long process
7:53
and so it's not something that can react
7:55
as quickly as monetary policy can okay
7:59
um so that's what we're going to look
8:01
that's that's that's that's the reason
8:03
why monetary policy is important for us
8:04
at this point then there are medium and
8:07
long run issues fiscal policies still
8:10
affects equilibrium output in the medium
8:12
and long run monetary policies much less
8:14
effective at that it's very difficult to
8:17
to change sort of equilibrium growth or
8:19
things like that with monetary policy
8:21
it's going to be pretty minor most of
8:23
the impact of monetary policy in the
8:25
minum and long run is really on the
8:27
price level and inflation more than on
8:29
real activity okay but in the short run
8:31
it's very powerful for reasons that
8:33
we're going to discuss in this and the
8:35
next
8:40
lecture okay so as I said well monetary
8:44
policy acts through financial markets I
8:46
I think it's a very
8:48
interesting part of my research agenda
8:50
is about that is I think is the central
8:52
bank is a very strange institution
8:54
because most of its mandate are in terms
8:57
of what happens in the Goods Market says
9:00
you know you don't try not to get into
9:02
recession try to get us out of a
9:04
recession and so on but unlike fiscal
9:06
policy which has tools that are directly
9:08
aim at the Goods Market remember it's a
9:11
it's a purchases by the government of
9:12
goods so if there isn't sufficient
9:14
demand for goods the fiscal policy the
9:17
fiscal Authority can go out there and
9:18
buy Goods that creates more demand the
9:21
the central bank is given the same
9:23
mandate aside from Price stability and
9:26
things like that we're want to worry
9:27
about later but it doesn't have any
9:29
tools the the the central bank if
9:31
there's insufficient demand the Central
9:33
Bank cannot go out there and buy
9:34
hamburgers right that's fiscal policy
9:36
can do that and expand the demand for
9:38
hamburgers but not monetary policy what
9:41
monetary policy can do is by bonds by
9:45
instruments in the financial markets and
9:47
through that affects real activity so
9:49
the is it's the fastest policy tool but
9:53
it's the most indirect in a sense
9:55
because it it it has to go through
9:57
financial market and and and and that CH
10:00
those channels can be very complex but
10:02
obviously we're not in the business of
10:05
complicating things in this course so
10:06
we're going to make it very very simple
10:09
we're going to assume that financial
10:11
markets only have two instruments
10:14
obviously the huge simplification there
10:16
are millions of financial instruments
10:17
out there but we're going to isolate two
10:20
instruments because this happens to be
10:22
the instrument
10:23
where that that that where the central
10:27
banks typically participate
10:30
they affect all asset prices around but
10:33
the direct interventions typically
10:36
recently has been a little different but
10:37
typically it's only in this kind of
10:41
instruments and so we're going to focus
10:43
all of our analysis on on those two
10:44
instruments for now later on we're going
10:46
to talk about equity and stuff like that
10:49
but but just to isolate the the the how
10:52
monetary policy works is sufficient to
10:55
just focus on two financial instruments
10:57
so we're going to assume that people
10:58
have their wealth in only two forms in
11:02
two Financial assets one we're going to
11:04
call it
11:06
money and the other one we want to call
11:08
it bonds okay
11:11
money the characteristic of money what
11:13
we call money there are many definitions
11:15
of money M1 M2 M3 M4 but let's keep it
11:18
very simple money essentially means
11:21
something that you can use very easily
11:23
for
11:24
transactions okay so for example the the
11:29
most important example of money not the
11:32
largest but the most important one is
11:34
Cash currency okay you can buy anything
11:38
with cash there no problem whatsoever
11:43
now the the the a characteristic that
11:45
money typically does not have is that it
11:48
doesn't give you any
11:49
return you don't invest in cash you know
11:53
you have cash because you need to do
11:55
transactions but it's not the way you
11:57
get a return and so money that's what
12:00
it's going to mean for us is something
12:02
that is used in transactions but it pays
12:04
no interest rate no interest there no
12:07
interest on that a bond is going to be
12:10
the polar opposite it's going to be
12:12
something that pays a positive interest
12:14
rate so if you buy a bone for 100 for 95
12:18
you're going to get a 100 a year from
12:19
now say so you get something out of that
12:21
bone but it's not very useful for
12:23
transactions I mean you cannot go and
12:26
buy your lunch with a bond you get the
12:28
piece of B for that and and and many
12:30
things cannot be even even within
12:32
financial markets you cannot buy asset
12:34
with asset you have to go through some
12:36
process in which you come sell something
12:39
get cash and and with cash you pay for
12:41
the other stuff not necessarily cash it
12:43
could be other forms of money but but
12:46
but typically Financial instrument need
12:48
to be sold before you can buy something
12:50
else you don't swap them it's not a part
12:53
them okay but this is what it means for
12:55
us so this whenever you see something
12:59
like this is always interesting for an
13:01
economist
13:06
why and any economies micro economies or
13:10
whatever what what have I done
13:14
there that makes economics is about
13:16
decisions and then it's about
13:18
equilibrium okay it's decisions and
13:22
equilibrium there's a decision to be
13:24
made here there's a tradeoff okay I I
13:27
you know if I need to do lots of
13:29
transactions I better sort of bias my
13:31
portfolio towards cash towards money if
13:35
if I don't need to do lots of
13:35
transaction then I and the interest rate
13:38
is very high particularly then I this is
13:39
an issue today today interest rates are
13:42
very high nobody care about bonds or
13:44
anything you know two years ago when
13:47
interest rate was Zero but today
13:49
interest rate is 5% so it's an issue
13:51
you're not going to if you want to keep
13:52
it in cash you're going to give up a lot
13:54
of return okay so it's a decision to be
13:56
made there a portfolio decision and
13:58
that's always interesting for
14:00
economies so let's talk about uh that
14:05
decision and we're going to talk you can
14:07
describe this decision either from the
14:09
side of bonds or from the side of money
14:11
we're going to describe from the side of
14:12
money because there's a total amount of
14:14
wealth and you have to decide what to
14:16
allocate it to so you know it suffices
14:20
if I tell you there a total amount of
14:21
wealth and if I tell you how to how much
14:24
you allocate to money then I'm telling
14:26
you implicitly how much you are
14:27
allocating to bonds it's a compliment to
14:29
that okay so I can do analysis either
14:31
way but I'm going to do it through money
14:33
which is the way is normally done so
14:36
money demand if I plot it in the space
14:38
of
14:39
M money and the interest rate is a
14:43
downward sloping
14:45
curve why is it a downward sloping
14:51
curve the interest rate is higher it
14:54
pays off more to have B your utility
14:56
should exactly your decision if the
14:59
interest rate is very high is to go more
15:01
towards bone the interest is very low I
15:03
don't care too much about bones I'd
15:04
rather keep the thing that helps me
15:06
transact which is money okay and it's
15:09
interesting because for most of your
15:12
adult life you have Liv in a world in
15:14
which that not was not a very
15:16
interesting decision actually no because
15:18
interest were very close to zero now
15:21
you're living in a different environment
15:22
interest Are For the First Time sort of
15:25
high for you there may a bigger decision
15:28
between invest in equity say and cash
15:30
but bonds and and and and these are safe
15:34
bonds by the way your treasures and
15:36
things like that and money is not
15:37
something you have to worry
15:40
about okay good what I'm saying is
15:43
interest is where around here so you
15:45
we're all in cash one way or the other
15:47
and now interest are a lot High the
15:50
other thing that so that's a movement
15:52
along the curve no I'm plotting
15:53
something in the space of interest rate
15:56
money and interest rate then when I tell
15:58
you
15:59
what happens when the inter Rises I'm
16:01
asking you for a a a movement along the
16:04
curve okay I see so if I raise interest
16:07
rate I move along the curve up so the
16:11
second thing that we have there is
16:12
argument we have is something that shift
16:14
the curve because it's not part of my
16:16
Axis so so it will shift the curve it's
16:18
a parameter for each of these curves and
16:20
that's nominal income so in particular
16:24
if nominal income goes
16:26
up I'm showing you there that money
16:29
demand goes out meaning for any given
16:31
level of interest rate you're going to
16:32
demand more
16:33
money why do you think that's the case
16:37
and again I'm looking here at the
16:38
aggregate but but it applies to an
16:41
individual as
16:44
well so for the same level of wealth now
16:49
nominal GDP is
16:51
higher remember that nominal GDP is the
16:54
same as nominal expenditure here okay so
16:58
if GDP is higher then that means there's
17:00
going to be more transactions because
17:02
there's going to be more
17:03
expenditure okay and therefore you need
17:07
more of the thing that is use useful for
17:09
transactions okay M demand goes up the
17:12
second point to highlight is that you
17:14
know while in most places I we use why
17:17
here I'm using dollar y nominal y why do
17:20
you think that's that why why don't I
17:22
just put there real GDP rather than
17:24
nominal GDP
17:30
is the
17:34
typo let's go in
17:37
steps suppose that prices are totally
17:40
fixed and real GDP goes
17:43
up that means that this economy needs
17:46
more transactions because it's going to
17:47
be more expenditure there okay so that
17:51
that explains that yeah when real output
17:53
goes up then money demand goes up when I
17:56
say money demand goes up I said for any
17:57
given interest rate we have more money
18:00
demand okay now fix real output and I
18:04
tell you suppose that the price of goods
18:08
doubles do you think you need more money
18:10
to transact of course because it's the
18:14
same it's equivalent now money is
18:17
dollars I have $10 and now prices are
18:19
twice what they used to be well I'm
18:21
going to need more dollars to transact
18:24
okay so that's a reason we have nominal
18:26
GDP here rather than real GDP
18:30
okay
18:32
good so let's now determine the interest
18:35
rate and I'm going to do it in the
18:36
simplest possible model first and and by
18:39
simplest I mean here in particular no
18:42
banks no intermediaries okay so there's
18:44
only Central Bank and and and and and
18:49
people okay so
18:52
so suppose that the central banks
18:54
decides that wants to this is the way
18:57
monetary policy used to be conducted
18:59
suppose is the size that it wants to
19:01
offer M dollars to the economy and the
19:04
central bank is the one that produces
19:06
the at this moment which I have no
19:09
intermediaries a ER money is really
19:13
currency okay the only one that can
19:16
produce currency forget Bitcoin only one
19:19
that can produce currency is the Central
19:22
Bank okay I mean dollars you can no one
19:26
else can produce dollars
19:28
watch out when we talk about Banks later
19:30
on in this economy I'm describing there
19:32
are no banks the only one that can
19:34
produce Dollars currency is the Central
19:36
Bank any other one that produces dollars
19:38
that's illegal okay so it's a central
19:42
bank so the central bank can decide how
19:44
much money to
19:45
supply and suppose it decides to supply
19:48
M that's it it's a
19:52
decision well what is a now for the
19:55
first time I can I can answer the
19:57
question is well what the interest rate
19:59
in this environment why do I know that
20:02
because I have a money supply I have a
20:04
money demand the intersection at this
20:07
level of money supply the equilibrium
20:09
interest rate that is interest is
20:10
consistent with money demand equal to
20:12
money supply is that
20:15
one
20:19
okay is it clear so I have my money
20:23
demand and I'm saying the Central Bank
20:26
suppos the Central Bank De size to
20:27
supply m well in equilibrium that will
20:30
be the interest
20:32
rate okay that's the way the interest
20:34
rate is
20:36
determined
20:40
now suppose that the Central Bank
20:42
increases remember the the goal of this
20:45
lecture is that we get to understand how
20:48
is that interest rate is deter is
20:50
determined how is that the fed the
20:52
Central Bank determines the interest
20:54
rate here we said look the Central Bank
20:57
decide on certain am amount of money and
20:59
then the market determines what the
21:00
interest rate
21:02
is and this is the way monetary policy
21:04
used to be conducted the central banks
21:07
would typically decide the amount of
21:09
money in the system it was called
21:10
monetary Aggregates the amount of money
21:13
in the system and then the market would
21:14
determine the interest
21:16
rate it turned out that that was a
21:19
nightmare and so now that's that's not
21:21
what central banks do but and it was a
21:24
night mayor because this money demand
21:26
that looks so peaceful here in practice
21:29
is moving around all the time for a
21:31
variety of reason you know even holidays
21:34
affect the money demand and all that so
21:36
so if you fix the monetary Aggregates
21:38
and many the man is moving all over the
21:40
place what what
21:44
happens suppose the Central Bank says
21:46
I'm going to offer this amount of M
21:48
that's it and now I tell you money the
21:50
money is moving all over the place
21:51
they're weeks that they have you know
21:53
three days of of weekend that have you
21:55
know vacations in between or there's a
21:58
Super Bowl lots of people decide to buy
22:00
tickets or whatever or beer so
22:06
whatever well
22:10
no because when you say shortage I mean
22:14
depends what you mean by shortage but so
22:16
so you could be right with that part of
22:18
the answer but but when you say exess
22:19
theand then I have a problem because
22:22
that's true only if the interest rate
22:23
doesn't
22:25
move but in a in a in a situation you
22:28
could just the Central Bank fix M and
22:30
let the market do its thing then the
22:33
interest rate will not be fixed and
22:35
that's exactly the problem that the
22:37
interest rate becomes very very volatile
22:39
if you if you do it only only through
22:41
through monetary arates because this guy
22:44
is moving all over the place and so
22:46
imagine what happens if this demand
22:47
shift up then in equilibrium it say goes
22:49
up precisely to avoid your excess demand
22:52
no because if this thing goes up I have
22:55
an excess demand at that interest rate
22:57
but what happen in equili is the
22:58
interest rate will go up and so until
23:00
the the excess demand
23:04
disappears now in in central banks like
23:07
the US Central Bank the FED they can
23:10
control this stuff fairly well many
23:12
other central banks don't have that if
23:13
you look at the at the central at at the
23:16
Bank of China for example they have lots
23:18
of high frequency movements in interest
23:20
rate because they not very good at doing
23:21
this stuff it's it's not that easy to
23:25
okay to to to control an interest rate
23:27
for example to keep it we but the
23:29
Central Bank used to do that that's what
23:32
I'm saying used to do that I'm saying in
23:34
practice this system wasn't very good
23:36
because this in practice this the man is
23:38
moving around for a lot of EOS syncratic
23:40
reasons okay some of them are EOS
23:42
syncratic some of them are very
23:44
predictable there was a lot of panic
23:46
around the shift of the year 2000 that
23:50
the ATMs would stop working and stuff
23:52
like that so it was a massive increase
23:54
in money demand because people wanted to
23:56
have cash just in case ATMs sto working
23:59
okay and and so there are some are
24:01
predictable and so but but you can get
24:03
very large fluctuations so in practice
24:05
what central banks do nowadays is really
24:09
is they tell you what the interest rate
24:10
is and then they offer whatever M the
24:13
market needs for that interest rate
24:15
that's the way modern monetary policy
24:17
works okay I I'll tell you a little bit
24:19
more about that so let's see what
24:21
happens here if if if if
24:25
uh if the suppose the the Fed
24:29
for reasons that you'll understand
24:30
better in the SEC in the next lecture
24:32
suppose the FED decides that they want
24:34
to have an expansionary monetary policy
24:37
expansion in monetary policy means it's
24:40
going to spand M it was offering certain
24:42
amount of M and now it decides to offer
24:45
more of the D so what happens in
24:49
equilibrium well we start from an
24:51
equilibrium here if the interest rate
24:54
remains at that level now we have an
24:55
excess
24:56
supply of money
24:59
okay and the only way to restore that
25:01
equilibrium is by people demanding more
25:04
money and how when will people demand
25:07
more money well when the interest rate
25:10
is
25:11
lower okay so excess demand the interest
25:14
start declining then demand for money
25:17
starts catching up with a new higher
25:18
supply of money okay and you end up with
25:21
a lower interest
25:23
rate okay so that's an expansion in
25:25
monetary policy an increasing M that
25:27
leads to a decline in the interest rate
25:30
again mod than central banks don't tell
25:32
you we're going to increase M by 20%
25:35
what they tell you is we're going to cut
25:37
interest rate by say 50 basis
25:41
points when they tell you that they're
25:43
going to C cut interest in by 50 point
25:45
they're reading you this
25:47
accxes but
25:51
behind that operation there must have
25:53
been an increase in money
25:55
supply and then it comes all the fine
25:57
tuning that that they have to do know so
26:00
so the interestate remains there when
26:02
the man is vibrating around that thing
26:03
there but the when we say an
26:05
expansionary monetary policy we really
26:07
mean cutting interest rates how is the
26:11
interest rates cut effectively by
26:13
increasing the money supply but they
26:15
don't tell you that they are doing that
26:17
but that's what they're doing
26:22
okay good so nowadays we're in the
26:26
opposite process we're moving that way
26:28
no
26:29
up but you seen in every single meeting
26:34
now for the last seven minutes or so we
26:35
have seen a hike in interest ratees okay
26:39
H well that's they don't tell you that
26:42
but they're saying we're going to cut
26:43
money supply and moving in that
26:45
direction that
26:47
direction because if they move in that
26:49
direction then interest rate go
26:52
up
26:54
clear good
26:59
what else shifts uh this is different
27:04
kind of shift suppose that nominal
27:06
income goes up and this is happening all
27:08
the time nominal income is growing in
27:10
most economies most of the time unless
27:12
you're in a recession nominal income is
27:14
growing it's growing for two reasons one
27:15
because we have inflation and the other
27:17
one is because real output is growing
27:19
that means that that typically in an
27:22
average year manyy demand is Shifting to
27:25
the
27:26
right okay
27:28
so if money demand shift to the right
27:31
and money supply does not
27:33
change then what happens to the interest
27:38
rate money demand goes up money supplies
27:41
doesn't change what happens to the
27:43
interest
27:45
rate increases because at this interest
27:48
rate here we have an excess demand for
27:51
money so we have to reduce the money
27:54
demand how do we reduce money Demand by
27:56
increasing the interest rate
27:58
that's way we so that's yet another
28:01
reason why why it's not a good idea to
28:04
be targeting monetary Aggregates the FED
28:07
tells you we we want the interest rate
28:09
at 5% say okay and then the economy will
28:12
be growing and so on and what the FED
28:14
will be doing is if they want to
28:16
maintain the interest rate at 5% well
28:17
they'll keep expanding M so the interest
28:19
rate doesn't go up okay that's the way
28:22
normally conduct but if the if the FED
28:25
stays sleepy and and and you have an
28:27
increasing many demand then then the
28:30
interest will tend to go
28:35
up so I told you that that
28:40
ER that the central bank is moving M
28:44
increasing them reducing them or
28:45
whatever so how do they do
28:47
that I
28:50
mean it's not that they although that
28:52
police has been advocated it's not that
28:55
they go in a helicopter and sort of fly
28:57
bills on top of all of us they don't do
28:59
that although again it has been
29:02
advocated in extreme cases of recessions
29:03
and so on and it's called helicopter
29:06
money just give money away okay
29:10
ER but that's not the way it's normally
29:12
done for normal operations is not done
29:14
that way so how is it done remember that
29:17
we have a financial system that is very
29:19
simple for now we have money and bonds
29:22
so what the Central Bank does the
29:25
Central Bank wants to change the
29:26
portfolio of people that they want
29:27
people to have less bonds say and more
29:29
money that's when that's to ruce the
29:31
interest rate so what the Central Bank
29:33
does is goes up there and expansionary
29:36
open market operation open market is
29:38
because they go into the open market to
29:40
buy bonds okay they as as opposed to an
29:44
operation that happens behind doors if
29:46
the if the FED went directly to the
29:48
treasury and bought bonds that would not
29:50
be an open market operation okay but
29:52
what they do is they go to financial
29:54
their financial system and they go with
29:56
a big bag of money and say okay we want
30:00
bones and so the public sells bones to
30:04
them in exchange for money okay that's
30:08
an expansion in market so what we saw
30:10
that before when M shift to the right
30:13
what the central bank really did is went
30:15
out there and bought bonds from the
30:18
public the public sold the
30:20
bonds and got the cash okay at some
30:24
price people when when I show you
30:26
equilibrium in the money market that
30:27
means also an equilibrium in the bond
30:29
market necessarily so it has to be that
30:32
the price is right for the for the
30:34
portfolio of individuals a
30:36
contractionary open market operation is
30:38
the opposite is a central bank goes out
30:40
there and sells bonds to the market and
30:43
takes the cash back okay that's a
30:45
contractionary monetary policy so when
30:47
the FED wants to yeah when the FED let
30:49
me justew when the FED wants to cut
30:52
interest rate what the FED does is an
30:54
expansion in monetary policy which means
30:57
it goes out there and buys bonds from
30:59
the market and gives cash to the market
31:01
yeah can how can the Central Banking
31:04
assistance guarantee that some's apply
31:06
their bonds like if they didn't have if
31:08
their government didn't have the
31:09
financial stability I guess the like
31:12
United States has how would they
31:13
guarantee that these bonds will be worth
31:16
anything in the long well I mean there's
31:18
you're talking about risk premium and
31:20
that's a that's
31:21
that's that's an an additional issue
31:25
typically a a central banks inter
31:28
in in in in very short duration bonds so
31:31
there it's not the typical bond that is
31:34
risky in many sense it's very very very
31:36
short duration bonds treasuries very
31:39
short duration in fact it's even less
31:42
nowadays central banks really intervene
31:44
in the in the overnight Market is is but
31:48
but you're right that that countries
31:50
that don't have a bond market a
31:52
well-developed market have problems with
31:54
the management of monetary policy and so
31:56
on because they have a cretive spread
31:57
that is moving around around as well but
31:59
they tend to focus on the type of
32:00
instruments that thing becomes very
32:02
important I mean for Japan even big guys
32:05
very big guys now they have an issue
32:07
because they have been buying bonds very
32:10
long duration bonds 10 year bonds and
32:13
stuff like that and there it's a little
32:16
trickier Market need to trust you a lot
32:17
more if you're dealing with 10e things
32:19
and you're dealing with a three-month
32:21
Horizons and so
32:23
on in other instances a um
32:28
erh for example Chile has a situation
32:31
like that the Central Bank itself can
32:33
issue bonds and so those are bonds
32:36
issued by the central banks and they
32:38
tend to be very reliable bonds because
32:40
these are bonds that are issuing your
32:42
same currency so you have the currency
32:43
to always pay the you can always print
32:45
money and pay for those bonds you see so
32:48
it rarely happens that there is default
32:50
on bonds of that kind
32:53
ER the typical bonds government bond
32:56
that defaults is a bond that is issuing
33:00
a currency different from the one you
33:01
have because then you may not have the
33:03
currency to pay for stu okay and that's
33:04
the reason em markets run into trouble
33:07
and things of that kind
33:09
okay so in terms of the balance sheet of
33:12
the Central Bank how does an open market
33:14
operation look so if you look at the at
33:17
the balance sheet this is an incredibly
33:18
simplified version of the balance sheet
33:20
of the of the FED no they have lots of
33:23
things some more assets gold and all
33:25
sort of stuff but in our simple economy
33:28
the government the the fed the assets of
33:32
the feds is they have some bonds it has
33:34
already some bonds out there and the
33:36
liabilities is the money they issue they
33:38
owe that to people I mean they issue
33:40
currency but you know but but that's
33:42
it's a
33:43
liability people can do things with can
33:46
buy things with that money and so it's a
33:47
liability so that's the way the balance
33:49
sheet looks so when when the the FED
33:52
decides to do an expansionary open
33:55
market operation then what it does is it
33:59
goes out there it IT issues an say a $1
34:03
million expansionary open market
34:06
operation they do it in much we get
34:08
tickets on this but let's make it simple
34:10
$1 million of an expansionary operation
34:13
but they go they go out there they they
34:15
print a million dollars and they buy a
34:18
million dollars from the market okay and
34:22
so at the end the balance sheet ends
34:25
like it used to be the there's an extra
34:28
$1 million of liabilities because now
34:30
there's a million more of dollars
34:32
circulating out there and but but the
34:36
against that the Central Bank also has a
34:38
million more of bonds Holdings
34:42
okay so that's that's what happens with
34:44
when so so when in an expansionary
34:47
monetary policy the balance sheet of the
34:49
Central Bank expands both sides expand
34:51
by the same amount okay but expands and
34:55
one of the big themes of recent years
34:58
starting from the global financial
34:59
crisis is that these balance sheets used
35:02
to be small peanuts type things for I
35:05
mean a trillion dollar or something like
35:07
that for something like the the US the
35:09
size nowadays they're much much larger
35:12
than that because they have done so many
35:14
operations to first get us out of the
35:15
global financial crisis and then to get
35:17
us out of covid and so on that these
35:19
balance sheets are
35:20
now an order or two orders of magnitude
35:23
larger than they used to be
35:25
okay but be in words they have had to do
35:28
lots of expansionary monetary policy
35:31
over the last couple of decades or
35:37
so so let me talk about a little bit
35:40
about interest rate and bond prices
35:43
because that's the other side of this
35:46
thing so so what is the connection
35:49
because sometimes it's easier to
35:50
understand things in terms of price in
35:52
terms of bonds so suppose a bond pays
35:56
$100 a year from now and and no coupon
35:58
in between so if you buy a bond now for
36:00
some price PB you get $100 a year from
36:05
now so what is the interest rate of that
36:07
bond that is what is the excess return
36:09
that you get out of that or the return
36:11
you get out of buying that
36:13
Bond well it's going to be $100 minus
36:17
whatever you pay today say you pay 95
36:20
then $5 divided by your investment
36:23
initial investment which was 95 okay so
36:26
that's a bond that gives you know a
36:29
little bit more than 5% in a year okay
36:32
that's a return that's interesting so
36:34
that's a connection between interest
36:35
rate and prices and notice that this is
36:38
an inverse
36:40
relation you know when the price of a
36:43
bond goes up the interest rate pay goes
36:46
down because you're paying more for the
36:47
same principle you're going to get 100
36:49
but now you're paying more for it well
36:51
that means the interest rate the return
36:52
on that Bond went down
36:56
okay conversion you can say the other
36:58
way around the higher is the interest
37:00
rate the lower is the price of bond of a
37:01
bond so for example today the interest
37:04
rate is
37:05
5% a ER if I want to issue a bond that
37:09
doesn't pay any coupon and I'm
37:11
completely safe so I'm the US Treasury
37:15
I'm going to be able to sell that bone
37:16
for
37:18
95 two years ago when the interest rate
37:20
was
37:21
Zero the fair would have been able to
37:23
sell that bond for
37:26
100 okay
37:28
so there's an inverse relationship
37:29
between the interest rate and the price
37:30
of bonds and now I can take you back to
37:34
my open market operation so remember
37:36
what what I said there's another way of
37:38
remembering sort of which way these
37:40
signs go remember when you have an
37:42
expansionary monetary operation I said
37:44
the FED goes out there with a back of
37:46
money and buys bonds from the market
37:49
when bonds when you buy something when
37:52
there's an enormous increase in demand
37:53
for something what do you think happens
37:55
to the price of that something
37:58
goes up no for anything cars whatever it
38:00
is if there's a lot more demand then
38:03
prices will go up and the FED has a lot
38:07
of cash so he can really buy large
38:10
amount of bonds and so when the FED goes
38:13
out there and does an expansionary open
38:15
market operation means it goes out there
38:17
and buys a lot of bonds the price of
38:19
those bonds goes up and made that
38:21
formula that means the interest rate is
38:23
going down okay so that's another way of
38:25
understanding how is it
38:27
expansion open market operation lowers
38:30
the interest rate it's because it raises
38:32
the price of the bonds that is
38:34
demanding and when you raise the price
38:36
of the bonds then the interest rate goes
38:43
down will I do this to
38:47
you well very quickly so really the only
38:51
thing I really care I want you to
38:53
understand what I what I just said well
38:55
because we're going to use it
38:58
I want to you to understand what comes
39:00
next ideally well but but it's okay if
39:03
you don't understand it too well okay
39:05
and I'm going to tell you when do you
39:06
have to start understanding very well
39:08
again okay for now this this is a pie in
39:11
qu is what I'm doing here is making
39:14
things a little bit more realistic the
39:16
the message will be similar but it's a
39:19
little bit more complicated okay and
39:21
that's the reason sort of
39:23
substantively H um I already told you
39:26
what I wanted to tell you
39:28
what I'm going to tell you now will give
39:29
you a little bit more realism and
39:31
therefore will allow you to understand a
39:32
little bit
39:34
better a technical description of
39:36
monetary policy or something like that
39:39
so in
39:40
practice you know in the economy I just
39:43
describe you had sort of households and
39:45
firms and the central bank but in
39:48
practice there are lot of financial
39:50
intermediaries okay and in financial
39:52
intermed the most prominent of them for
39:54
especially for monetary policy are the
39:56
banks and there are certain Banks
39:58
actually they're even more important
39:59
than others but banks are financially
40:02
intim intimidates they take money from
40:04
someone or deposit from someone and lend
40:07
it to someone else or buy some
40:09
instruments okay so so they intermediate
40:11
the funds of somebody that wants to save
40:13
on in the bank a deposit in a deposit
40:16
account or something and they they lend
40:19
that
40:19
money effectively in the name of the
40:22
other person to H someone else okay so
40:28
Banks do two things to the model I just
40:32
described the first is that they produce
40:35
money as
40:36
well
40:38
okay
40:40
because ER money is made of currency
40:43
which is is issued by the central bank
40:45
but it's also made of a checkable
40:48
deposits if you have a a checking
40:51
account something you can have a debit
40:53
card against or something like that then
40:56
then that's money for you okay if you
40:59
deposit in a bank in a checking
41:02
account that's money okay and so when
41:07
Banks the liabilities of banks the
41:09
deposits is part of money it's something
41:12
you can use for transactions you can
41:13
write checks you can use your debit card
41:15
and stuff like that okay so that's the
41:17
first thing that Banks do okay the other
41:20
thing the banks
41:22
do
41:23
is they themselves have a deposit
41:27
account at the Central
41:29
Bank okay so they themselves take part
41:34
of the deposits they take the deposits
41:37
part of the deposit they lend to other
41:39
people another part they buy financial
41:41
instruments Bond and stuff like that in
41:43
this economy would be only bonds and the
41:46
other part smaller part 10% or something
41:49
like that they deposit at the central
41:53
bank that deposit at the central bank is
41:55
called Reserves
41:58
okay so when you he the word reserves of
42:01
the banking sector this is the deposits
42:04
of the banks at the Central
42:07
Bank okay and that's that's also
42:10
liability for the Central Bank the
42:11
central bank is holding that deposit of
42:13
the banks it's not the central bank's
42:15
money it's the it's the bank's money
42:17
okay and they're holding it there it's a
42:19
liability as
42:22
well so now if you look at how the
42:25
balance sheets look
42:27
our central bank now has more things he
42:30
has assets going to be Bonds in this
42:33
economy this only thing you can have but
42:35
now it will have the currency that had
42:38
before and in liabilities but also will
42:40
have the Reserves the deposits of the
42:42
banks themselves
42:48
okay okay and this is called this stuff
42:51
here is called central bank money in
42:54
contrast it is called Central Bank it
42:56
has so many names
42:57
it's called central bank money high
42:59
power
43:01
money some other name have some but but
43:04
but he has several names and what is I I
43:07
like the name central bank money because
43:09
that's in contrast with this kind of
43:11
money it's the money that the banking
43:13
sector produces the checkable deposits
43:16
okay so this is the money produced by
43:18
the central bank and then the and then
43:20
through deposits the financial system
43:22
the banks themselves produce more
43:25
money so The Total Money in the system
43:28
is much more than the central bank money
43:32
because deposits is a big thing you
43:35
know this is much larger than that in
43:39
practice okay good how does this change
43:43
our mold not really much and so so again
43:46
that's the reason I don't care too much
43:47
if you understand these last two slides
43:50
so let me rederive what we
43:53
have with this approach with with this
43:56
this uh extension so money demand is the
43:59
same as it used to be what happens is
44:01
you're going to demand it in the form of
44:03
currency or checking accounts or
44:04
something like that but but the total
44:06
money demand is exactly as it used to
44:09
be Banks typically hold a share of a and
44:15
assume for now that there's no currency
44:16
so everything is check is deposit
44:18
otherwise you get a more complicated
44:20
formula okay so no one holds cash which
44:23
probably quite realistic nowadays you so
44:26
everyone has a checking account and
44:28
that's it
44:30
okay
44:33
so the banks
44:36
typically hold for regulatory reasons a
44:40
share of their Deposit they have a
44:42
minimum for regulatory reasons a minimum
44:45
share of the deposit they have that they
44:48
need to hold in the form of reserves
44:50
okay and I'm going to call that a fixed
44:52
fraction Theta so if all the money is
44:55
held in the form of the deposits then
44:58
Theta which is a number like 0.1 say
45:01
times the deposits which is money demand
45:05
is equal to the reserves at the is equal
45:08
to the central the demand for central
45:10
bank
45:11
money this is the demand for central
45:13
bank money because is this are the N
45:16
these are the reserves that the banks
45:17
want to have at the central bank so the
45:20
demand they they want to have this
45:22
amount of deposits at the central bank
45:24
this what we call HD it's Theta time m
45:28
and so now rather than M what the
45:30
Central Bank controls really because
45:31
it's the only thing can really control
45:34
is the money that it issues issues which
45:36
is the central bank money so R supplying
45:39
M which used to be currency now m is a
45:42
bigger thing because has deposits and
45:43
all sort of stuff but the central bank
45:46
is the one that controls how much high
45:48
power money how much central bank money
45:50
it issues and we're going to call that
45:53
H okay so if we go back to my balance
45:57
sheet here the Central Bank cannot
45:59
control total money because it cannot
46:01
control the amount of checkable deposits
46:03
in the economy but it can control this
46:06
money here and since we have no currency
46:08
my example it really can control how
46:10
much supply of reserves it can do okay
46:14
and so now we have a demand for Reserve
46:16
which is just proportional to money
46:17
demand equal to some fixed amount H
46:20
which is the supply of high power money
46:22
by the central bank and then the
46:24
equilibrium looks exactly
46:27
like before it's going to be some
46:28
remember before we have m equal to
46:32
Dollar y i now we're saying it's not M
46:36
it's Theta times M really no because
46:39
it's a fraction only of Total Money okay
46:43
has to be equal to a money demand it's
46:47
not Total Money demand it's the money
46:48
demand that ends up being demand for
46:50
central bank money because Total Money
46:52
demand is the checkable checking
46:55
account that leads to a demand for
46:58
central bank money by the Banks which is
47:00
Theta times those deposits it's not the
47:03
full Deposit they don't Deposit they
47:04
don't take all the deposit and deposit
47:05
at Central Bank they say only 10% of
47:07
those deposit will keep them at the
47:09
central bank so $100 in deposit if 30 is
47:12
point1 $100 in deposit leads to a demand
47:15
for reserves that mean for deposits by
47:17
the bank and the Central Bank of
47:20
$10 okay and that is the thing that the
47:23
central bank can control very well it's
47:26
a m the is the demand that comes to me
47:28
the central bank is $10 and I decide
47:31
whether we do $10 or not you we can do
47:34
five and then we're going to have the
47:35
interest rate sort out five to be in
47:38
equilibrium so it's if if if the banking
47:41
sector wanted 10 and I'm only going to
47:43
supply five then something the interest
47:46
rate is going to have to rise so that
47:48
deposits you know decline less demand
47:51
for money and and the and the final
47:54
demand that gets to me is five not 10
47:57
but the mechanism is exactly the same I
47:59
know this this can be a little confusing
48:01
but the mechanism exactly the same it's
48:03
just this just illustrates it makes I
48:06
mean this this is important
48:09
because it's institutionally important
48:12
more than conceptually important because
48:14
this is the market where really the
48:16
interest rate is
48:17
set okay so this I'm doing next time
48:21
that market the market for reserves
48:24
really because what the banks do is they
48:25
want Reserves
48:27
okay deposit at the central bank that
48:29
market for reserves the interest rate in
48:31
that market for reserves is called the
48:33
federal funds rate and it's called the
48:36
federal funds rate because the Federal
48:37
Reserves controls that rate so when the
48:40
FED when when there is a meeting by the
48:42
fed or a policy announcement that tell
48:44
you that the the FED has increased the
48:45
rate by 50 basis points it means it has
48:48
increased the interest rate in that
48:50
market by 50 basis points okay so the
48:54
interest rate that the Central Bank
48:56
controls corly is called the federal
48:57
funds rate and the federal funds rate is
49:01
that market is market for reserve for
49:02
high power money so all the operations
49:05
happen there they don't participate in
49:08
the deposit Market or anything they
49:11
participate in that market which every
49:13
night is a is a Hu huge number of
49:15
transactions every night because I put
49:17
all the banks together but what happens
49:19
every night is some banks have more
49:20
reserves than they need some other banks
49:22
have less reserves than they need so
49:24
they supply and demand within the
49:26
banking sector for for reserves and
49:28
there's an interest rate that tends to
49:29
equilibrate if too many banks are short
49:31
reserves then there's going to be lots
49:33
of demand for reserve and interest rate
49:34
is going to tend to go up If the Fed
49:36
doesn't want that interest rate to go up
49:38
then what it will do overnight it will
49:40
go there and inject reserves into the
49:42
system high power money so the interest
49:44
rate in that market comes down okay and
49:47
that's the way the FED operates that's
49:50
the way it controls it participates in
49:51
that market controls the amount of high
49:53
power money which regulates the rate in
49:57
the resarch market and here it's only
50:00
you know and then so here you have sort
50:02
of the major Banks participating here
50:06
and and and then this leaks into the
50:09
other interest rates in the economy to
50:10
into deposit rates to to bond rates and
50:13
so on but but the real rate they control
50:15
the rate that they control most directly
50:18
is that rate here okay and that's the
50:21
reason I wanted to give you a little bit
50:22
of
50:23
institutional I mean to add complexity
50:26
so we could get
50:29
to so you could get to this word federal
50:32
funds rate because that's what you're
50:34
going to read in the newspapers the FED
50:36
increase the federal funds Target is
50:38
going to say because they target they
50:39
cannot guarantee it's going to be that
50:41
they target an interest rate and
50:42
typically they give you a range it's a
50:44
very narrow range okay you let me just
50:49
conclude by showing you how that rate
50:51
has looked in the US recently okay and I
50:55
finish here so here here is before covid
51:00
okay H the interest rate the Fed was
51:02
already hik in interest rate it had
51:04
overdone it there so it was beginning to
51:06
lower interest rate and then covid came
51:08
boom and they cut interest rate very
51:10
aggressively the this is the maximum
51:13
they can cut it too and we're going to
51:14
talk about that briefly in the next to
51:15
zero you cannot go below zero you cannot
51:18
pay negative interest rate because then
51:20
I don't demand money I don't demand
51:22
bonds why should I hold a bond that pays
51:24
me a negative interest rate when cash
51:26
pays zero always zero I can always keep
51:28
it under the mattress and and and I
51:30
don't pay in negative so the interest
51:31
rate the lowest can be zero and you see
51:33
that they they did the maximum they
51:35
could in terms of cutting interest rate
51:36
they went to zero effectively zero and
51:39
now they have been trying to catch up
51:40
because inflation is very high and so
51:42
they're trying to to hike interest rate
51:44
and you see how what they're doing okay
51:46
well all those interventions happen in
51:48
the reserve Market that's what where
51:50
this is that's the rate is in that
51:52
market over okay okay so I think we're
51:56
meeting on Tuesday next week uh I think
51:59
that's the plan
— end of transcript —
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