[00:17] all right let's uh let's start um so
[00:23] today I want to talk about uh interest
[00:26] rates uh you know if you have followed
[00:29] the news there's a lot of debate on
[00:31] these days on on on where will the
[00:35] interest rate in the US end at the end
[00:37] of this Titan tiing tightening
[00:40] cycle
[00:46] uh and um so I'll show you there has
[00:50] been a very aggressive monetary policy
[00:52] trying to fight the inflationary episode
[00:54] we're going through uh and that's done
[00:57] through interest rates and and the
[01:00] question that I want to address today is
[01:03] H well how is it that the interest rate
[01:05] is determined so when a central bank
[01:07] decides to hike interest rates how do
[01:11] they do that okay and obviously this is
[01:13] about financial markets interest rate
[01:15] are set in financial markets and
[01:17] financial markets are very very
[01:19] complicated so we're going to keep it
[01:21] very very simple we're want to make
[01:23] introduce more complexity later on in
[01:25] the course but still we're going to keep
[01:26] it pretty simple because our main
[01:28] objective in studying Financial Market
[01:31] is really a a to to re to achieve some
[01:35] sort of understanding of how the
[01:38] interest rate policy that the Central
[01:39] Bank H controls is is
[01:43] determined so before
[01:46] [Music]
[01:48] I I get into specifics so let's let's
[01:51] see some trivia here who knows who that
[01:54] person is
[01:56] okay you
[02:00] Geron Powell exactly and who's Jeron
[02:04] Powell the chair of the Federal Reserve
[02:08] uh system in the US which is the Central
[02:11] Bank of the US okay so that's that was
[02:13] an easy one and and every you know if
[02:17] you are into financial markets everyone
[02:19] is worried about what this guy is
[02:20] thinking and his friends are thinking at
[02:22] this moment because they determine the
[02:24] interest rate how do they do that well
[02:26] that's what we're going to talk about
[02:28] later on a little speaker who is
[02:34] this no no that's that's
[02:38] cheating katsu WEA he is the next ER
[02:43] president of the bank of Japan the
[02:45] Central Bank of Japan and an interesting
[02:49] there are many interesting things of him
[02:50] but about him but he's a he's a graduate
[02:52] from our program the PHD
[02:54] program which actually is an incredibly
[02:58] successful program at producing major
[03:00] Central Bankers Ben Bernan is our Alum
[03:04] Alum that he was
[03:06] the the chairman of the Central Bank the
[03:09] chair of the Central Bank of the FED
[03:11] during the financial crisis Mario dragi
[03:14] is a one of our graduates Mario dragi
[03:17] was the the most successful ER Central
[03:21] Banker in Europe he was the president of
[03:24] the ECB European Central Bank for many
[03:27] years and in particular during the
[03:29] Global Financial crisis and the European
[03:32] crisis which followed the global
[03:33] financial
[03:34] crisis uh I mean but you name it Stan
[03:38] Fisher in the past of the Bank of Israel
[03:41] and nowadays feel low of the the chair
[03:43] of the Reserve Bank of Australia in
[03:47] Chile we have had two or three er
[03:50] presents and so on so if you if this is
[03:52] your career this is a good program you
[03:53] should join our program you may end up
[03:56] in a in a good place but that's the the
[03:58] next one for Japan
[04:00] and and Japan is a very interesting
[04:02] place from the point of view of monetary
[04:04] policy precisely because they they
[04:06] haven't had much space to do
[04:08] conventional monetary policy so they
[04:10] have had to do lots of unconventional
[04:12] things from the point of view of what a
[04:14] central bank typically does but today
[04:17] we're going to study conventional things
[04:18] and we'll talk a little bit more about
[04:20] unconventional things later in the
[04:22] course now some institutional knowledge
[04:25] this is the the again in the US the
[04:28] Central Bank of the US is called called
[04:29] the Federal Reserve System and it's a
[04:31] system really H it's a he has a um in um
[04:36] the Board of Governors which sits in
[04:39] Washington
[04:40] DC um and and there are seven Governors
[04:43] and the governors are are are nominated
[04:46] by the president and and then confirmed
[04:48] by by the Senate and the president of
[04:51] that board is is H is so the president
[04:56] of the FED of the FED will be one of
[04:59] those members okay now on in addition to
[05:03] that the the US has a Federal Reserve
[05:05] Bank system there are seven there are 12
[05:08] Regional Banks uh there's one in Boston
[05:11] in fact if you look at the skyline near
[05:13] the Waterfront there's a building built
[05:15] out of recycled aluminum well that's the
[05:19] Reserve Bank of Boston and uh and uh and
[05:23] of those 12 Regional Banks they
[05:27] rotate so so policy the interested is
[05:30] set into in a committee which is called
[05:32] the fomc Federal Open Market Committee
[05:35] um and and the member of that the voting
[05:38] members of that committee are the the
[05:41] seven Governors plus h four out of the
[05:45] 12 and they rotate most of them rotate
[05:48] the the only one I think does not rotate
[05:50] is the is the is the president of the of
[05:53] the New York fed because they're so
[05:56] important because that's a financial
[05:58] heart of the US
[06:00] that you certainly want that H ER
[06:04] president to be involved in in interest
[06:06] rate decisions and it's really the FED
[06:09] that is in charge of communication with
[06:11] financial Market which is a huge thing
[06:12] for the FED okay they are in New York
[06:16] and they're crucial for that okay so
[06:18] that's that's that's those are the
[06:20] people that and in most places around
[06:23] the world you're going to have at least
[06:26] something equivalent to the the seven
[06:28] governors out there okay most places
[06:31] obviously the ECB is different because
[06:33] it's multiple countries so each country
[06:35] sends one member
[06:38] no but but but
[06:41] otherwise um it tends to be like like
[06:44] the US without the the the regional
[06:48] Banks so why do we care about monetary
[06:51] policy well because I think it's one of
[06:53] the main policy tools you have in the
[06:54] short run remember in this part of the
[06:56] course we're trying to understand output
[06:58] in the short ter and one of the main
[07:01] policy levels I mean how can you affect
[07:03] output is monetary policy which one is
[07:06] the other
[07:08] one there are two major ones fiscal
[07:12] policy exactly and fiscal policy we did
[07:14] look at in the previous lecture remember
[07:16] we said an expansionary fiscal policies
[07:18] an increase in G or a decline in t would
[07:20] lead to an expansion in a great demand
[07:22] equilibrium output would go out up okay
[07:25] so fiscal policy is something you always
[07:27] use in in in deep recessions
[07:30] uh but monetary policy is much more
[07:32] Nimble is I mean it's a it's a bunch of
[07:35] people that need to meet and just change
[07:36] the interest rate anything that is
[07:38] fiscal there are some automatic
[07:40] stabilizers by the way so automatically
[07:42] fiscal policy becomes more expansionary
[07:44] during recessions and stuff like that
[07:46] but any deviation from the typical
[07:48] automatic stabilizers require Congress
[07:50] to approve things it's a long process
[07:53] and so it's not something that can react
[07:55] as quickly as monetary policy can okay
[07:59] um so that's what we're going to look
[08:01] that's that's that's that's the reason
[08:03] why monetary policy is important for us
[08:04] at this point then there are medium and
[08:07] long run issues fiscal policies still
[08:10] affects equilibrium output in the medium
[08:12] and long run monetary policies much less
[08:14] effective at that it's very difficult to
[08:17] to change sort of equilibrium growth or
[08:19] things like that with monetary policy
[08:21] it's going to be pretty minor most of
[08:23] the impact of monetary policy in the
[08:25] minum and long run is really on the
[08:27] price level and inflation more than on
[08:29] real activity okay but in the short run
[08:31] it's very powerful for reasons that
[08:33] we're going to discuss in this and the
[08:35] next
[08:40] lecture okay so as I said well monetary
[08:44] policy acts through financial markets I
[08:46] I think it's a very
[08:48] interesting part of my research agenda
[08:50] is about that is I think is the central
[08:52] bank is a very strange institution
[08:54] because most of its mandate are in terms
[08:57] of what happens in the Goods Market says
[09:00] you know you don't try not to get into
[09:02] recession try to get us out of a
[09:04] recession and so on but unlike fiscal
[09:06] policy which has tools that are directly
[09:08] aim at the Goods Market remember it's a
[09:11] it's a purchases by the government of
[09:12] goods so if there isn't sufficient
[09:14] demand for goods the fiscal policy the
[09:17] fiscal Authority can go out there and
[09:18] buy Goods that creates more demand the
[09:21] the central bank is given the same
[09:23] mandate aside from Price stability and
[09:26] things like that we're want to worry
[09:27] about later but it doesn't have any
[09:29] tools the the the central bank if
[09:31] there's insufficient demand the Central
[09:33] Bank cannot go out there and buy
[09:34] hamburgers right that's fiscal policy
[09:36] can do that and expand the demand for
[09:38] hamburgers but not monetary policy what
[09:41] monetary policy can do is by bonds by
[09:45] instruments in the financial markets and
[09:47] through that affects real activity so
[09:49] the is it's the fastest policy tool but
[09:53] it's the most indirect in a sense
[09:55] because it it it has to go through
[09:57] 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