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44:36
Transcript
0:16
expectations play a huge role in
0:18
economics so what I want to today not
0:21
only in asset pricing I mean asset
0:23
pricing obviously it's all about the
0:24
future really H but but also in the kind
0:28
of issues we have discussed ER in
0:31
throughout the course and so that's what
0:34
I want to do essentially is I want to uh
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0:37
give you a shortcut to think about the
0:40
role of expectations in in the kind of
0:43
models we have already discussed and so
0:44
I'm going to do all that in the most
0:46
basic mode we have discussed which is
0:47
the eslm mod and and and I hope you
0:51
you'll get sort of the yeast of what
0:53
expectations can do in in economics so
0:57
this is going to be a very compressed
0:59
version
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1:00
adapted version of chapters 15 and 16
1:03
but in terms of material mapping into
1:06
the book those are the relevant chapters
1:09
and the main idea here is that the islm
1:12
model as we have described it up to now
1:14
really it overweights h the present okay
1:19
and uh and in practice expectations
1:22
about future conditions play a big role
1:25
in the decision of all economic actors
1:27
we we look at you know investors as a
1:29
pricing and so on but it's also true of
1:31
consumers it's also true of firms I mean
1:34
if you think about firms an investment
1:36
decision we made a function of the
1:38
interest rate and current output but
1:40
it's quite clear that the reason firms
1:42
invest is not because of the current
1:43
condition it's because they anticipate
1:45
making profits in the future so it's all
1:47
about fre expectations and even
1:49
governments and foreigners when they
1:51
invest sort of do foreign direct
1:53
investment they go and invest in a
1:54
country is a lot about expectations of
1:57
what the country will do H in in the
1:59
future I mean political elections for
2:01
example have huge impact on asset prices
2:04
and so on precisely because they change
2:07
what people think for good or for bad
2:10
about future conditions okay so so
2:12
expectations is just huge in economics
2:15
so I want to do things in two steps the
2:18
first I'm going to revisit sort of the
2:20
the consumption function and the
2:22
investment function now taking into
2:24
account expectations and and motivate
2:27
how how you should really think about
2:29
consumption an investment in a more
2:31
realistic mod than we have been dis
2:34
discussing H and then I want to embed
2:38
not the fully flesh out consumption and
2:40
investment decisions but the flavor of
2:43
of the role of the future into H the
2:46
islm model okay and uh and by then sort
2:51
of you you would have seen you will have
2:53
seen all that I wanted to communicate at
2:55
least in in in this set of
2:58
lectures so let's think about first
3:02
consumption um and
3:05
uh up to now we assume that consumption
3:08
depended only on disposable income you
3:10
know on current disposable income um but
3:14
that's not the the way it works and one
3:17
of the first in
3:18
formulating ER more or less formally how
3:21
consumption decisions are really made is
3:24
Milton fitman and he call it the
3:26
permanent income theory of consumption
3:28
meaning what really matters to you in a
3:30
consumption decision is not so much at
3:32
your current income but it's what you
3:34
expect to get on average during your
3:36
lifetime and and you know you don't want
3:38
to be moving consumption up and down
3:39
like
3:40
crazy you know once you realize sort of
3:43
more or less what you'll get on average
3:44
then you should consumption should be
3:46
related to that
3:48
concept and and in a sense it's
3:51
also by thinking in this in these terms
3:54
you're also drawing a big distinction
3:56
between things that are temporary and
3:58
that shouldn't matter a lot for your
4:00
consumption decisions versus things that
4:02
are permanent that clearly have a
4:04
potential to have a much larger impact
4:06
on your consumption of course you can
4:08
have temporary things that are very
4:09
large I mean you win the lottery that's
4:11
a huge temporary shock but probably
4:13
you're not going to spend the whole
4:14
Lottery right away you're going to
4:15
smooth it over your lifetime in any
4:17
event okay and and that actually relates
4:21
to more or less at the same time Milton
4:25
fredman was at
4:26
Chicago Franco modani at MIT
4:30
we will develop sort of the life cycle
4:31
theory of consumption who says look even
4:33
at the level of an
4:35
individual the day-to-day income is not
4:38
really what pins down the level of
4:39
consumption because people know early on
4:41
life that they have a lower income than
4:42
they will have later on so they will
4:44
tend to spend and borrow more when
4:46
they're young then in the middle when
4:49
they're in the middle of their life
4:50
cycle you know before retirement they
4:52
panic and you tend to save more so you
4:54
don't consume all you have because you
4:55
know that there are many years ahead of
4:57
you where income will be lower than your
4:58
consumption needs so there's also a
5:00
sense of inter temporary smoothing of
5:03
your consumption you don't follow income
5:05
second by second you sort of try to
5:08
stabilize consumption over time more or
5:11
less and that means that you know you
5:13
have to think more about your permanent
5:14
income but you'll get on average rather
5:16
than what you get in the short ter so
5:19
when you start thinking about
5:21
consumption in those terms what really
5:23
you think well what really matters then
5:25
is is total wealth more than income okay
5:28
how wealthy you are will pin down more
5:30
or less the consumption you have more
5:33
than than your current income and there
5:35
are two senses of
5:37
wealth one is financial wealth okay all
5:40
the assets you may have you may expect
5:42
to inherit or whatever minus the debts
5:45
you have so very much as we discussed in
5:48
the previous lecture in the context of
5:49
asset pricing the expected present
5:52
discounted value of the cash flows of
5:54
all the assets you have okay that's your
5:56
financial
5:57
wealth uh and that's important you have
6:00
more financial wealth even if you have
6:02
no income today you will probably borrow
6:05
against that wealth to the extent that
6:06
you can and ER and probably the banks
6:10
will be more willing to lend to you if
6:11
they know that you have a lot of wealth
6:14
H and and so you're going to fund the
6:15
consumption which is above your current
6:17
income just because you have more
6:18
financial wealth
6:24
okay in fact the very rich seldom sell
6:29
assets they borrow against those assets
6:31
to fund consumption that's the that's
6:33
the way sort of it works there are tax
6:36
advantages of doing that and so on but
6:38
but that's the way it works and the very
6:41
rich often have no
6:43
income at least labor income all the
6:45
income comes from from Returns on assets
6:48
and uh and again we mostly
6:50
borrow but
6:52
inent the point there is that what
6:55
really pins out your consumption is your
6:56
wealth not not the current flow of
6:59
income and the other very important
7:01
concept which is a bigger thing for most
7:04
individuals is human wealth I mean this
7:06
is huge for all of you
7:08
here it's obvious that your current
7:10
income is a lot lower than what your
7:12
income will be in the future you have a
7:14
lot of human capital okay and and so
7:17
that's also concept of expected present
7:19
discounted value is you expect to end a
7:23
lot of income in the future and
7:25
therefore it makes sense that this stage
7:27
of your life you borrow now now banks
7:30
are a little bit more reluctant of
7:31
lending you against your human capital
7:33
than lending you against your financial
7:36
assets it's easier to borrow against a
7:37
house than against your future income
7:40
but even there probably you're going to
7:41
sort of not going to be saving a lot on
7:44
this time of your
7:45
life because you know that your income
7:47
is a lot higher in the future that's
7:49
that we call human wealth okay and total
7:52
wealth is just a sum of financial wealth
7:55
plus human wealth so at its most basic
7:57
level and those are sorry just to relate
7:59
to things we did in the previous two
8:01
lectures those are two expected present
8:04
discounted value you don't know exactly
8:06
how much income you're going to get you
8:07
get a sense of more or less what
8:08
somebody like you does in the future
8:10
more or less on average and so on so you
8:12
have a sense you have an expected cash
8:15
flow labor income flow in the future you
8:17
don't know what the interest rates are
8:19
exactly so you're going to guess more or
8:21
less what the the future interest rate
8:23
is and that gives you a sense of human
8:25
wealth and I know that many of these
8:28
things you're not calculating every what
8:29
your human wealth is and then calculate
8:32
in general consumes 5% of that or 3.5%
8:35
of that but you know a lot of this is
8:37
very Behavior it's really ingraining you
8:40
and and and uh and uh you're probably
8:43
more likely to spend more if you think
8:45
that you're going to be doing well in
8:47
the future but not maybe you're too busy
8:49
now to spend a lot but you know at some
8:51
point when you're given the
8:53
opportunity that that will make a
8:56
difference Traders very successful
8:59
Traders they get a very low income so
9:01
essentially they live out of the income
9:03
that they
9:04
get they couldn't afford what they
9:06
normally afford but they spend a lot
9:08
more than that income because they
9:09
expect to get a big bonus and things
9:11
like that that's income that comes in
9:13
the
9:14
future so in principle your consumption
9:17
should be something that is not
9:19
proportional to your disposable income
9:21
but really proportional to your wealth
9:24
okay and there are estimates of what
9:26
that that proportionality factor is and
9:29
that's I said it depends on the type of
9:31
assets we're talking about that is about
9:33
03 that kind of thing okay
9:37
now in reality that's just it's true
9:41
this is a better economic concept than
9:43
just putting income in there but in
9:45
reality both things really matter so a
9:48
more realistic consumption function is
9:50
something that depends on both things
9:52
for a variety of
9:54
reasons that maybe we have no savings
9:57
and really we call even them hand to
9:59
mouth they leave by the income they're
10:00
receiv receiving in every single period
10:02
those those people are not thinking
10:04
about smoothing consumption over time
10:06
they're consuming whatever income they
10:09
receive ER as I said before most banks
10:12
are not likely to lend you a lot against
10:16
your expected present discounted value
10:18
of Labor income okay so you may be
10:20
constrained in the short your your
10:22
income you you think about how wealthy
10:24
you'll be but you also think about sort
10:26
of your flows the cash flow you're
10:28
receiving that's also part of of your
10:30
consideration so in reality it's a
10:31
mixture of those two things when you
10:33
look at the micro level at different
10:35
individuals the composition changes the
10:38
Richer you are the more this term
10:40
matters the less this one matters the
10:42
poorer you are you know this term
10:45
overwhelms that term that's more or less
10:47
how it works but on
10:50
average it looks like that so you know
10:54
we weren't wrong when we did islm and
10:56
having the consumption function as
10:58
increasing in in in in disposable income
11:02
but I always told you there is a lot of
11:03
interesting stuff hidden in that little
11:05
CZ in the you know in that autonomous
11:08
component of consumption well that lots
11:09
of interesting things has a lot to do
11:12
with wealth
11:16
okay and again this term here is
11:20
something that captures a lot s of
11:22
things that are permanent well this one
11:24
captures a lot cyclical components and
11:26
things of that kind
11:30
so interpreted this way you know the
11:33
reason people during
11:35
booms even though human wealth may not
11:38
change much over time Financial wealth
11:41
typically change in in a boom but it's
11:45
also the case and in a boom you know
11:46
wages are higher and all that and people
11:48
tend to spend more okay even so this
11:51
captures a lot the temporary component
11:53
when you're in a in a boom you're going
11:54
to like it's likely that you're going to
11:55
consume more for any given level of
11:58
wealth okay
12:00
it's temporary but that's what it
12:02
is what about
12:04
investment that's a decision by The Firm
12:07
how much physical capital I'm talking
12:08
about physical investment real
12:10
investment not Financial
12:12
investment the decision also depend on
12:15
current but particularly on expected
12:18
profits and when you think about
12:20
expected profits you need to think about
12:22
interest rate as well we put the
12:24
interest rate aside we say okay it's
12:25
more expensive to borrow if the interest
12:27
rate is high true but matters a lot more
12:30
than just that because it matters also
12:32
through the the the the expected present
12:35
discounted value of your future cash
12:37
flows the interests are very high and
12:38
they're expect to remain very high that
12:41
means a project that gives you lots of
12:43
return in the future lots of cash flow
12:44
in the future may not be worth a lot
12:46
simply because interest rates are very
12:48
high so the discounting of the future
12:50
cash flows is very high in that
12:52
environment you know Investments that
12:54
give you return a quick return are worth
12:56
more than things that give have a pay
12:58
off very in the very long
13:00
run so so the decision for example of
13:03
buying a
13:06
machine needs to look at the price of
13:08
the machine right now and then
13:09
unexpected present discounted value of
13:12
the cash flows okay so let's think a bit
13:16
more carefully about about that decision
13:19
H so suppose you buy a machine for a
13:21
price let's normalize that price to one
13:24
the first thing you need to know is well
13:26
how long will this machine last because
13:28
I need to know you know for how many
13:30
years I'm going to get a cash flow out
13:31
of these things h and a reasonable
13:35
assumption is is is for most machines
13:38
it's have some sort of geometric
13:39
depreciation so meaning you know it's
13:42
not deterministic it's more or less
13:45
machines break break break down
13:47
occasionally but there's certain
13:48
probability that they break down we
13:50
typically call that notation in
13:53
economics is we we refer to that as
13:56
Delta that's the depreciation
13:58
probability so if you think in terms of
14:00
expected value you buy a machine today
14:03
and you
14:04
ask how much of a machine I'll have next
14:07
year well it's going to be a weighted
14:08
average of zero and one probably but on
14:11
average it's going to be one minus Delta
14:14
so it's a machine that Peres sort of the
14:16
probability of the machine breaking down
14:18
over a year is 5% then one minus Delta
14:21
is
14:22
095 what is the probability that machine
14:24
is still producing two years from now
14:26
well 1 minus Delta square and so on and
14:29
so forth okay so that's the first thing
14:30
you know I have this machine and it's
14:32
likely to give me cash flows over these
14:34
many years and so on and then I have to
14:38
know how much I expected profits I
14:40
expect to get in each of those years and
14:43
then I need also to know what are the
14:45
interest rates that are likely to
14:47
Prevail during the lifetime of the
14:49
machine and so on so at the end of the
14:52
day when I calculate I do my little
14:54
project and I need to decide whether one
14:56
which was the price of the machine or
14:57
not is too expensive or too cheap I need
15:00
to compare it with the spec present
15:02
discounted
15:03
value that I have for that machine so
15:06
here is an example this is a machine
15:08
that gives the first expected cash flow
15:10
comes next year I set it up today and I
15:13
generate profit by the end of the the
15:15
year or at the beginning of the next
15:16
year thus expected profits for the first
15:18
year of the machine which comes at the
15:20
end of the first year is counted by an
15:23
interest rate that I know today I know
15:25
the interest rate for for one
15:27
year what about the cash flow that I
15:30
expect for two years from now well
15:31
that's going to be that's expected cash
15:34
flow if the M machine is working
15:35
properly that's the probability that the
15:38
machine last to the second year and and
15:42
uh or or you can also assume that the
15:45
machine sort of breaks down in little
15:46
pieces every year you get 90 0 95 of the
15:49
machine in second
15:53
year 1 minus
15:56
1.05 uh Square two years from now and so
16:00
on so forth
16:02
so but I also now when I think about the
16:04
cash flow in the second year I don't
16:06
know the interest rate for the second
16:07
year so h i I need to have an expected
16:11
interest rate
16:15
here and so on so forth okay because the
16:18
machine lasts for many many years that's
16:20
what I get a question by the
16:24
way I'm saying yeah I need to have
16:26
expectations here and so on
16:29
but the truth is that the guy that
16:32
invests in the machine doesn't need to
16:34
have that expectation because I could
16:35
replace this for something that is known
16:38
today what would that
16:48
be I'm saying you know when I calculate
16:50
the expected cash flow when I'm
16:52
discounting the two years out cash flow
16:55
I'm going to have an interest rate that
16:56
I know the one from Time Zero to to the
16:59
end of the first year but I don't know
17:01
the interest rate that prevails H
17:05
from the end of year one to the end of
17:09
year two that's what I wrote here but I
17:12
said but there is something in the
17:14
market that I could look at and that I
17:17
really know what is
17:19
that exactly I could use one plus R2
17:25
these are onee rates
17:26
r2t Square
17:29
okay so so when you have the ter
17:32
structure when you see all the interest
17:33
rates a a a firm deciding where invest
17:37
on not has the interest it needs it
17:38
doesn't need to have expectations form
17:41
expectations about the interest rate the
17:42
market is doing it for them now the guy
17:45
may choose to be a Trader and decide
17:46
that I doesn't like the interest rate
17:48
that the market is is is pricing in but
17:51
that's a different trade it's not the
17:52
investment decision of the firm The Firm
17:55
will have to make a forecast about
17:57
expected cash flow and so on but that's
18:00
it from the machine so on
18:03
okay so obviously the larger disase the
18:07
more you're going to invest the more
18:08
machines you're going to buy and so on
18:11
okay
18:13
um so so in principle you know a better
18:17
investment function we remember we wrote
18:19
an investment function as investment a
18:22
function of output current output which
18:25
is said is approxim for sales and then
18:27
the interest rate well a better concept
18:30
is that one which does depend on
18:32
aggregate activity depends on many
18:34
things but not only today also the ones
18:37
you expect for the future okay and it
18:40
depends on the interest rate not only
18:42
today's interest rate though also the
18:44
interest rate of the
18:45
future if I if I look at this expression
18:50
you know if if even if the interest rate
18:51
today doesn't change but I expect the
18:53
interest rate to change in the future to
18:54
go up that will lower the value of my
18:57
project okay we have had no space for
18:59
that when we posit the initial
19:01
investment function but but here we have
19:06
that and sorry and this is an increasing
19:09
function of that the higher is
19:11
V the highest expected per discounted
19:13
value of buying a machine given the
19:17
price the larger is investment now this
19:20
is in principle in practice current cash
19:23
flows also matter a lot okay H so in the
19:27
same sense as in the case of of the
19:29
consumption function we said yeah in
19:31
principle it's only wealth that matters
19:32
but in practice there's lots of
19:34
consumers that are financially
19:35
constrained they're have to mouth and so
19:37
on so current income also matters but
19:40
for firms the same is
19:43
true
19:45
because and and and the main the main
19:47
reason for that really is Financial
19:49
frictions in the case of the firm
19:52
because a firm may arrive with a great
19:54
project to a bank but the bank may
19:57
decide that it doesn't trust as much
19:58
it's or is not as optimistic as the firm
20:00
is and so on so it may not
20:03
borrow the firm may not be able to
20:05
borrow as much as it would want given
20:07
how optimistic that particular firm is
20:09
you on its own project I may say no you
20:12
know I'm going to be more conservative
20:14
here since I'm lending you the money and
20:18
one way that firms use actually to get
20:20
around Financial constraints is simply
20:22
by
20:24
returning retaining their retaining
20:26
earnings meaning they they generate a
20:28
cash flow they save firms Save A Lot by
20:31
the
20:32
way you know companies like apple and so
20:35
on save an enormous amount and huge
20:38
deposits us treasuries and so on so
20:40
forth in the case of Apple is not to
20:43
relax Financial constraint although it
20:45
is has something to do with being
20:48
opportunistic ER having the opportunity
20:51
to buy things that are in distress but
20:53
many firms especially smaller firms have
20:56
deposits and cash flow and so on mostly
20:59
because uh if they get a good
21:01
opportunity they they may face Financial
21:03
constraint so if current activity is
21:05
high sales are high firms are going to
21:07
be less likely to be financially
21:09
constrained and that's the reason
21:11
current profits also
21:12
end now current profit is going to be an
21:15
increasing function of output over over
21:17
Capital that you
21:21
know for any given level of capital if
21:23
output goes up that's going to generate
21:25
more profit and so we can write our in
21:28
mment function a little bit like we had
21:31
in the in in in in the earlier lectures
21:34
but now we put VT here why YT and the
21:38
interest rate and interest interest and
21:40
future output and future interest rates
21:43
enter all through the ter here and again
21:46
investment here is increasing with
21:47
respect to VT and it's increasing with
21:50
respect to YT okay so that's a far more
21:52
realistic model so you go back
21:54
tolm and and and uh and put this type of
21:58
consumption function and investment
22:00
functions and they're going to make a
22:03
lot of
22:05
sense again the concept of something
22:07
persistent persistent things should
22:09
matter a lot more than temporary things
22:11
okay so naturally if if you expect
22:15
profits to remain high for a very long
22:16
period of time that machine is going to
22:18
be worth a a lot more than if you only
22:20
expect the machine to be very profitable
22:22
for only one year okay and and and and
22:25
and and so anything that's likely to be
22:28
perceived system is also likely to have
22:30
a much larger
22:33
impact there are important exceptions
22:36
but I'm not going to get into that now
22:39
and the same is true for interest rates
22:41
know if I expect if interest rat are
22:43
high today but we expect them to go down
22:45
in the near future then that's not going
22:48
to affect a lot the discounting of very
22:51
future profits but if I if I interest
22:54
rate go up today and I expect them to
22:56
remain high for a long time that's going
22:58
to affect a lot more the present value
23:00
of profits and therefore it's going to
23:02
depress investment a lot more in
23:06
fact central
23:09
banks much more than playing with the
23:11
current interest rate they play with
23:13
your minds that's what they do they they
23:15
are always telling you stories for why
23:17
interest will remain high for why you
23:19
know they don't want they want they only
23:23
control an interest rate that is is an
23:24
overnight interest rate really but they
23:27
and with that nobody cares about the
23:29
overnight rate except for some Traders
23:31
out there no but since they want to
23:34
influence aggregate demand that is they
23:36
want to influence consumption and
23:37
investment they need to convince you
23:39
that this stuff will last for some time
23:40
because otherwise it would be relevant
23:43
because if you want to reduce aggregate
23:46
demand you want to cons
23:48
convince firms and households and so on
23:51
that that the interest will remain high
23:52
for a while otherwise you're going to
23:54
get very little effect out of
23:56
that one of the pro problem s they're
23:59
having now actually you know with the
24:00
FED is trying to cool the economy is
24:03
that they keep hiking rates but the loan
24:04
rates have began to decline already
24:07
that's a problem you know they would
24:09
like you not to believe Market not to
24:11
believe that that will happen and that's
24:13
that's a that's a big
24:16
issue okay so let's think about this
24:20
islm with expectations so what we said
24:23
is you know what really we after in the
24:26
slm model remember slm model is a model
24:28
in which aggregate demand determines
24:30
output and that's what happens in the
24:31
short and the biggest components of
24:34
aggregate demand as aside from the
24:37
government which is something that moves
24:38
more or less okay different behavioral
24:41
functions we're not talking a lot about
24:43
that here but the big drivers are
24:45
consumption and investment those are at
24:47
least the private sector drivers of
24:48
aggregate demand consumption and
24:50
investment and we have said now is that
24:52
you know that H human wealth is affected
24:57
not only by current income but future
24:59
after future after Labor income future
25:02
real interest rate that affects human
25:04
wealth that affects
25:05
consumption future real dividends plus
25:09
future real interest rate affect the
25:12
value of stocks that's a very important
25:14
Financial well H future nominal interest
25:17
rate affect the price of bonds so all
25:19
these rates enter here the the price of
25:22
nominal
25:23
bonds ER for firms future after tax
25:27
profits affect expected present value
25:30
future real interest rate affect H also
25:33
this expected present value okay so
25:35
there's a lot that says future in this
25:38
column here that enters into the
25:42
consumption and investment decisions
25:44
that we care about that's what I show
25:45
you in in the previous
25:49
slides so remember the basic islm model
25:52
we wrote it this way output was
25:54
determined by agre demand and close
25:56
economy forget all that
25:58
fully sticky prices and uh and we wrote
26:02
consumption as this functions so
26:04
aggregate demand was increasing in
26:07
output and government expenditure
26:09
decreasing in taxes and decreasing on
26:11
the interest
26:12
rate so a shortcut so what I want to do
26:16
now is is give you a shortcut to
26:19
integrate this views of expectations or
26:22
the concept of expectations into this
26:24
very basic isnm model Okay so think of
26:29
now of aggregate demand rather than just
26:32
being a function of current variables be
26:34
also function of the same variables but
26:36
in the
26:37
future okay so aggregate demand is a
26:41
function as before of current output
26:44
current taxes current interest rate
26:47
current expenditure but also function
26:50
and with the same signs of future output
26:53
so it's increasing a is increasing in
26:56
expected future out output is decreasing
26:59
unexpected future taxes is decreasing in
27:02
expected future interest rate is
27:04
increasing in expected future government
27:06
expenditure although I'm not going to
27:07
play with this here because of something
27:10
very specific I'll discuss later on okay
27:14
but so that's the shortcut okay the limb
27:18
is going to be the same as before so
27:20
what I want you to think about now is a
27:22
mod that is like the one you had before
27:25
H with the same LM but now that yes is a
27:28
little bit richer it has more parameters
27:31
these are parameters because I'm going
27:33
to determine today's output uh but it's
27:36
going to be a function of more
27:37
parameters and all these parameters are
27:39
essentially the same variables that we
27:41
worry about today but are the variables
27:44
we
27:45
expect of those are the values we expect
27:47
for those variables in the future and
27:50
again with the same sign so if output so
27:53
if taxes go up
27:55
today aggregate demand will Decline and
27:57
output will decline but if I expect
28:00
future taxes to go up as well then
28:03
that's going to the price aggregate
28:04
demand even more okay that's the type of
28:06
logic I want you to devel so that's the
28:09
way our model will look so this is the
28:13
the is in the same space I had before
28:17
know interest rate and a output current
28:20
output I'm trying to determine current
28:22
output um but now I have lots of
28:25
parameters that I didn't have before
28:28
I have a you know things that shift the
28:32
yes to the left if taxes go up today
28:36
this will shift to the left do you think
28:39
it will shift to the left more or less
28:42
than it did in lecture three or
28:48
four so suppose we increase taxes by you
28:53
know 10% will that reduce output more or
28:57
less than when we have the static islm
29:00
mode yeah the expectation okay I haven't
29:04
moved these are parameters for my curve
29:06
so I I don't get the right to move
29:08
them less no less because now we said
29:12
it's not only the present that matter
29:13
it's a combination of the present and
29:15
the future so if if if I that means that
29:19
anything that is just the present will
29:21
matter less than in the in the past
29:24
otherwise you see that and suppose we
29:27
had a two period model and and I give
29:29
equal weight to the present and the and
29:31
the and the and the future then I'm
29:33
going to cut the effect of the present
29:35
in half that's I'm exaggerating there
29:38
that's more or less the logic
29:41
okay
29:43
um
29:44
so so the you you correctly said well it
29:48
depends on whether I expect the future
29:50
taxes to change or not fine that tells
29:53
you there a difference between changing
29:56
temporarily the taxes and
29:58
and and and and and increasing taxes
30:01
permanently permanently here means for
30:03
the two periods so what happens with
30:06
this curve so we decided that increasing
30:08
increasing taxes reduces this to the
30:11
left by a smaller amount than in the
30:13
past what happens if you expect taxes to
30:15
increase in the
30:20
future which wealth goes
30:23
down human wealth in particular your
30:26
human wealth will go down because you
30:27
expect your disos able income to be
30:28
taxed more in the future so that will
30:30
also shift the yes to the to the left
30:33
okay and that's the reason that if you
30:35
have a permanent expected permanent
30:37
increase in taxes today and next year
30:41
then that gets us back to the type of
30:43
shift in the yes that we had when we had
30:45
the static model okay it's the sum of
30:47
the two it's a permanent so permanent
30:49
changes will behave very similarly to
30:53
the way sort of the the the static model
30:56
work permanent
31:00
okay in a sense that model was a very
31:03
good summary of permanent changes
31:05
permanent changes in taxes permanent
31:07
changes in interest rate and so
31:09
on ER changing go on expenditure same
31:13
same idea it will also move aggregate
31:16
demand to the right
31:19
um
31:21
but will it do it by more or
31:25
less well think how government
31:27
expenditure worked in in in the basic
31:30
mod in the static model it increased
31:33
aggregate demand and that then led to
31:36
multiplier and we got a lot more income
31:38
and so on now if we expect this govern
31:41
to be temporary that multiplier also
31:43
will be a lot smaller because yes it
31:45
will increase income but people are not
31:47
going to spend all day income today that
31:49
depends on whether they expect future
31:51
income to also go up as well or not okay
31:54
and that's the reason that it is again
31:57
it us expect this going expenditure to
31:59
go up permanently and nothing else
32:01
change then you can expect income to go
32:04
up in the future as well and then you
32:06
get more or less the same effect now
32:09
that's a trick experiment because if you
32:11
and it's very Rel for today if you
32:13
govern exp goes out permanently it's
32:15
unlikely that the central bank will
32:17
remain and and move and so you also have
32:20
to start thinking well where will the
32:21
Central Bank do okay and that takes me
32:24
to this variable here okay this variable
32:29
here
32:31
so well before I discuss this variable
32:34
actually let me point out that it's not
32:37
accidental that I made this curve a lot
32:39
steeper than it used to look I mean this
32:42
looks like a pretty steep I curve which
32:45
is a way of saying that a given change
32:48
in interest rate now has a very small
32:50
effect on current
32:52
output okay much smaller than we have in
32:54
the static
32:56
model and the reason is
32:59
again this permanent investor transitory
33:02
if you expect the interest rate to
33:03
decline only for today and that's it
33:06
that's not going to have a very large
33:07
effect on consumption it's not going to
33:08
have a very large effect on on on
33:11
investment for the interest rate de
33:13
client to have a very lasting effect a
33:16
very large impact on consumption and
33:18
investment it has to affect the expected
33:20
present discounted values in a
33:21
meaningful way and for that you want
33:24
those changes to be more or less
33:25
permanent persistent that you
33:28
the private agents think that this
33:30
change in the interet will
33:31
be significant so so if they if so it
33:36
good to separate two things so if the if
33:37
the if the if the FED cuts the interest
33:40
rate but doesn't persuade anyone that
33:44
that that this rate will remain low in
33:45
the future then it will is going to get
33:47
very small effect on out however if you
33:50
convince people that that there will be
33:52
future changes that the the rates will
33:55
remain lower for a long time that means
33:58
that this is now will shift to the right
34:01
okay that's what we have
34:04
here so you have to distinguish is a
34:07
move when the FED cuts the interest rate
34:09
you get a small movement along the curve
34:11
but if the fed persuades you that this a
34:14
long lasting cut in interest rate then
34:16
they yes shift to the right and you
34:17
recover sort of the power of monetary
34:19
policy monetary policy depends a lot on
34:22
its ability to convince people that
34:25
things will remain in the direction this
34:27
they want okay if they fail there was a
34:30
famous episode in US monetary policy
34:33
during the times of Alan greensman Alan
34:35
gensman is known as one of the biggest
34:37
Central Bankers that the US has had at
34:39
least in recent
34:41
memory H he went through a period which
34:43
was called was known as the Greenspan
34:45
conu that is the economy was
34:48
overheating he kept hiking interest
34:51
rates but the long rates kept coming
34:54
coming down so he couldn't cool off the
34:56
economy there was no way around that
34:58
because they couldn't persuade the
35:00
markets that that this would be a longl
35:02
lasting effect the reason was a
35:04
different one it was not that you
35:05
couldn't persuade the market it happens
35:07
that at the same time you had china
35:08
sending massive Capital flows to the US
35:11
and so so but the point is that the FED
35:13
had couldn't move the interest rate in
35:15
the long run and and so it was very
35:17
ineffective in terms of his monetary
35:19
policy so again expectations matter
35:22
quite a
35:24
bit so let's think about our well this I
35:27
was just discussing so monetary policy
35:30
you know I should have this so you're
35:33
not going to do a lot if if unless you
35:36
persuade people that that the interest a
35:40
will remain low for quite some time and
35:42
notice that there like here this
35:46
everything comes comes into line because
35:49
if the FED convinced that the interest
35:51
rate will be lower in the future as well
35:53
then you get the yes to shift to the
35:55
right but if inter will be low in the
35:58
future that means output will be high in
36:00
the future as well which further shift
36:03
that yes to the right okay if you
36:06
convince the markets that and the
36:08
markets and cons consumers households
36:10
and so on that that you're cutting
36:12
interest rate and that with that you'll
36:13
be successful in creating a getting out
36:16
of a recession for example in the future
36:18
that also increases human wealth
36:21
expected percent value of cash flows of
36:24
of profits and so on so forth because
36:27
you you giving sort of better economic
36:29
conditions in the future again for
36:31
central banks is a lot like er it's it's
36:37
mostly about expectations management
36:39
that's the business of a central bank
36:43
really I don't know how many of you are
36:45
soccer fans but but um there was a
36:49
famous story of Marvin King Marvin King
36:51
was also one of the biggest Central
36:53
Bankers that the UK has had fairly
36:55
recent and he described he's British L
37:00
nowadays and he described um good
37:05
monetary policy very much like
37:06
maradona's go score against the
37:10
UK England in in in in in some World cap
37:13
I don't remember which
37:16
one and it's essentially Maradona picked
37:18
the ball you know in his side of the
37:20
field and he essentially RW a straight
37:23
line H to the goal and a score but but
37:27
he persu Ed everyone around to move away
37:29
from his path and that was a successful
37:30
strategy and central banks do a lot of
37:32
that lots of talking and you know at the
37:35
end of the day the true actions of
37:37
moving the interest rate are the least
37:39
important part of really the a monetary
37:41
policy
37:43
strategy fiscal policy can be quite
37:46
tricky here actually
37:48
um so we know that that you know that
37:52
the fiscal
37:53
contraction a reduction in government
37:56
expenditure ER if you just think about
37:59
the basic islm model what happens it's a
38:02
fiscal contraction you reduce go in
38:04
expenditure that will
38:07
certainly reduce
38:09
output all the slm you reduce govern
38:13
expenditure just shift the to the left
38:15
and that reduces
38:18
output when you have expectations things
38:21
are a little
38:22
trickier because it depends a lot of
38:25
what you expect the central bank to do
38:26
in the future
38:28
and it expects a lot on what you
38:31
know the private sector how the private
38:34
sector responds to that so for example
38:38
if you have a a um fiscal contraction
38:43
that leads to an anticipation of a big
38:45
cutting interest rate in the future that
38:48
may be expansionary or is it can ofset
38:51
quite a bit of the fiscal contraction
38:53
side and in fact most of the time when
38:55
you have episodes of fiscal consolid
38:58
solation H in environments that are not
39:00
of very high distress financial crisis
39:02
and so on H it typically sort of how
39:06
successful that is depends a lot on
39:08
whether people expect to be a sort of
39:10
implicit deal between the central bank
39:12
and the treasury okay if people expect
39:15
that that fiscal contraction will come
39:17
with much looser monetary policy
39:18
conditions then the fiscal contraction
39:21
is
39:22
not as contraction as could be otherwise
39:25
and if for some reason you know know the
39:27
fiscal deficit sort of the perception of
39:30
fiscal deficit was really dragging the
39:31
economy down because people didn't know
39:33
when there could be a financial crisis
39:35
in the near future and so on then you
39:38
can get a situation in which the
39:40
contraction fiscal contraction today
39:42
improves the perception of a stability
39:44
of the country in the future which in
39:46
turn may increase expected future income
39:49
and and and be expansionary
39:51
so you know most of the fiscal
39:54
contractions are contractionary but
39:56
there are some famous
39:58
of what they of called expansionary
40:01
fiscal
40:02
contractions one of the most classic
40:04
cases was known case is
40:07
Ireland in the late 80s Ireland had
40:12
massive fiscal deficit and and and all
40:14
they talk about was fiscal deficits okay
40:17
because they had very large fiscal
40:18
deficits related to GDP and and the
40:22
economy was really sort of stagnating
40:25
and going through cycles and so on and
40:27
it was all around this fiscal deficit
40:29
and so so towards the late 80s they
40:33
began a a deliberate plan
40:36
of of U of fiscal consolidation fiscal
40:39
consolidation means essentially reducing
40:41
the deficit and they were very
40:43
successful as you can see but contrary
40:46
to expectations at least output growth
40:48
did not declin actually they finally
40:50
sort of they had a very good period like
40:54
that so that's that's all it was all
40:57
about expectations notice that
40:58
unemployment though did go up okay so
41:02
despite the fact that you know you got
41:03
more unemployment and so on output began
41:06
to grow okay because firms began to
41:09
invest more consumers became more
41:12
optimistic in fact you see the house
41:13
household saving rate declined
41:15
dramatically this all consumption and
41:18
investment did that
41:21
okay consumption and investment people
41:23
consume more invested more because sort
41:26
of everything looks a lot better they
41:28
have been struggling with this for very
41:29
long and they finally they had gotten
41:32
that
41:34
behind now this example is Abus by
41:37
almost anyone that wants to cut taxes
41:39
and things like that but
41:43
but
41:48
um um no sorry by almost anyone that
41:52
wants to cut fiscal expenditure um but
41:56
there are experiences there's a whole
41:58
spectrum of experiences but in
42:00
situations that as Extreme as this
42:03
one it it clearly prove to be very
42:08
effective so that's that so let me take
42:11
a stock so so the role of this lecture
42:14
was ER to say something that I sort of
42:18
should have said earlier on but I would
42:20
have been a bit confusing so I decided
42:22
not to talk too much about it but it's
42:24
very important expectations plays play a
42:26
central role in economic
42:28
in particular H expectations influence
42:31
aggregate demand and for us this course
42:33
was a lot about aggregate demand except
42:35
for the part on growth it was a lot
42:37
about agre demand now we did talk about
42:40
expectations but we did talk about
42:42
expectations mostly in the context of
42:43
agre Supply remember when we talk about
42:46
the Philips curve we did have
42:47
expectations because weight setting was
42:49
a function of expected prices and so on
42:52
so forth so we did talk about the role
42:53
of expectation Supply very quickly uh
42:57
but I think a much bigger role is play
43:00
of expectation is really on on aggregate
43:03
demand and certainly on asset prices but
43:05
aggregate demand asset prices are
43:06
connected because agre asset pric is
43:08
about wealth and you know and and the
43:10
value of future cash flows which are
43:13
more or less the same drivers as for
43:16
investment and and and and consumption
43:19
and finally I want to say the many times
43:22
when you find sort of episodes of
43:25
fiscally even sometimes monetary policy
43:27
that are
43:29
counterintuitive is entirely due to the
43:31
the expectations part so this case of
43:33
fiscal consolation is not that the C the
43:36
cutting in fiscal
43:37
expenditure was expansionary that was
43:39
not that was contractionary but it was
43:42
overwhelmed or offset more than upset by
43:45
the out the Improvement in the
43:47
Outlook that that uh that you had and
43:51
that also happens with monetary policy
43:52
countries that have high inflation
43:54
problems and so on er er
43:58
sometimes ER get and they have to go
44:02
through dramatic tightenings and so on
44:04
yes most of them get sort of very short
44:06
lead recession but sometimes they're
44:08
very short lead recessions because
44:09
eventually sort of the the the reduction
44:12
of the in the instability caused by by
44:16
high and unstable inflation sort of ends
44:18
up dominating any direct contractional
44:21
effect of monetary
44:26
a e
— end of transcript —
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