1 00:00:16,278 --> 00:00:21,518 expectations play a huge role in 2 00:00:18,239 --> 00:00:23,479 economics so what I want to today not 3 00:00:21,518 --> 00:00:24,799 only in asset pricing I mean asset 4 00:00:23,480 --> 00:00:28,000 pricing obviously it's all about the 5 00:00:24,800 --> 00:00:31,560 future really H but but also in the kind 6 00:00:28,000 --> 00:00:34,320 of issues we have discussed ER in 7 00:00:31,559 --> 00:00:37,600 throughout the course and so that's what 8 00:00:34,320 --> 00:00:40,399 I want to do essentially is I want to uh 9 00:00:37,600 --> 00:00:43,039 give you a shortcut to think about the 10 00:00:40,399 --> 00:00:44,759 role of expectations in in the kind of 11 00:00:43,039 --> 00:00:46,280 models we have already discussed and so 12 00:00:44,759 --> 00:00:47,599 I'm going to do all that in the most 13 00:00:46,280 --> 00:00:51,239 basic mode we have discussed which is 14 00:00:47,600 --> 00:00:53,359 the eslm mod and and and I hope you 15 00:00:51,238 --> 00:00:57,799 you'll get sort of the yeast of what 16 00:00:53,359 --> 00:00:59,198 expectations can do in in economics so 17 00:00:57,799 --> 00:01:00,679 this is going to be a very compressed 18 00:00:59,198 --> 00:01:03,280 version 19 00:01:00,679 --> 00:01:06,079 adapted version of chapters 15 and 16 20 00:01:03,280 --> 00:01:09,280 but in terms of material mapping into 21 00:01:06,079 --> 00:01:12,039 the book those are the relevant chapters 22 00:01:09,280 --> 00:01:14,759 and the main idea here is that the islm 23 00:01:12,040 --> 00:01:19,118 model as we have described it up to now 24 00:01:14,759 --> 00:01:22,239 really it overweights h the present okay 25 00:01:19,118 --> 00:01:25,200 and uh and in practice expectations 26 00:01:22,239 --> 00:01:27,599 about future conditions play a big role 27 00:01:25,200 --> 00:01:29,478 in the decision of all economic actors 28 00:01:27,599 --> 00:01:31,118 we we look at you know investors as a 29 00:01:29,478 --> 00:01:34,478 pricing and so on but it's also true of 30 00:01:31,118 --> 00:01:36,560 consumers it's also true of firms I mean 31 00:01:34,478 --> 00:01:38,039 if you think about firms an investment 32 00:01:36,560 --> 00:01:40,240 decision we made a function of the 33 00:01:38,040 --> 00:01:42,159 interest rate and current output but 34 00:01:40,239 --> 00:01:43,798 it's quite clear that the reason firms 35 00:01:42,159 --> 00:01:45,280 invest is not because of the current 36 00:01:43,799 --> 00:01:47,000 condition it's because they anticipate 37 00:01:45,280 --> 00:01:49,478 making profits in the future so it's all 38 00:01:47,000 --> 00:01:51,280 about fre expectations and even 39 00:01:49,478 --> 00:01:53,280 governments and foreigners when they 40 00:01:51,280 --> 00:01:54,718 invest sort of do foreign direct 41 00:01:53,280 --> 00:01:57,159 investment they go and invest in a 42 00:01:54,718 --> 00:01:59,959 country is a lot about expectations of 43 00:01:57,159 --> 00:02:01,560 what the country will do H in in the 44 00:01:59,959 --> 00:02:04,718 future I mean political elections for 45 00:02:01,560 --> 00:02:07,240 example have huge impact on asset prices 46 00:02:04,718 --> 00:02:10,118 and so on precisely because they change 47 00:02:07,239 --> 00:02:12,878 what people think for good or for bad 48 00:02:10,118 --> 00:02:15,598 about future conditions okay so so 49 00:02:12,878 --> 00:02:18,359 expectations is just huge in economics 50 00:02:15,598 --> 00:02:20,318 so I want to do things in two steps the 51 00:02:18,360 --> 00:02:22,519 first I'm going to revisit sort of the 52 00:02:20,318 --> 00:02:24,679 the consumption function and the 53 00:02:22,519 --> 00:02:27,159 investment function now taking into 54 00:02:24,680 --> 00:02:29,439 account expectations and and motivate 55 00:02:27,159 --> 00:02:31,840 how how you should really think about 56 00:02:29,439 --> 00:02:34,878 consumption an investment in a more 57 00:02:31,840 --> 00:02:38,280 realistic mod than we have been dis 58 00:02:34,878 --> 00:02:40,518 discussing H and then I want to embed 59 00:02:38,280 --> 00:02:43,120 not the fully flesh out consumption and 60 00:02:40,519 --> 00:02:46,400 investment decisions but the flavor of 61 00:02:43,120 --> 00:02:51,120 of the role of the future into H the 62 00:02:46,400 --> 00:02:53,439 islm model okay and uh and by then sort 63 00:02:51,120 --> 00:02:55,719 of you you would have seen you will have 64 00:02:53,439 --> 00:02:58,840 seen all that I wanted to communicate at 65 00:02:55,719 --> 00:03:02,280 least in in in this set of 66 00:02:58,840 --> 00:03:05,400 lectures so let's think about first 67 00:03:02,280 --> 00:03:08,000 consumption um and 68 00:03:05,400 --> 00:03:10,560 uh up to now we assume that consumption 69 00:03:08,000 --> 00:03:14,680 depended only on disposable income you 70 00:03:10,560 --> 00:03:17,239 know on current disposable income um but 71 00:03:14,680 --> 00:03:18,640 that's not the the way it works and one 72 00:03:17,239 --> 00:03:21,560 of the first in 73 00:03:18,639 --> 00:03:24,238 formulating ER more or less formally how 74 00:03:21,560 --> 00:03:26,840 consumption decisions are really made is 75 00:03:24,239 --> 00:03:28,920 Milton fitman and he call it the 76 00:03:26,840 --> 00:03:30,840 permanent income theory of consumption 77 00:03:28,919 --> 00:03:32,679 meaning what really matters to you in a 78 00:03:30,840 --> 00:03:34,719 consumption decision is not so much at 79 00:03:32,680 --> 00:03:36,400 your current income but it's what you 80 00:03:34,719 --> 00:03:38,280 expect to get on average during your 81 00:03:36,400 --> 00:03:39,799 lifetime and and you know you don't want 82 00:03:38,280 --> 00:03:40,640 to be moving consumption up and down 83 00:03:39,799 --> 00:03:43,120 like 84 00:03:40,639 --> 00:03:44,878 crazy you know once you realize sort of 85 00:03:43,120 --> 00:03:46,438 more or less what you'll get on average 86 00:03:44,878 --> 00:03:48,560 then you should consumption should be 87 00:03:46,438 --> 00:03:51,438 related to that 88 00:03:48,560 --> 00:03:54,680 concept and and in a sense it's 89 00:03:51,438 --> 00:03:56,560 also by thinking in this in these terms 90 00:03:54,680 --> 00:03:58,400 you're also drawing a big distinction 91 00:03:56,560 --> 00:04:00,079 between things that are temporary and 92 00:03:58,400 --> 00:04:02,039 that shouldn't matter a lot for your 93 00:04:00,079 --> 00:04:04,719 consumption decisions versus things that 94 00:04:02,039 --> 00:04:06,598 are permanent that clearly have a 95 00:04:04,719 --> 00:04:08,519 potential to have a much larger impact 96 00:04:06,598 --> 00:04:09,719 on your consumption of course you can 97 00:04:08,519 --> 00:04:11,438 have temporary things that are very 98 00:04:09,719 --> 00:04:13,799 large I mean you win the lottery that's 99 00:04:11,438 --> 00:04:14,560 a huge temporary shock but probably 100 00:04:13,799 --> 00:04:15,799 you're not going to spend the whole 101 00:04:14,560 --> 00:04:17,798 Lottery right away you're going to 102 00:04:15,799 --> 00:04:21,199 smooth it over your lifetime in any 103 00:04:17,798 --> 00:04:25,079 event okay and and that actually relates 104 00:04:21,199 --> 00:04:26,400 to more or less at the same time Milton 105 00:04:25,079 --> 00:04:30,000 fredman was at 106 00:04:26,399 --> 00:04:31,679 Chicago Franco modani at MIT 107 00:04:30,000 --> 00:04:33,918 we will develop sort of the life cycle 108 00:04:31,680 --> 00:04:35,439 theory of consumption who says look even 109 00:04:33,918 --> 00:04:38,399 at the level of an 110 00:04:35,439 --> 00:04:39,759 individual the day-to-day income is not 111 00:04:38,399 --> 00:04:41,519 really what pins down the level of 112 00:04:39,759 --> 00:04:42,960 consumption because people know early on 113 00:04:41,519 --> 00:04:44,359 life that they have a lower income than 114 00:04:42,959 --> 00:04:46,758 they will have later on so they will 115 00:04:44,360 --> 00:04:49,319 tend to spend and borrow more when 116 00:04:46,759 --> 00:04:50,560 they're young then in the middle when 117 00:04:49,319 --> 00:04:52,519 they're in the middle of their life 118 00:04:50,560 --> 00:04:54,280 cycle you know before retirement they 119 00:04:52,519 --> 00:04:55,599 panic and you tend to save more so you 120 00:04:54,279 --> 00:04:57,000 don't consume all you have because you 121 00:04:55,600 --> 00:04:58,879 know that there are many years ahead of 122 00:04:57,000 --> 00:05:00,839 you where income will be lower than your 123 00:04:58,879 --> 00:05:03,600 consumption needs so there's also a 124 00:05:00,839 --> 00:05:05,478 sense of inter temporary smoothing of 125 00:05:03,600 --> 00:05:08,560 your consumption you don't follow income 126 00:05:05,478 --> 00:05:11,319 second by second you sort of try to 127 00:05:08,560 --> 00:05:13,280 stabilize consumption over time more or 128 00:05:11,319 --> 00:05:14,759 less and that means that you know you 129 00:05:13,279 --> 00:05:16,799 have to think more about your permanent 130 00:05:14,759 --> 00:05:19,600 income but you'll get on average rather 131 00:05:16,800 --> 00:05:21,400 than what you get in the short ter so 132 00:05:19,600 --> 00:05:23,840 when you start thinking about 133 00:05:21,399 --> 00:05:25,599 consumption in those terms what really 134 00:05:23,839 --> 00:05:28,439 you think well what really matters then 135 00:05:25,600 --> 00:05:30,280 is is total wealth more than income okay 136 00:05:28,439 --> 00:05:33,120 how wealthy you are will pin down more 137 00:05:30,279 --> 00:05:35,399 or less the consumption you have more 138 00:05:33,120 --> 00:05:37,038 than than your current income and there 139 00:05:35,399 --> 00:05:40,560 are two senses of 140 00:05:37,038 --> 00:05:42,759 wealth one is financial wealth okay all 141 00:05:40,560 --> 00:05:45,399 the assets you may have you may expect 142 00:05:42,759 --> 00:05:48,439 to inherit or whatever minus the debts 143 00:05:45,399 --> 00:05:49,799 you have so very much as we discussed in 144 00:05:48,439 --> 00:05:52,160 the previous lecture in the context of 145 00:05:49,800 --> 00:05:54,160 asset pricing the expected present 146 00:05:52,160 --> 00:05:56,880 discounted value of the cash flows of 147 00:05:54,160 --> 00:05:57,960 all the assets you have okay that's your 148 00:05:56,879 --> 00:06:00,079 financial 149 00:05:57,959 --> 00:06:02,680 wealth uh and that's important you have 150 00:06:00,079 --> 00:06:05,038 more financial wealth even if you have 151 00:06:02,680 --> 00:06:06,478 no income today you will probably borrow 152 00:06:05,038 --> 00:06:10,360 against that wealth to the extent that 153 00:06:06,478 --> 00:06:11,918 you can and ER and probably the banks 154 00:06:10,360 --> 00:06:14,000 will be more willing to lend to you if 155 00:06:11,918 --> 00:06:15,758 they know that you have a lot of wealth 156 00:06:14,000 --> 00:06:17,240 H and and so you're going to fund the 157 00:06:15,759 --> 00:06:18,639 consumption which is above your current 158 00:06:17,240 --> 00:06:22,319 income just because you have more 159 00:06:18,639 --> 00:06:22,319 financial wealth 160 00:06:24,038 --> 00:06:31,399 okay in fact the very rich seldom sell 161 00:06:29,038 --> 00:06:33,519 assets they borrow against those assets 162 00:06:31,399 --> 00:06:36,279 to fund consumption that's the that's 163 00:06:33,519 --> 00:06:38,439 the way sort of it works there are tax 164 00:06:36,279 --> 00:06:41,000 advantages of doing that and so on but 165 00:06:38,439 --> 00:06:43,038 but that's the way it works and the very 166 00:06:41,000 --> 00:06:45,720 rich often have no 167 00:06:43,038 --> 00:06:48,598 income at least labor income all the 168 00:06:45,720 --> 00:06:50,680 income comes from from Returns on assets 169 00:06:48,598 --> 00:06:52,719 and uh and again we mostly 170 00:06:50,680 --> 00:06:55,000 borrow but 171 00:06:52,720 --> 00:06:56,840 inent the point there is that what 172 00:06:55,000 --> 00:06:59,598 really pins out your consumption is your 173 00:06:56,839 --> 00:07:01,079 wealth not not the current flow of 174 00:06:59,598 --> 00:07:04,360 income and the other very important 175 00:07:01,079 --> 00:07:06,639 concept which is a bigger thing for most 176 00:07:04,360 --> 00:07:08,360 individuals is human wealth I mean this 177 00:07:06,639 --> 00:07:10,759 is huge for all of you 178 00:07:08,360 --> 00:07:12,319 here it's obvious that your current 179 00:07:10,759 --> 00:07:14,400 income is a lot lower than what your 180 00:07:12,319 --> 00:07:17,960 income will be in the future you have a 181 00:07:14,399 --> 00:07:19,799 lot of human capital okay and and so 182 00:07:17,959 --> 00:07:23,560 that's also concept of expected present 183 00:07:19,800 --> 00:07:25,639 discounted value is you expect to end a 184 00:07:23,560 --> 00:07:27,160 lot of income in the future and 185 00:07:25,639 --> 00:07:30,439 therefore it makes sense that this stage 186 00:07:27,160 --> 00:07:31,919 of your life you borrow now now banks 187 00:07:30,439 --> 00:07:33,839 are a little bit more reluctant of 188 00:07:31,918 --> 00:07:36,000 lending you against your human capital 189 00:07:33,839 --> 00:07:37,758 than lending you against your financial 190 00:07:36,000 --> 00:07:40,079 assets it's easier to borrow against a 191 00:07:37,759 --> 00:07:41,800 house than against your future income 192 00:07:40,079 --> 00:07:44,240 but even there probably you're going to 193 00:07:41,800 --> 00:07:45,439 sort of not going to be saving a lot on 194 00:07:44,240 --> 00:07:47,680 this time of your 195 00:07:45,439 --> 00:07:49,439 life because you know that your income 196 00:07:47,680 --> 00:07:52,000 is a lot higher in the future that's 197 00:07:49,439 --> 00:07:55,279 that we call human wealth okay and total 198 00:07:52,000 --> 00:07:57,800 wealth is just a sum of financial wealth 199 00:07:55,279 --> 00:07:59,878 plus human wealth so at its most basic 200 00:07:57,800 --> 00:08:01,280 level and those are sorry just to relate 201 00:07:59,879 --> 00:08:04,080 to things we did in the previous two 202 00:08:01,279 --> 00:08:06,000 lectures those are two expected present 203 00:08:04,079 --> 00:08:07,478 discounted value you don't know exactly 204 00:08:06,000 --> 00:08:08,759 how much income you're going to get you 205 00:08:07,478 --> 00:08:10,878 get a sense of more or less what 206 00:08:08,759 --> 00:08:12,919 somebody like you does in the future 207 00:08:10,879 --> 00:08:15,240 more or less on average and so on so you 208 00:08:12,918 --> 00:08:17,839 have a sense you have an expected cash 209 00:08:15,240 --> 00:08:19,240 flow labor income flow in the future you 210 00:08:17,839 --> 00:08:21,038 don't know what the interest rates are 211 00:08:19,240 --> 00:08:23,120 exactly so you're going to guess more or 212 00:08:21,038 --> 00:08:25,279 less what the the future interest rate 213 00:08:23,120 --> 00:08:28,000 is and that gives you a sense of human 214 00:08:25,279 --> 00:08:29,918 wealth and I know that many of these 215 00:08:28,000 --> 00:08:32,240 things you're not calculating every what 216 00:08:29,918 --> 00:08:35,319 your human wealth is and then calculate 217 00:08:32,240 --> 00:08:37,519 in general consumes 5% of that or 3.5% 218 00:08:35,320 --> 00:08:40,080 of that but you know a lot of this is 219 00:08:37,519 --> 00:08:43,639 very Behavior it's really ingraining you 220 00:08:40,080 --> 00:08:45,278 and and and uh and uh you're probably 221 00:08:43,639 --> 00:08:47,080 more likely to spend more if you think 222 00:08:45,278 --> 00:08:49,519 that you're going to be doing well in 223 00:08:47,080 --> 00:08:51,320 the future but not maybe you're too busy 224 00:08:49,519 --> 00:08:53,519 now to spend a lot but you know at some 225 00:08:51,320 --> 00:08:56,440 point when you're given the 226 00:08:53,519 --> 00:08:59,440 opportunity that that will make a 227 00:08:56,440 --> 00:09:01,360 difference Traders very successful 228 00:08:59,440 --> 00:09:03,640 Traders they get a very low income so 229 00:09:01,360 --> 00:09:04,560 essentially they live out of the income 230 00:09:03,639 --> 00:09:06,958 that they 231 00:09:04,559 --> 00:09:08,479 get they couldn't afford what they 232 00:09:06,958 --> 00:09:09,879 normally afford but they spend a lot 233 00:09:08,480 --> 00:09:11,680 more than that income because they 234 00:09:09,879 --> 00:09:13,000 expect to get a big bonus and things 235 00:09:11,679 --> 00:09:14,958 like that that's income that comes in 236 00:09:13,000 --> 00:09:17,839 the 237 00:09:14,958 --> 00:09:19,239 future so in principle your consumption 238 00:09:17,839 --> 00:09:21,880 should be something that is not 239 00:09:19,240 --> 00:09:24,399 proportional to your disposable income 240 00:09:21,879 --> 00:09:26,879 but really proportional to your wealth 241 00:09:24,399 --> 00:09:29,120 okay and there are estimates of what 242 00:09:26,879 --> 00:09:31,120 that that proportionality factor is and 243 00:09:29,120 --> 00:09:33,600 that's I said it depends on the type of 244 00:09:31,120 --> 00:09:37,480 assets we're talking about that is about 245 00:09:33,600 --> 00:09:41,040 03 that kind of thing okay 246 00:09:37,480 --> 00:09:43,200 now in reality that's just it's true 247 00:09:41,039 --> 00:09:45,759 this is a better economic concept than 248 00:09:43,200 --> 00:09:48,320 just putting income in there but in 249 00:09:45,759 --> 00:09:50,360 reality both things really matter so a 250 00:09:48,320 --> 00:09:52,800 more realistic consumption function is 251 00:09:50,360 --> 00:09:54,879 something that depends on both things 252 00:09:52,799 --> 00:09:57,240 for a variety of 253 00:09:54,879 --> 00:09:59,439 reasons that maybe we have no savings 254 00:09:57,240 --> 00:10:00,919 and really we call even them hand to 255 00:09:59,440 --> 00:10:02,399 mouth they leave by the income they're 256 00:10:00,919 --> 00:10:04,278 receiv receiving in every single period 257 00:10:02,399 --> 00:10:06,839 those those people are not thinking 258 00:10:04,278 --> 00:10:09,240 about smoothing consumption over time 259 00:10:06,839 --> 00:10:12,959 they're consuming whatever income they 260 00:10:09,240 --> 00:10:16,200 receive ER as I said before most banks 261 00:10:12,958 --> 00:10:18,039 are not likely to lend you a lot against 262 00:10:16,200 --> 00:10:20,360 your expected present discounted value 263 00:10:18,039 --> 00:10:22,439 of Labor income okay so you may be 264 00:10:20,360 --> 00:10:24,360 constrained in the short your your 265 00:10:22,440 --> 00:10:26,040 income you you think about how wealthy 266 00:10:24,360 --> 00:10:28,000 you'll be but you also think about sort 267 00:10:26,039 --> 00:10:30,078 of your flows the cash flow you're 268 00:10:28,000 --> 00:10:31,919 receiving that's also part of of your 269 00:10:30,078 --> 00:10:33,958 consideration so in reality it's a 270 00:10:31,919 --> 00:10:35,679 mixture of those two things when you 271 00:10:33,958 --> 00:10:38,039 look at the micro level at different 272 00:10:35,679 --> 00:10:40,399 individuals the composition changes the 273 00:10:38,039 --> 00:10:42,439 Richer you are the more this term 274 00:10:40,399 --> 00:10:45,559 matters the less this one matters the 275 00:10:42,440 --> 00:10:47,839 poorer you are you know this term 276 00:10:45,559 --> 00:10:50,199 overwhelms that term that's more or less 277 00:10:47,839 --> 00:10:54,360 how it works but on 278 00:10:50,200 --> 00:10:56,680 average it looks like that so you know 279 00:10:54,360 --> 00:10:58,360 we weren't wrong when we did islm and 280 00:10:56,679 --> 00:11:02,039 having the consumption function as 281 00:10:58,360 --> 00:11:03,720 increasing in in in in disposable income 282 00:11:02,039 --> 00:11:05,559 but I always told you there is a lot of 283 00:11:03,720 --> 00:11:08,000 interesting stuff hidden in that little 284 00:11:05,559 --> 00:11:09,799 CZ in the you know in that autonomous 285 00:11:08,000 --> 00:11:12,120 component of consumption well that lots 286 00:11:09,799 --> 00:11:15,278 of interesting things has a lot to do 287 00:11:12,120 --> 00:11:15,278 with wealth 288 00:11:16,759 --> 00:11:22,159 okay and again this term here is 289 00:11:20,639 --> 00:11:24,320 something that captures a lot s of 290 00:11:22,159 --> 00:11:26,480 things that are permanent well this one 291 00:11:24,320 --> 00:11:30,079 captures a lot cyclical components and 292 00:11:26,480 --> 00:11:30,079 things of that kind 293 00:11:30,360 --> 00:11:35,800 so interpreted this way you know the 294 00:11:33,519 --> 00:11:38,639 reason people during 295 00:11:35,799 --> 00:11:41,559 booms even though human wealth may not 296 00:11:38,639 --> 00:11:45,079 change much over time Financial wealth 297 00:11:41,559 --> 00:11:46,799 typically change in in a boom but it's 298 00:11:45,078 --> 00:11:48,559 also the case and in a boom you know 299 00:11:46,799 --> 00:11:51,479 wages are higher and all that and people 300 00:11:48,559 --> 00:11:53,159 tend to spend more okay even so this 301 00:11:51,480 --> 00:11:54,680 captures a lot the temporary component 302 00:11:53,159 --> 00:11:55,838 when you're in a in a boom you're going 303 00:11:54,679 --> 00:11:58,000 to like it's likely that you're going to 304 00:11:55,839 --> 00:12:00,560 consume more for any given level of 305 00:11:58,000 --> 00:12:02,958 wealth okay 306 00:12:00,559 --> 00:12:04,958 it's temporary but that's what it 307 00:12:02,958 --> 00:12:07,278 is what about 308 00:12:04,958 --> 00:12:08,719 investment that's a decision by The Firm 309 00:12:07,278 --> 00:12:10,600 how much physical capital I'm talking 310 00:12:08,720 --> 00:12:12,480 about physical investment real 311 00:12:10,600 --> 00:12:15,440 investment not Financial 312 00:12:12,480 --> 00:12:18,480 investment the decision also depend on 313 00:12:15,440 --> 00:12:20,600 current but particularly on expected 314 00:12:18,480 --> 00:12:22,159 profits and when you think about 315 00:12:20,600 --> 00:12:24,199 expected profits you need to think about 316 00:12:22,159 --> 00:12:25,679 interest rate as well we put the 317 00:12:24,198 --> 00:12:27,120 interest rate aside we say okay it's 318 00:12:25,679 --> 00:12:30,120 more expensive to borrow if the interest 319 00:12:27,120 --> 00:12:32,278 rate is high true but matters a lot more 320 00:12:30,120 --> 00:12:35,600 than just that because it matters also 321 00:12:32,278 --> 00:12:37,278 through the the the the expected present 322 00:12:35,600 --> 00:12:38,879 discounted value of your future cash 323 00:12:37,278 --> 00:12:41,120 flows the interests are very high and 324 00:12:38,879 --> 00:12:43,278 they're expect to remain very high that 325 00:12:41,120 --> 00:12:44,879 means a project that gives you lots of 326 00:12:43,278 --> 00:12:46,958 return in the future lots of cash flow 327 00:12:44,879 --> 00:12:48,600 in the future may not be worth a lot 328 00:12:46,958 --> 00:12:50,919 simply because interest rates are very 329 00:12:48,600 --> 00:12:52,680 high so the discounting of the future 330 00:12:50,919 --> 00:12:54,679 cash flows is very high in that 331 00:12:52,679 --> 00:12:56,799 environment you know Investments that 332 00:12:54,679 --> 00:12:58,958 give you return a quick return are worth 333 00:12:56,799 --> 00:13:00,759 more than things that give have a pay 334 00:12:58,958 --> 00:13:03,958 off very in the very long 335 00:13:00,759 --> 00:13:06,319 run so so the decision for example of 336 00:13:03,958 --> 00:13:06,319 buying a 337 00:13:06,360 --> 00:13:09,800 machine needs to look at the price of 338 00:13:08,360 --> 00:13:12,519 the machine right now and then 339 00:13:09,799 --> 00:13:16,359 unexpected present discounted value of 340 00:13:12,519 --> 00:13:19,399 the cash flows okay so let's think a bit 341 00:13:16,360 --> 00:13:21,480 more carefully about about that decision 342 00:13:19,399 --> 00:13:24,320 H so suppose you buy a machine for a 343 00:13:21,480 --> 00:13:26,639 price let's normalize that price to one 344 00:13:24,320 --> 00:13:28,360 the first thing you need to know is well 345 00:13:26,639 --> 00:13:30,320 how long will this machine last because 346 00:13:28,360 --> 00:13:31,759 I need to know you know for how many 347 00:13:30,320 --> 00:13:35,079 years I'm going to get a cash flow out 348 00:13:31,759 --> 00:13:38,480 of these things h and a reasonable 349 00:13:35,078 --> 00:13:39,879 assumption is is is for most machines 350 00:13:38,480 --> 00:13:42,519 it's have some sort of geometric 351 00:13:39,879 --> 00:13:45,320 depreciation so meaning you know it's 352 00:13:42,519 --> 00:13:47,480 not deterministic it's more or less 353 00:13:45,320 --> 00:13:48,839 machines break break break down 354 00:13:47,480 --> 00:13:50,920 occasionally but there's certain 355 00:13:48,839 --> 00:13:53,720 probability that they break down we 356 00:13:50,919 --> 00:13:56,198 typically call that notation in 357 00:13:53,720 --> 00:13:58,399 economics is we we refer to that as 358 00:13:56,198 --> 00:14:00,599 Delta that's the depreciation 359 00:13:58,399 --> 00:14:03,639 probability so if you think in terms of 360 00:14:00,600 --> 00:14:04,759 expected value you buy a machine today 361 00:14:03,639 --> 00:14:07,480 and you 362 00:14:04,759 --> 00:14:08,560 ask how much of a machine I'll have next 363 00:14:07,480 --> 00:14:11,399 year well it's going to be a weighted 364 00:14:08,559 --> 00:14:14,198 average of zero and one probably but on 365 00:14:11,399 --> 00:14:16,559 average it's going to be one minus Delta 366 00:14:14,198 --> 00:14:18,120 so it's a machine that Peres sort of the 367 00:14:16,559 --> 00:14:21,078 probability of the machine breaking down 368 00:14:18,120 --> 00:14:22,278 over a year is 5% then one minus Delta 369 00:14:21,078 --> 00:14:24,519 is 370 00:14:22,278 --> 00:14:26,720 095 what is the probability that machine 371 00:14:24,519 --> 00:14:29,240 is still producing two years from now 372 00:14:26,720 --> 00:14:30,720 well 1 minus Delta square and so on and 373 00:14:29,240 --> 00:14:32,879 so forth okay so that's the first thing 374 00:14:30,720 --> 00:14:34,680 you know I have this machine and it's 375 00:14:32,879 --> 00:14:38,159 likely to give me cash flows over these 376 00:14:34,679 --> 00:14:40,278 many years and so on and then I have to 377 00:14:38,159 --> 00:14:43,719 know how much I expected profits I 378 00:14:40,278 --> 00:14:45,958 expect to get in each of those years and 379 00:14:43,720 --> 00:14:47,440 then I need also to know what are the 380 00:14:45,958 --> 00:14:49,919 interest rates that are likely to 381 00:14:47,440 --> 00:14:52,360 Prevail during the lifetime of the 382 00:14:49,919 --> 00:14:54,319 machine and so on so at the end of the 383 00:14:52,360 --> 00:14:56,560 day when I calculate I do my little 384 00:14:54,320 --> 00:14:57,879 project and I need to decide whether one 385 00:14:56,559 --> 00:15:00,399 which was the price of the machine or 386 00:14:57,879 --> 00:15:02,120 not is too expensive or too cheap I need 387 00:15:00,399 --> 00:15:03,519 to compare it with the spec present 388 00:15:02,120 --> 00:15:06,879 discounted 389 00:15:03,519 --> 00:15:08,919 value that I have for that machine so 390 00:15:06,879 --> 00:15:10,958 here is an example this is a machine 391 00:15:08,919 --> 00:15:13,240 that gives the first expected cash flow 392 00:15:10,958 --> 00:15:15,518 comes next year I set it up today and I 393 00:15:13,240 --> 00:15:16,759 generate profit by the end of the the 394 00:15:15,519 --> 00:15:18,959 year or at the beginning of the next 395 00:15:16,759 --> 00:15:20,720 year thus expected profits for the first 396 00:15:18,958 --> 00:15:23,159 year of the machine which comes at the 397 00:15:20,720 --> 00:15:25,399 end of the first year is counted by an 398 00:15:23,159 --> 00:15:27,600 interest rate that I know today I know 399 00:15:25,399 --> 00:15:30,078 the interest rate for for one 400 00:15:27,600 --> 00:15:31,839 year what about the cash flow that I 401 00:15:30,078 --> 00:15:34,000 expect for two years from now well 402 00:15:31,839 --> 00:15:35,839 that's going to be that's expected cash 403 00:15:34,000 --> 00:15:38,039 flow if the M machine is working 404 00:15:35,839 --> 00:15:42,440 properly that's the probability that the 405 00:15:38,039 --> 00:15:45,240 machine last to the second year and and 406 00:15:42,440 --> 00:15:46,839 uh or or you can also assume that the 407 00:15:45,240 --> 00:15:49,480 machine sort of breaks down in little 408 00:15:46,839 --> 00:15:52,240 pieces every year you get 90 0 95 of the 409 00:15:49,480 --> 00:15:52,240 machine in second 410 00:15:53,360 --> 00:16:00,159 year 1 minus 411 00:15:56,639 --> 00:16:02,198 1.05 uh Square two years from now and so 412 00:16:00,159 --> 00:16:04,879 on so forth 413 00:16:02,198 --> 00:16:06,479 so but I also now when I think about the 414 00:16:04,879 --> 00:16:07,879 cash flow in the second year I don't 415 00:16:06,480 --> 00:16:11,639 know the interest rate for the second 416 00:16:07,879 --> 00:16:14,639 year so h i I need to have an expected 417 00:16:11,639 --> 00:16:14,639 interest rate 418 00:16:15,480 --> 00:16:20,440 here and so on so forth okay because the 419 00:16:18,480 --> 00:16:24,639 machine lasts for many many years that's 420 00:16:20,440 --> 00:16:26,880 what I get a question by the 421 00:16:24,639 --> 00:16:29,440 way I'm saying yeah I need to have 422 00:16:26,879 --> 00:16:32,879 expectations here and so on 423 00:16:29,440 --> 00:16:34,279 but the truth is that the guy that 424 00:16:32,879 --> 00:16:35,679 invests in the machine doesn't need to 425 00:16:34,278 --> 00:16:38,439 have that expectation because I could 426 00:16:35,679 --> 00:16:42,078 replace this for something that is known 427 00:16:38,440 --> 00:16:42,079 today what would that 428 00:16:48,198 --> 00:16:52,879 be I'm saying you know when I calculate 429 00:16:50,799 --> 00:16:55,278 the expected cash flow when I'm 430 00:16:52,879 --> 00:16:56,439 discounting the two years out cash flow 431 00:16:55,278 --> 00:16:59,318 I'm going to have an interest rate that 432 00:16:56,440 --> 00:17:01,519 I know the one from Time Zero to to the 433 00:16:59,318 --> 00:17:05,279 end of the first year but I don't know 434 00:17:01,519 --> 00:17:09,359 the interest rate that prevails H 435 00:17:05,279 --> 00:17:12,480 from the end of year one to the end of 436 00:17:09,359 --> 00:17:14,479 year two that's what I wrote here but I 437 00:17:12,480 --> 00:17:17,000 said but there is something in the 438 00:17:14,480 --> 00:17:19,838 market that I could look at and that I 439 00:17:17,000 --> 00:17:25,038 really know what is 440 00:17:19,838 --> 00:17:26,720 that exactly I could use one plus R2 441 00:17:25,038 --> 00:17:29,599 these are onee rates 442 00:17:26,720 --> 00:17:32,440 r2t Square 443 00:17:29,599 --> 00:17:33,839 okay so so when you have the ter 444 00:17:32,440 --> 00:17:37,038 structure when you see all the interest 445 00:17:33,839 --> 00:17:38,639 rates a a a firm deciding where invest 446 00:17:37,038 --> 00:17:41,038 on not has the interest it needs it 447 00:17:38,640 --> 00:17:42,679 doesn't need to have expectations form 448 00:17:41,038 --> 00:17:45,000 expectations about the interest rate the 449 00:17:42,679 --> 00:17:46,798 market is doing it for them now the guy 450 00:17:45,000 --> 00:17:48,359 may choose to be a Trader and decide 451 00:17:46,798 --> 00:17:51,119 that I doesn't like the interest rate 452 00:17:48,359 --> 00:17:52,519 that the market is is is pricing in but 453 00:17:51,119 --> 00:17:55,879 that's a different trade it's not the 454 00:17:52,519 --> 00:17:57,240 investment decision of the firm The Firm 455 00:17:55,880 --> 00:18:00,159 will have to make a forecast about 456 00:17:57,240 --> 00:18:03,279 expected cash flow and so on but that's 457 00:18:00,159 --> 00:18:07,280 it from the machine so on 458 00:18:03,279 --> 00:18:08,440 okay so obviously the larger disase the 459 00:18:07,279 --> 00:18:11,678 more you're going to invest the more 460 00:18:08,440 --> 00:18:13,440 machines you're going to buy and so on 461 00:18:11,679 --> 00:18:17,600 okay 462 00:18:13,440 --> 00:18:19,240 um so so in principle you know a better 463 00:18:17,599 --> 00:18:22,079 investment function we remember we wrote 464 00:18:19,240 --> 00:18:25,120 an investment function as investment a 465 00:18:22,079 --> 00:18:27,279 function of output current output which 466 00:18:25,119 --> 00:18:30,279 is said is approxim for sales and then 467 00:18:27,279 --> 00:18:32,480 the interest rate well a better concept 468 00:18:30,279 --> 00:18:34,079 is that one which does depend on 469 00:18:32,480 --> 00:18:37,319 aggregate activity depends on many 470 00:18:34,079 --> 00:18:40,839 things but not only today also the ones 471 00:18:37,319 --> 00:18:42,439 you expect for the future okay and it 472 00:18:40,839 --> 00:18:44,119 depends on the interest rate not only 473 00:18:42,440 --> 00:18:45,480 today's interest rate though also the 474 00:18:44,119 --> 00:18:50,000 interest rate of the 475 00:18:45,480 --> 00:18:51,720 future if I if I look at this expression 476 00:18:50,000 --> 00:18:53,119 you know if if even if the interest rate 477 00:18:51,720 --> 00:18:54,759 today doesn't change but I expect the 478 00:18:53,119 --> 00:18:57,119 interest rate to change in the future to 479 00:18:54,759 --> 00:18:59,679 go up that will lower the value of my 480 00:18:57,119 --> 00:19:01,959 project okay we have had no space for 481 00:18:59,679 --> 00:19:06,880 that when we posit the initial 482 00:19:01,960 --> 00:19:09,159 investment function but but here we have 483 00:19:06,880 --> 00:19:11,159 that and sorry and this is an increasing 484 00:19:09,159 --> 00:19:13,960 function of that the higher is 485 00:19:11,159 --> 00:19:17,640 V the highest expected per discounted 486 00:19:13,960 --> 00:19:20,880 value of buying a machine given the 487 00:19:17,640 --> 00:19:23,520 price the larger is investment now this 488 00:19:20,880 --> 00:19:27,600 is in principle in practice current cash 489 00:19:23,519 --> 00:19:29,000 flows also matter a lot okay H so in the 490 00:19:27,599 --> 00:19:31,119 same sense as in the case of of the 491 00:19:29,000 --> 00:19:32,880 consumption function we said yeah in 492 00:19:31,119 --> 00:19:34,599 principle it's only wealth that matters 493 00:19:32,880 --> 00:19:35,760 but in practice there's lots of 494 00:19:34,599 --> 00:19:37,599 consumers that are financially 495 00:19:35,759 --> 00:19:40,798 constrained they're have to mouth and so 496 00:19:37,599 --> 00:19:43,319 on so current income also matters but 497 00:19:40,798 --> 00:19:45,079 for firms the same is 498 00:19:43,319 --> 00:19:47,519 true 499 00:19:45,079 --> 00:19:49,279 because and and and the main the main 500 00:19:47,519 --> 00:19:52,400 reason for that really is Financial 501 00:19:49,279 --> 00:19:54,240 frictions in the case of the firm 502 00:19:52,400 --> 00:19:57,038 because a firm may arrive with a great 503 00:19:54,240 --> 00:19:58,440 project to a bank but the bank may 504 00:19:57,038 --> 00:20:00,759 decide that it doesn't trust as much 505 00:19:58,440 --> 00:20:03,400 it's or is not as optimistic as the firm 506 00:20:00,759 --> 00:20:05,440 is and so on so it may not 507 00:20:03,400 --> 00:20:07,600 borrow the firm may not be able to 508 00:20:05,440 --> 00:20:09,840 borrow as much as it would want given 509 00:20:07,599 --> 00:20:12,240 how optimistic that particular firm is 510 00:20:09,839 --> 00:20:14,240 you on its own project I may say no you 511 00:20:12,240 --> 00:20:18,038 know I'm going to be more conservative 512 00:20:14,240 --> 00:20:20,000 here since I'm lending you the money and 513 00:20:18,038 --> 00:20:22,798 one way that firms use actually to get 514 00:20:20,000 --> 00:20:24,079 around Financial constraints is simply 515 00:20:22,798 --> 00:20:26,558 by 516 00:20:24,079 --> 00:20:28,678 returning retaining their retaining 517 00:20:26,558 --> 00:20:31,759 earnings meaning they they generate a 518 00:20:28,679 --> 00:20:32,679 cash flow they save firms Save A Lot by 519 00:20:31,759 --> 00:20:35,679 the 520 00:20:32,679 --> 00:20:38,200 way you know companies like apple and so 521 00:20:35,679 --> 00:20:40,919 on save an enormous amount and huge 522 00:20:38,200 --> 00:20:43,200 deposits us treasuries and so on so 523 00:20:40,919 --> 00:20:45,159 forth in the case of Apple is not to 524 00:20:43,200 --> 00:20:48,600 relax Financial constraint although it 525 00:20:45,159 --> 00:20:51,000 is has something to do with being 526 00:20:48,599 --> 00:20:53,959 opportunistic ER having the opportunity 527 00:20:51,000 --> 00:20:56,640 to buy things that are in distress but 528 00:20:53,960 --> 00:20:59,279 many firms especially smaller firms have 529 00:20:56,640 --> 00:21:01,280 deposits and cash flow and so on mostly 530 00:20:59,279 --> 00:21:03,240 because uh if they get a good 531 00:21:01,279 --> 00:21:05,599 opportunity they they may face Financial 532 00:21:03,240 --> 00:21:07,880 constraint so if current activity is 533 00:21:05,599 --> 00:21:09,279 high sales are high firms are going to 534 00:21:07,880 --> 00:21:11,120 be less likely to be financially 535 00:21:09,279 --> 00:21:12,918 constrained and that's the reason 536 00:21:11,119 --> 00:21:15,158 current profits also 537 00:21:12,919 --> 00:21:17,880 end now current profit is going to be an 538 00:21:15,159 --> 00:21:21,360 increasing function of output over over 539 00:21:17,880 --> 00:21:23,960 Capital that you 540 00:21:21,359 --> 00:21:25,519 know for any given level of capital if 541 00:21:23,960 --> 00:21:28,600 output goes up that's going to generate 542 00:21:25,519 --> 00:21:31,440 more profit and so we can write our in 543 00:21:28,599 --> 00:21:34,879 mment function a little bit like we had 544 00:21:31,440 --> 00:21:38,320 in the in in in in the earlier lectures 545 00:21:34,880 --> 00:21:40,120 but now we put VT here why YT and the 546 00:21:38,319 --> 00:21:43,319 interest rate and interest interest and 547 00:21:40,119 --> 00:21:46,359 future output and future interest rates 548 00:21:43,319 --> 00:21:47,720 enter all through the ter here and again 549 00:21:46,359 --> 00:21:50,000 investment here is increasing with 550 00:21:47,720 --> 00:21:52,919 respect to VT and it's increasing with 551 00:21:50,000 --> 00:21:54,880 respect to YT okay so that's a far more 552 00:21:52,919 --> 00:21:58,120 realistic model so you go back 553 00:21:54,880 --> 00:22:00,559 tolm and and and uh and put this type of 554 00:21:58,119 --> 00:22:03,879 consumption function and investment 555 00:22:00,558 --> 00:22:05,200 functions and they're going to make a 556 00:22:03,880 --> 00:22:07,720 lot of 557 00:22:05,200 --> 00:22:09,519 sense again the concept of something 558 00:22:07,720 --> 00:22:11,519 persistent persistent things should 559 00:22:09,519 --> 00:22:15,038 matter a lot more than temporary things 560 00:22:11,519 --> 00:22:16,679 okay so naturally if if you expect 561 00:22:15,038 --> 00:22:18,158 profits to remain high for a very long 562 00:22:16,679 --> 00:22:20,880 period of time that machine is going to 563 00:22:18,159 --> 00:22:22,480 be worth a a lot more than if you only 564 00:22:20,880 --> 00:22:25,799 expect the machine to be very profitable 565 00:22:22,480 --> 00:22:28,200 for only one year okay and and and and 566 00:22:25,798 --> 00:22:30,480 and and so anything that's likely to be 567 00:22:28,200 --> 00:22:33,798 perceived system is also likely to have 568 00:22:30,480 --> 00:22:33,798 a much larger 569 00:22:33,880 --> 00:22:39,840 impact there are important exceptions 570 00:22:36,038 --> 00:22:41,400 but I'm not going to get into that now 571 00:22:39,839 --> 00:22:43,240 and the same is true for interest rates 572 00:22:41,400 --> 00:22:45,720 know if I expect if interest rat are 573 00:22:43,240 --> 00:22:48,319 high today but we expect them to go down 574 00:22:45,720 --> 00:22:51,200 in the near future then that's not going 575 00:22:48,319 --> 00:22:54,038 to affect a lot the discounting of very 576 00:22:51,200 --> 00:22:56,319 future profits but if I if I interest 577 00:22:54,038 --> 00:22:58,359 rate go up today and I expect them to 578 00:22:56,319 --> 00:23:00,839 remain high for a long time that's going 579 00:22:58,359 --> 00:23:02,359 to affect a lot more the present value 580 00:23:00,839 --> 00:23:06,199 of profits and therefore it's going to 581 00:23:02,359 --> 00:23:09,119 depress investment a lot more in 582 00:23:06,200 --> 00:23:11,679 fact central 583 00:23:09,119 --> 00:23:13,038 banks much more than playing with the 584 00:23:11,679 --> 00:23:15,600 current interest rate they play with 585 00:23:13,038 --> 00:23:17,200 your minds that's what they do they they 586 00:23:15,599 --> 00:23:19,359 are always telling you stories for why 587 00:23:17,200 --> 00:23:23,000 interest will remain high for why you 588 00:23:19,359 --> 00:23:24,719 know they don't want they want they only 589 00:23:23,000 --> 00:23:27,880 control an interest rate that is is an 590 00:23:24,720 --> 00:23:29,640 overnight interest rate really but they 591 00:23:27,880 --> 00:23:31,799 and with that nobody cares about the 592 00:23:29,640 --> 00:23:34,600 overnight rate except for some Traders 593 00:23:31,798 --> 00:23:36,079 out there no but since they want to 594 00:23:34,599 --> 00:23:37,359 influence aggregate demand that is they 595 00:23:36,079 --> 00:23:39,359 want to influence consumption and 596 00:23:37,359 --> 00:23:40,959 investment they need to convince you 597 00:23:39,359 --> 00:23:43,879 that this stuff will last for some time 598 00:23:40,960 --> 00:23:46,000 because otherwise it would be relevant 599 00:23:43,880 --> 00:23:48,440 because if you want to reduce aggregate 600 00:23:46,000 --> 00:23:51,200 demand you want to cons 601 00:23:48,440 --> 00:23:52,919 convince firms and households and so on 602 00:23:51,200 --> 00:23:54,759 that that the interest will remain high 603 00:23:52,919 --> 00:23:56,840 for a while otherwise you're going to 604 00:23:54,759 --> 00:23:59,200 get very little effect out of 605 00:23:56,839 --> 00:24:00,918 that one of the pro problem s they're 606 00:23:59,200 --> 00:24:03,038 having now actually you know with the 607 00:24:00,919 --> 00:24:04,640 FED is trying to cool the economy is 608 00:24:03,038 --> 00:24:07,278 that they keep hiking rates but the loan 609 00:24:04,640 --> 00:24:09,278 rates have began to decline already 610 00:24:07,278 --> 00:24:11,839 that's a problem you know they would 611 00:24:09,278 --> 00:24:13,720 like you not to believe Market not to 612 00:24:11,839 --> 00:24:16,079 believe that that will happen and that's 613 00:24:13,720 --> 00:24:20,798 that's a that's a big 614 00:24:16,079 --> 00:24:23,158 issue okay so let's think about this 615 00:24:20,798 --> 00:24:26,158 islm with expectations so what we said 616 00:24:23,159 --> 00:24:28,640 is you know what really we after in the 617 00:24:26,159 --> 00:24:30,120 slm model remember slm model is a model 618 00:24:28,640 --> 00:24:31,919 in which aggregate demand determines 619 00:24:30,119 --> 00:24:34,038 output and that's what happens in the 620 00:24:31,919 --> 00:24:37,000 short and the biggest components of 621 00:24:34,038 --> 00:24:38,440 aggregate demand as aside from the 622 00:24:37,000 --> 00:24:41,960 government which is something that moves 623 00:24:38,440 --> 00:24:43,399 more or less okay different behavioral 624 00:24:41,960 --> 00:24:45,440 functions we're not talking a lot about 625 00:24:43,398 --> 00:24:47,000 that here but the big drivers are 626 00:24:45,440 --> 00:24:48,960 consumption and investment those are at 627 00:24:47,000 --> 00:24:50,480 least the private sector drivers of 628 00:24:48,960 --> 00:24:52,679 aggregate demand consumption and 629 00:24:50,480 --> 00:24:57,278 investment and we have said now is that 630 00:24:52,679 --> 00:24:59,600 you know that H human wealth is affected 631 00:24:57,278 --> 00:25:02,200 not only by current income but future 632 00:24:59,599 --> 00:25:04,359 after future after Labor income future 633 00:25:02,200 --> 00:25:05,798 real interest rate that affects human 634 00:25:04,359 --> 00:25:09,199 wealth that affects 635 00:25:05,798 --> 00:25:12,319 consumption future real dividends plus 636 00:25:09,200 --> 00:25:14,038 future real interest rate affect the 637 00:25:12,319 --> 00:25:17,319 value of stocks that's a very important 638 00:25:14,038 --> 00:25:19,240 Financial well H future nominal interest 639 00:25:17,319 --> 00:25:22,038 rate affect the price of bonds so all 640 00:25:19,240 --> 00:25:23,759 these rates enter here the the price of 641 00:25:22,038 --> 00:25:27,319 nominal 642 00:25:23,759 --> 00:25:30,079 bonds ER for firms future after tax 643 00:25:27,319 --> 00:25:33,439 profits affect expected present value 644 00:25:30,079 --> 00:25:35,439 future real interest rate affect H also 645 00:25:33,440 --> 00:25:38,159 this expected present value okay so 646 00:25:35,440 --> 00:25:42,278 there's a lot that says future in this 647 00:25:38,159 --> 00:25:44,039 column here that enters into the 648 00:25:42,278 --> 00:25:45,720 consumption and investment decisions 649 00:25:44,038 --> 00:25:49,240 that we care about that's what I show 650 00:25:45,720 --> 00:25:49,240 you in in the previous 651 00:25:49,398 --> 00:25:54,759 slides so remember the basic islm model 652 00:25:52,880 --> 00:25:56,880 we wrote it this way output was 653 00:25:54,759 --> 00:25:58,879 determined by agre demand and close 654 00:25:56,880 --> 00:26:02,200 economy forget all that 655 00:25:58,880 --> 00:26:04,440 fully sticky prices and uh and we wrote 656 00:26:02,200 --> 00:26:07,120 consumption as this functions so 657 00:26:04,440 --> 00:26:09,399 aggregate demand was increasing in 658 00:26:07,119 --> 00:26:11,239 output and government expenditure 659 00:26:09,398 --> 00:26:12,879 decreasing in taxes and decreasing on 660 00:26:11,240 --> 00:26:16,200 the interest 661 00:26:12,880 --> 00:26:19,278 rate so a shortcut so what I want to do 662 00:26:16,200 --> 00:26:22,319 now is is give you a shortcut to 663 00:26:19,278 --> 00:26:24,720 integrate this views of expectations or 664 00:26:22,319 --> 00:26:29,278 the concept of expectations into this 665 00:26:24,720 --> 00:26:32,038 very basic isnm model Okay so think of 666 00:26:29,278 --> 00:26:34,519 now of aggregate demand rather than just 667 00:26:32,038 --> 00:26:36,679 being a function of current variables be 668 00:26:34,519 --> 00:26:37,879 also function of the same variables but 669 00:26:36,679 --> 00:26:41,919 in the 670 00:26:37,880 --> 00:26:44,600 future okay so aggregate demand is a 671 00:26:41,919 --> 00:26:47,159 function as before of current output 672 00:26:44,599 --> 00:26:50,359 current taxes current interest rate 673 00:26:47,159 --> 00:26:53,640 current expenditure but also function 674 00:26:50,359 --> 00:26:56,918 and with the same signs of future output 675 00:26:53,640 --> 00:26:59,720 so it's increasing a is increasing in 676 00:26:56,919 --> 00:27:02,600 expected future out output is decreasing 677 00:26:59,720 --> 00:27:04,319 unexpected future taxes is decreasing in 678 00:27:02,599 --> 00:27:06,599 expected future interest rate is 679 00:27:04,319 --> 00:27:07,759 increasing in expected future government 680 00:27:06,599 --> 00:27:10,599 expenditure although I'm not going to 681 00:27:07,759 --> 00:27:14,480 play with this here because of something 682 00:27:10,599 --> 00:27:18,639 very specific I'll discuss later on okay 683 00:27:14,480 --> 00:27:20,839 but so that's the shortcut okay the limb 684 00:27:18,640 --> 00:27:22,679 is going to be the same as before so 685 00:27:20,839 --> 00:27:25,720 what I want you to think about now is a 686 00:27:22,679 --> 00:27:28,679 mod that is like the one you had before 687 00:27:25,720 --> 00:27:31,558 H with the same LM but now that yes is a 688 00:27:28,679 --> 00:27:33,240 little bit richer it has more parameters 689 00:27:31,558 --> 00:27:36,720 these are parameters because I'm going 690 00:27:33,240 --> 00:27:37,919 to determine today's output uh but it's 691 00:27:36,720 --> 00:27:39,480 going to be a function of more 692 00:27:37,919 --> 00:27:41,519 parameters and all these parameters are 693 00:27:39,480 --> 00:27:44,159 essentially the same variables that we 694 00:27:41,519 --> 00:27:45,000 worry about today but are the variables 695 00:27:44,159 --> 00:27:47,679 we 696 00:27:45,000 --> 00:27:50,000 expect of those are the values we expect 697 00:27:47,679 --> 00:27:53,278 for those variables in the future and 698 00:27:50,000 --> 00:27:55,240 again with the same sign so if output so 699 00:27:53,278 --> 00:27:57,759 if taxes go up 700 00:27:55,240 --> 00:28:00,558 today aggregate demand will Decline and 701 00:27:57,759 --> 00:28:03,278 output will decline but if I expect 702 00:28:00,558 --> 00:28:04,319 future taxes to go up as well then 703 00:28:03,278 --> 00:28:06,359 that's going to the price aggregate 704 00:28:04,319 --> 00:28:09,599 demand even more okay that's the type of 705 00:28:06,359 --> 00:28:13,519 logic I want you to devel so that's the 706 00:28:09,599 --> 00:28:17,038 way our model will look so this is the 707 00:28:13,519 --> 00:28:20,278 the is in the same space I had before 708 00:28:17,038 --> 00:28:22,119 know interest rate and a output current 709 00:28:20,278 --> 00:28:25,038 output I'm trying to determine current 710 00:28:22,119 --> 00:28:28,319 output um but now I have lots of 711 00:28:25,038 --> 00:28:32,919 parameters that I didn't have before 712 00:28:28,319 --> 00:28:36,079 I have a you know things that shift the 713 00:28:32,919 --> 00:28:39,519 yes to the left if taxes go up today 714 00:28:36,079 --> 00:28:42,199 this will shift to the left do you think 715 00:28:39,519 --> 00:28:45,798 it will shift to the left more or less 716 00:28:42,200 --> 00:28:45,798 than it did in lecture three or 717 00:28:48,880 --> 00:28:57,320 four so suppose we increase taxes by you 718 00:28:53,278 --> 00:29:00,720 know 10% will that reduce output more or 719 00:28:57,319 --> 00:29:04,839 less than when we have the static islm 720 00:29:00,720 --> 00:29:06,360 mode yeah the expectation okay I haven't 721 00:29:04,839 --> 00:29:08,558 moved these are parameters for my curve 722 00:29:06,359 --> 00:29:12,119 so I I don't get the right to move 723 00:29:08,558 --> 00:29:13,599 them less no less because now we said 724 00:29:12,119 --> 00:29:15,000 it's not only the present that matter 725 00:29:13,599 --> 00:29:19,480 it's a combination of the present and 726 00:29:15,000 --> 00:29:21,278 the future so if if if I that means that 727 00:29:19,480 --> 00:29:24,399 anything that is just the present will 728 00:29:21,278 --> 00:29:27,119 matter less than in the in the past 729 00:29:24,398 --> 00:29:29,239 otherwise you see that and suppose we 730 00:29:27,119 --> 00:29:31,000 had a two period model and and I give 731 00:29:29,240 --> 00:29:33,240 equal weight to the present and the and 732 00:29:31,000 --> 00:29:35,398 the and the and the future then I'm 733 00:29:33,240 --> 00:29:38,480 going to cut the effect of the present 734 00:29:35,398 --> 00:29:41,558 in half that's I'm exaggerating there 735 00:29:38,480 --> 00:29:43,079 that's more or less the logic 736 00:29:41,558 --> 00:29:44,798 okay 737 00:29:43,079 --> 00:29:48,398 um 738 00:29:44,798 --> 00:29:50,240 so so the you you correctly said well it 739 00:29:48,398 --> 00:29:53,439 depends on whether I expect the future 740 00:29:50,240 --> 00:29:56,000 taxes to change or not fine that tells 741 00:29:53,440 --> 00:29:58,558 you there a difference between changing 742 00:29:56,000 --> 00:30:01,278 temporarily the taxes and 743 00:29:58,558 --> 00:30:03,398 and and and and and increasing taxes 744 00:30:01,278 --> 00:30:06,359 permanently permanently here means for 745 00:30:03,398 --> 00:30:08,798 the two periods so what happens with 746 00:30:06,359 --> 00:30:11,079 this curve so we decided that increasing 747 00:30:08,798 --> 00:30:13,359 increasing taxes reduces this to the 748 00:30:11,079 --> 00:30:15,639 left by a smaller amount than in the 749 00:30:13,359 --> 00:30:18,158 past what happens if you expect taxes to 750 00:30:15,640 --> 00:30:18,159 increase in the 751 00:30:20,038 --> 00:30:26,000 future which wealth goes 752 00:30:23,000 --> 00:30:27,359 down human wealth in particular your 753 00:30:26,000 --> 00:30:28,720 human wealth will go down because you 754 00:30:27,359 --> 00:30:30,879 expect your disos able income to be 755 00:30:28,720 --> 00:30:33,798 taxed more in the future so that will 756 00:30:30,880 --> 00:30:35,440 also shift the yes to the to the left 757 00:30:33,798 --> 00:30:37,480 okay and that's the reason that if you 758 00:30:35,440 --> 00:30:41,278 have a permanent expected permanent 759 00:30:37,480 --> 00:30:43,720 increase in taxes today and next year 760 00:30:41,278 --> 00:30:45,440 then that gets us back to the type of 761 00:30:43,720 --> 00:30:47,240 shift in the yes that we had when we had 762 00:30:45,440 --> 00:30:49,919 the static model okay it's the sum of 763 00:30:47,240 --> 00:30:53,519 the two it's a permanent so permanent 764 00:30:49,919 --> 00:30:56,919 changes will behave very similarly to 765 00:30:53,519 --> 00:31:00,480 the way sort of the the the static model 766 00:30:56,919 --> 00:31:03,080 work permanent 767 00:31:00,480 --> 00:31:05,480 okay in a sense that model was a very 768 00:31:03,079 --> 00:31:07,158 good summary of permanent changes 769 00:31:05,480 --> 00:31:09,679 permanent changes in taxes permanent 770 00:31:07,159 --> 00:31:13,480 changes in interest rate and so 771 00:31:09,679 --> 00:31:16,038 on ER changing go on expenditure same 772 00:31:13,480 --> 00:31:19,000 same idea it will also move aggregate 773 00:31:16,038 --> 00:31:21,759 demand to the right 774 00:31:19,000 --> 00:31:25,519 um 775 00:31:21,759 --> 00:31:27,440 but will it do it by more or 776 00:31:25,519 --> 00:31:30,480 less well think how government 777 00:31:27,440 --> 00:31:33,798 expenditure worked in in in the basic 778 00:31:30,480 --> 00:31:36,000 mod in the static model it increased 779 00:31:33,798 --> 00:31:38,158 aggregate demand and that then led to 780 00:31:36,000 --> 00:31:41,519 multiplier and we got a lot more income 781 00:31:38,159 --> 00:31:43,919 and so on now if we expect this govern 782 00:31:41,519 --> 00:31:45,638 to be temporary that multiplier also 783 00:31:43,919 --> 00:31:47,679 will be a lot smaller because yes it 784 00:31:45,638 --> 00:31:49,599 will increase income but people are not 785 00:31:47,679 --> 00:31:51,080 going to spend all day income today that 786 00:31:49,599 --> 00:31:54,199 depends on whether they expect future 787 00:31:51,079 --> 00:31:57,439 income to also go up as well or not okay 788 00:31:54,200 --> 00:31:59,480 and that's the reason that it is again 789 00:31:57,440 --> 00:32:01,798 it us expect this going expenditure to 790 00:31:59,480 --> 00:32:04,599 go up permanently and nothing else 791 00:32:01,798 --> 00:32:06,720 change then you can expect income to go 792 00:32:04,599 --> 00:32:09,319 up in the future as well and then you 793 00:32:06,720 --> 00:32:11,639 get more or less the same effect now 794 00:32:09,319 --> 00:32:13,200 that's a trick experiment because if you 795 00:32:11,638 --> 00:32:15,959 and it's very Rel for today if you 796 00:32:13,200 --> 00:32:17,519 govern exp goes out permanently it's 797 00:32:15,960 --> 00:32:20,079 unlikely that the central bank will 798 00:32:17,519 --> 00:32:21,679 remain and and move and so you also have 799 00:32:20,079 --> 00:32:24,319 to start thinking well where will the 800 00:32:21,679 --> 00:32:29,000 Central Bank do okay and that takes me 801 00:32:24,319 --> 00:32:31,879 to this variable here okay this variable 802 00:32:29,000 --> 00:32:34,398 here 803 00:32:31,880 --> 00:32:37,278 so well before I discuss this variable 804 00:32:34,398 --> 00:32:39,959 actually let me point out that it's not 805 00:32:37,278 --> 00:32:42,240 accidental that I made this curve a lot 806 00:32:39,960 --> 00:32:45,038 steeper than it used to look I mean this 807 00:32:42,240 --> 00:32:48,638 looks like a pretty steep I curve which 808 00:32:45,038 --> 00:32:50,359 is a way of saying that a given change 809 00:32:48,638 --> 00:32:52,278 in interest rate now has a very small 810 00:32:50,359 --> 00:32:54,879 effect on current 811 00:32:52,278 --> 00:32:56,839 output okay much smaller than we have in 812 00:32:54,880 --> 00:32:59,360 the static 813 00:32:56,839 --> 00:33:02,158 model and the reason is 814 00:32:59,359 --> 00:33:03,199 again this permanent investor transitory 815 00:33:02,159 --> 00:33:06,000 if you expect the interest rate to 816 00:33:03,200 --> 00:33:07,319 decline only for today and that's it 817 00:33:06,000 --> 00:33:08,839 that's not going to have a very large 818 00:33:07,319 --> 00:33:11,519 effect on consumption it's not going to 819 00:33:08,839 --> 00:33:13,558 have a very large effect on on on 820 00:33:11,519 --> 00:33:16,000 investment for the interest rate de 821 00:33:13,558 --> 00:33:18,079 client to have a very lasting effect a 822 00:33:16,000 --> 00:33:20,558 very large impact on consumption and 823 00:33:18,079 --> 00:33:21,918 investment it has to affect the expected 824 00:33:20,558 --> 00:33:24,638 present discounted values in a 825 00:33:21,919 --> 00:33:25,919 meaningful way and for that you want 826 00:33:24,638 --> 00:33:28,678 those changes to be more or less 827 00:33:25,919 --> 00:33:30,278 permanent persistent that you 828 00:33:28,679 --> 00:33:31,919 the private agents think that this 829 00:33:30,278 --> 00:33:36,000 change in the interet will 830 00:33:31,919 --> 00:33:37,759 be significant so so if they if so it 831 00:33:36,000 --> 00:33:40,240 good to separate two things so if the if 832 00:33:37,759 --> 00:33:44,000 the if the if the FED cuts the interest 833 00:33:40,240 --> 00:33:45,759 rate but doesn't persuade anyone that 834 00:33:44,000 --> 00:33:47,519 that that this rate will remain low in 835 00:33:45,759 --> 00:33:50,278 the future then it will is going to get 836 00:33:47,519 --> 00:33:52,880 very small effect on out however if you 837 00:33:50,278 --> 00:33:55,919 convince people that that there will be 838 00:33:52,880 --> 00:33:58,600 future changes that the the rates will 839 00:33:55,919 --> 00:34:01,600 remain lower for a long time that means 840 00:33:58,599 --> 00:34:04,759 that this is now will shift to the right 841 00:34:01,599 --> 00:34:04,759 okay that's what we have 842 00:34:04,880 --> 00:34:09,280 here so you have to distinguish is a 843 00:34:07,398 --> 00:34:11,598 move when the FED cuts the interest rate 844 00:34:09,280 --> 00:34:14,000 you get a small movement along the curve 845 00:34:11,599 --> 00:34:16,079 but if the fed persuades you that this a 846 00:34:14,000 --> 00:34:17,918 long lasting cut in interest rate then 847 00:34:16,079 --> 00:34:19,560 they yes shift to the right and you 848 00:34:17,918 --> 00:34:22,719 recover sort of the power of monetary 849 00:34:19,559 --> 00:34:25,639 policy monetary policy depends a lot on 850 00:34:22,719 --> 00:34:27,759 its ability to convince people that 851 00:34:25,639 --> 00:34:30,519 things will remain in the direction this 852 00:34:27,760 --> 00:34:33,119 they want okay if they fail there was a 853 00:34:30,519 --> 00:34:35,239 famous episode in US monetary policy 854 00:34:33,119 --> 00:34:37,358 during the times of Alan greensman Alan 855 00:34:35,239 --> 00:34:39,638 gensman is known as one of the biggest 856 00:34:37,358 --> 00:34:41,039 Central Bankers that the US has had at 857 00:34:39,639 --> 00:34:43,720 least in recent 858 00:34:41,039 --> 00:34:45,759 memory H he went through a period which 859 00:34:43,719 --> 00:34:48,199 was called was known as the Greenspan 860 00:34:45,760 --> 00:34:51,000 conu that is the economy was 861 00:34:48,199 --> 00:34:54,158 overheating he kept hiking interest 862 00:34:51,000 --> 00:34:56,159 rates but the long rates kept coming 863 00:34:54,159 --> 00:34:58,320 coming down so he couldn't cool off the 864 00:34:56,159 --> 00:35:00,400 economy there was no way around that 865 00:34:58,320 --> 00:35:02,838 because they couldn't persuade the 866 00:35:00,400 --> 00:35:04,599 markets that that this would be a longl 867 00:35:02,838 --> 00:35:05,759 lasting effect the reason was a 868 00:35:04,599 --> 00:35:07,079 different one it was not that you 869 00:35:05,760 --> 00:35:08,599 couldn't persuade the market it happens 870 00:35:07,079 --> 00:35:11,519 that at the same time you had china 871 00:35:08,599 --> 00:35:13,480 sending massive Capital flows to the US 872 00:35:11,519 --> 00:35:15,039 and so so but the point is that the FED 873 00:35:13,480 --> 00:35:17,240 had couldn't move the interest rate in 874 00:35:15,039 --> 00:35:19,239 the long run and and so it was very 875 00:35:17,239 --> 00:35:22,799 ineffective in terms of his monetary 876 00:35:19,239 --> 00:35:24,799 policy so again expectations matter 877 00:35:22,800 --> 00:35:27,880 quite a 878 00:35:24,800 --> 00:35:30,920 bit so let's think about our well this I 879 00:35:27,880 --> 00:35:33,880 was just discussing so monetary policy 880 00:35:30,920 --> 00:35:36,838 you know I should have this so you're 881 00:35:33,880 --> 00:35:40,000 not going to do a lot if if unless you 882 00:35:36,838 --> 00:35:42,679 persuade people that that the interest a 883 00:35:40,000 --> 00:35:46,039 will remain low for quite some time and 884 00:35:42,679 --> 00:35:49,039 notice that there like here this 885 00:35:46,039 --> 00:35:51,199 everything comes comes into line because 886 00:35:49,039 --> 00:35:53,559 if the FED convinced that the interest 887 00:35:51,199 --> 00:35:55,559 rate will be lower in the future as well 888 00:35:53,559 --> 00:35:58,159 then you get the yes to shift to the 889 00:35:55,559 --> 00:36:00,400 right but if inter will be low in the 890 00:35:58,159 --> 00:36:03,399 future that means output will be high in 891 00:36:00,400 --> 00:36:06,318 the future as well which further shift 892 00:36:03,400 --> 00:36:08,039 that yes to the right okay if you 893 00:36:06,318 --> 00:36:10,519 convince the markets that and the 894 00:36:08,039 --> 00:36:12,400 markets and cons consumers households 895 00:36:10,519 --> 00:36:13,920 and so on that that you're cutting 896 00:36:12,400 --> 00:36:16,680 interest rate and that with that you'll 897 00:36:13,920 --> 00:36:18,720 be successful in creating a getting out 898 00:36:16,679 --> 00:36:21,838 of a recession for example in the future 899 00:36:18,719 --> 00:36:24,519 that also increases human wealth 900 00:36:21,838 --> 00:36:27,078 expected percent value of cash flows of 901 00:36:24,519 --> 00:36:29,199 of profits and so on so forth because 902 00:36:27,079 --> 00:36:31,640 you you giving sort of better economic 903 00:36:29,199 --> 00:36:37,318 conditions in the future again for 904 00:36:31,639 --> 00:36:39,960 central banks is a lot like er it's it's 905 00:36:37,318 --> 00:36:43,079 mostly about expectations management 906 00:36:39,960 --> 00:36:45,039 that's the business of a central bank 907 00:36:43,079 --> 00:36:49,119 really I don't know how many of you are 908 00:36:45,039 --> 00:36:51,679 soccer fans but but um there was a 909 00:36:49,119 --> 00:36:53,240 famous story of Marvin King Marvin King 910 00:36:51,679 --> 00:36:55,799 was also one of the biggest Central 911 00:36:53,239 --> 00:37:00,639 Bankers that the UK has had fairly 912 00:36:55,800 --> 00:37:05,039 recent and he described he's British L 913 00:37:00,639 --> 00:37:06,920 nowadays and he described um good 914 00:37:05,039 --> 00:37:10,279 monetary policy very much like 915 00:37:06,920 --> 00:37:13,880 maradona's go score against the 916 00:37:10,280 --> 00:37:16,079 UK England in in in in in some World cap 917 00:37:13,880 --> 00:37:18,640 I don't remember which 918 00:37:16,079 --> 00:37:20,519 one and it's essentially Maradona picked 919 00:37:18,639 --> 00:37:23,480 the ball you know in his side of the 920 00:37:20,519 --> 00:37:27,079 field and he essentially RW a straight 921 00:37:23,480 --> 00:37:29,000 line H to the goal and a score but but 922 00:37:27,079 --> 00:37:30,880 he persu Ed everyone around to move away 923 00:37:29,000 --> 00:37:32,960 from his path and that was a successful 924 00:37:30,880 --> 00:37:35,760 strategy and central banks do a lot of 925 00:37:32,960 --> 00:37:37,318 that lots of talking and you know at the 926 00:37:35,760 --> 00:37:39,040 end of the day the true actions of 927 00:37:37,318 --> 00:37:41,719 moving the interest rate are the least 928 00:37:39,039 --> 00:37:43,759 important part of really the a monetary 929 00:37:41,719 --> 00:37:46,239 policy 930 00:37:43,760 --> 00:37:48,680 strategy fiscal policy can be quite 931 00:37:46,239 --> 00:37:52,159 tricky here actually 932 00:37:48,679 --> 00:37:53,480 um so we know that that you know that 933 00:37:52,159 --> 00:37:56,239 the fiscal 934 00:37:53,480 --> 00:37:59,039 contraction a reduction in government 935 00:37:56,239 --> 00:38:02,519 expenditure ER if you just think about 936 00:37:59,039 --> 00:38:04,719 the basic islm model what happens it's a 937 00:38:02,519 --> 00:38:07,039 fiscal contraction you reduce go in 938 00:38:04,719 --> 00:38:09,519 expenditure that will 939 00:38:07,039 --> 00:38:13,119 certainly reduce 940 00:38:09,519 --> 00:38:15,960 output all the slm you reduce govern 941 00:38:13,119 --> 00:38:18,800 expenditure just shift the to the left 942 00:38:15,960 --> 00:38:21,199 and that reduces 943 00:38:18,800 --> 00:38:22,400 output when you have expectations things 944 00:38:21,199 --> 00:38:25,239 are a little 945 00:38:22,400 --> 00:38:26,960 trickier because it depends a lot of 946 00:38:25,239 --> 00:38:28,159 what you expect the central bank to do 947 00:38:26,960 --> 00:38:31,838 in the future 948 00:38:28,159 --> 00:38:34,519 and it expects a lot on what you 949 00:38:31,838 --> 00:38:38,880 know the private sector how the private 950 00:38:34,519 --> 00:38:43,559 sector responds to that so for example 951 00:38:38,880 --> 00:38:45,400 if you have a a um fiscal contraction 952 00:38:43,559 --> 00:38:48,519 that leads to an anticipation of a big 953 00:38:45,400 --> 00:38:51,079 cutting interest rate in the future that 954 00:38:48,519 --> 00:38:53,039 may be expansionary or is it can ofset 955 00:38:51,079 --> 00:38:55,079 quite a bit of the fiscal contraction 956 00:38:53,039 --> 00:38:58,039 side and in fact most of the time when 957 00:38:55,079 --> 00:39:00,519 you have episodes of fiscal consolid 958 00:38:58,039 --> 00:39:02,719 solation H in environments that are not 959 00:39:00,519 --> 00:39:06,480 of very high distress financial crisis 960 00:39:02,719 --> 00:39:08,118 and so on H it typically sort of how 961 00:39:06,480 --> 00:39:10,318 successful that is depends a lot on 962 00:39:08,119 --> 00:39:12,519 whether people expect to be a sort of 963 00:39:10,318 --> 00:39:15,358 implicit deal between the central bank 964 00:39:12,519 --> 00:39:17,159 and the treasury okay if people expect 965 00:39:15,358 --> 00:39:18,759 that that fiscal contraction will come 966 00:39:17,159 --> 00:39:21,399 with much looser monetary policy 967 00:39:18,760 --> 00:39:22,079 conditions then the fiscal contraction 968 00:39:21,400 --> 00:39:25,680 is 969 00:39:22,079 --> 00:39:27,960 not as contraction as could be otherwise 970 00:39:25,679 --> 00:39:30,118 and if for some reason you know know the 971 00:39:27,960 --> 00:39:31,760 fiscal deficit sort of the perception of 972 00:39:30,119 --> 00:39:33,920 fiscal deficit was really dragging the 973 00:39:31,760 --> 00:39:35,599 economy down because people didn't know 974 00:39:33,920 --> 00:39:38,599 when there could be a financial crisis 975 00:39:35,599 --> 00:39:40,079 in the near future and so on then you 976 00:39:38,599 --> 00:39:42,440 can get a situation in which the 977 00:39:40,079 --> 00:39:44,800 contraction fiscal contraction today 978 00:39:42,440 --> 00:39:46,920 improves the perception of a stability 979 00:39:44,800 --> 00:39:49,519 of the country in the future which in 980 00:39:46,920 --> 00:39:51,480 turn may increase expected future income 981 00:39:49,519 --> 00:39:54,318 and and and be expansionary 982 00:39:51,480 --> 00:39:56,440 so you know most of the fiscal 983 00:39:54,318 --> 00:39:58,199 contractions are contractionary but 984 00:39:56,440 --> 00:40:01,039 there are some famous 985 00:39:58,199 --> 00:40:02,879 of what they of called expansionary 986 00:40:01,039 --> 00:40:04,920 fiscal 987 00:40:02,880 --> 00:40:07,960 contractions one of the most classic 988 00:40:04,920 --> 00:40:12,318 cases was known case is 989 00:40:07,960 --> 00:40:14,838 Ireland in the late 80s Ireland had 990 00:40:12,318 --> 00:40:17,079 massive fiscal deficit and and and all 991 00:40:14,838 --> 00:40:18,960 they talk about was fiscal deficits okay 992 00:40:17,079 --> 00:40:22,318 because they had very large fiscal 993 00:40:18,960 --> 00:40:25,358 deficits related to GDP and and the 994 00:40:22,318 --> 00:40:27,838 economy was really sort of stagnating 995 00:40:25,358 --> 00:40:29,759 and going through cycles and so on and 996 00:40:27,838 --> 00:40:33,000 it was all around this fiscal deficit 997 00:40:29,760 --> 00:40:36,040 and so so towards the late 80s they 998 00:40:33,000 --> 00:40:39,920 began a a deliberate plan 999 00:40:36,039 --> 00:40:41,519 of of U of fiscal consolidation fiscal 1000 00:40:39,920 --> 00:40:43,280 consolidation means essentially reducing 1001 00:40:41,519 --> 00:40:46,000 the deficit and they were very 1002 00:40:43,280 --> 00:40:48,560 successful as you can see but contrary 1003 00:40:46,000 --> 00:40:50,800 to expectations at least output growth 1004 00:40:48,559 --> 00:40:54,358 did not declin actually they finally 1005 00:40:50,800 --> 00:40:57,039 sort of they had a very good period like 1006 00:40:54,358 --> 00:40:58,880 that so that's that's all it was all 1007 00:40:57,039 --> 00:41:02,159 about expectations notice that 1008 00:40:58,880 --> 00:41:03,800 unemployment though did go up okay so 1009 00:41:02,159 --> 00:41:06,399 despite the fact that you know you got 1010 00:41:03,800 --> 00:41:09,800 more unemployment and so on output began 1011 00:41:06,400 --> 00:41:12,119 to grow okay because firms began to 1012 00:41:09,800 --> 00:41:13,960 invest more consumers became more 1013 00:41:12,119 --> 00:41:15,920 optimistic in fact you see the house 1014 00:41:13,960 --> 00:41:18,960 household saving rate declined 1015 00:41:15,920 --> 00:41:21,280 dramatically this all consumption and 1016 00:41:18,960 --> 00:41:23,559 investment did that 1017 00:41:21,280 --> 00:41:26,040 okay consumption and investment people 1018 00:41:23,559 --> 00:41:28,159 consume more invested more because sort 1019 00:41:26,039 --> 00:41:29,599 of everything looks a lot better they 1020 00:41:28,159 --> 00:41:32,879 have been struggling with this for very 1021 00:41:29,599 --> 00:41:34,480 long and they finally they had gotten 1022 00:41:32,880 --> 00:41:37,519 that 1023 00:41:34,480 --> 00:41:39,519 behind now this example is Abus by 1024 00:41:37,519 --> 00:41:43,199 almost anyone that wants to cut taxes 1025 00:41:39,519 --> 00:41:46,199 and things like that but 1026 00:41:43,199 --> 00:41:46,199 but 1027 00:41:48,159 --> 00:41:56,159 um um no sorry by almost anyone that 1028 00:41:52,000 --> 00:41:58,559 wants to cut fiscal expenditure um but 1029 00:41:56,159 --> 00:42:00,358 there are experiences there's a whole 1030 00:41:58,559 --> 00:42:03,880 spectrum of experiences but in 1031 00:42:00,358 --> 00:42:08,440 situations that as Extreme as this 1032 00:42:03,880 --> 00:42:11,318 one it it clearly prove to be very 1033 00:42:08,440 --> 00:42:14,760 effective so that's that so let me take 1034 00:42:11,318 --> 00:42:18,960 a stock so so the role of this lecture 1035 00:42:14,760 --> 00:42:20,319 was ER to say something that I sort of 1036 00:42:18,960 --> 00:42:22,440 should have said earlier on but I would 1037 00:42:20,318 --> 00:42:24,079 have been a bit confusing so I decided 1038 00:42:22,440 --> 00:42:26,159 not to talk too much about it but it's 1039 00:42:24,079 --> 00:42:28,519 very important expectations plays play a 1040 00:42:26,159 --> 00:42:31,759 central role in economic 1041 00:42:28,519 --> 00:42:33,559 in particular H expectations influence 1042 00:42:31,760 --> 00:42:35,160 aggregate demand and for us this course 1043 00:42:33,559 --> 00:42:37,960 was a lot about aggregate demand except 1044 00:42:35,159 --> 00:42:40,358 for the part on growth it was a lot 1045 00:42:37,960 --> 00:42:42,318 about agre demand now we did talk about 1046 00:42:40,358 --> 00:42:43,838 expectations but we did talk about 1047 00:42:42,318 --> 00:42:46,000 expectations mostly in the context of 1048 00:42:43,838 --> 00:42:47,719 agre Supply remember when we talk about 1049 00:42:46,000 --> 00:42:49,760 the Philips curve we did have 1050 00:42:47,719 --> 00:42:52,078 expectations because weight setting was 1051 00:42:49,760 --> 00:42:53,920 a function of expected prices and so on 1052 00:42:52,079 --> 00:42:57,680 so forth so we did talk about the role 1053 00:42:53,920 --> 00:43:00,800 of expectation Supply very quickly uh 1054 00:42:57,679 --> 00:43:03,000 but I think a much bigger role is play 1055 00:43:00,800 --> 00:43:05,280 of expectation is really on on aggregate 1056 00:43:03,000 --> 00:43:06,440 demand and certainly on asset prices but 1057 00:43:05,280 --> 00:43:08,359 aggregate demand asset prices are 1058 00:43:06,440 --> 00:43:10,838 connected because agre asset pric is 1059 00:43:08,358 --> 00:43:13,239 about wealth and you know and and the 1060 00:43:10,838 --> 00:43:16,119 value of future cash flows which are 1061 00:43:13,239 --> 00:43:19,679 more or less the same drivers as for 1062 00:43:16,119 --> 00:43:22,280 investment and and and and consumption 1063 00:43:19,679 --> 00:43:25,519 and finally I want to say the many times 1064 00:43:22,280 --> 00:43:27,519 when you find sort of episodes of 1065 00:43:25,519 --> 00:43:29,000 fiscally even sometimes monetary policy 1066 00:43:27,519 --> 00:43:31,759 that are 1067 00:43:29,000 --> 00:43:33,599 counterintuitive is entirely due to the 1068 00:43:31,760 --> 00:43:36,119 the expectations part so this case of 1069 00:43:33,599 --> 00:43:37,559 fiscal consolation is not that the C the 1070 00:43:36,119 --> 00:43:39,760 cutting in fiscal 1071 00:43:37,559 --> 00:43:42,000 expenditure was expansionary that was 1072 00:43:39,760 --> 00:43:45,680 not that was contractionary but it was 1073 00:43:42,000 --> 00:43:47,960 overwhelmed or offset more than upset by 1074 00:43:45,679 --> 00:43:51,000 the out the Improvement in the 1075 00:43:47,960 --> 00:43:52,760 Outlook that that uh that you had and 1076 00:43:51,000 --> 00:43:54,920 that also happens with monetary policy 1077 00:43:52,760 --> 00:43:58,559 countries that have high inflation 1078 00:43:54,920 --> 00:44:02,358 problems and so on er er 1079 00:43:58,559 --> 00:44:04,800 sometimes ER get and they have to go 1080 00:44:02,358 --> 00:44:06,880 through dramatic tightenings and so on 1081 00:44:04,800 --> 00:44:08,119 yes most of them get sort of very short 1082 00:44:06,880 --> 00:44:09,480 lead recession but sometimes they're 1083 00:44:08,119 --> 00:44:12,640 very short lead recessions because 1084 00:44:09,480 --> 00:44:16,039 eventually sort of the the the reduction 1085 00:44:12,639 --> 00:44:18,838 of the in the instability caused by by 1086 00:44:16,039 --> 00:44:21,519 high and unstable inflation sort of ends 1087 00:44:18,838 --> 00:44:25,159 up dominating any direct contractional 1088 00:44:21,519 --> 00:44:25,159 effect of monetary 1089 00:44:26,039 --> 00:44:30,079 a e