[00:16] expectations play a huge role in
[00:18] economics so what I want to today not
[00:21] only in asset pricing I mean asset
[00:23] pricing obviously it's all about the
[00:24] future really H but but also in the kind
[00:28] of issues we have discussed ER in
[00:31] throughout the course and so that's what
[00:34] I want to do essentially is I want to uh
[00:37] give you a shortcut to think about the
[00:40] role of expectations in in the kind of
[00:43] models we have already discussed and so
[00:44] I'm going to do all that in the most
[00:46] basic mode we have discussed which is
[00:47] the eslm mod and and and I hope you
[00:51] you'll get sort of the yeast of what
[00:53] expectations can do in in economics so
[00:57] this is going to be a very compressed
[00:59] version
[01:00] adapted version of chapters 15 and 16
[01:03] but in terms of material mapping into
[01:06] the book those are the relevant chapters
[01:09] and the main idea here is that the islm
[01:12] model as we have described it up to now
[01:14] really it overweights h the present okay
[01:19] and uh and in practice expectations
[01:22] about future conditions play a big role
[01:25] in the decision of all economic actors
[01:27] we we look at you know investors as a
[01:29] pricing and so on but it's also true of
[01:31] consumers it's also true of firms I mean
[01:34] if you think about firms an investment
[01:36] decision we made a function of the
[01:38] interest rate and current output but
[01:40] it's quite clear that the reason firms
[01:42] invest is not because of the current
[01:43] condition it's because they anticipate
[01:45] making profits in the future so it's all
[01:47] about fre expectations and even
[01:49] governments and foreigners when they
[01:51] invest sort of do foreign direct
[01:53] investment they go and invest in a
[01:54] country is a lot about expectations of
[01:57] what the country will do H in in the
[01:59] future I mean political elections for
[02:01] example have huge impact on asset prices
[02:04] and so on precisely because they change
[02:07] what people think for good or for bad
[02:10] about future conditions okay so so
[02:12] expectations is just huge in economics
[02:15] so I want to do things in two steps the
[02:18] first I'm going to revisit sort of the
[02:20] the consumption function and the
[02:22] investment function now taking into
[02:24] account expectations and and motivate
[02:27] how how you should really think about
[02:29] consumption an investment in a more
[02:31] realistic mod than we have been dis
[02:34] discussing H and then I want to embed
[02:38] not the fully flesh out consumption and
[02:40] investment decisions but the flavor of
[02:43] of the role of the future into H the
[02:46] islm model okay and uh and by then sort
[02:51] of you you would have seen you will have
[02:53] seen all that I wanted to communicate at
[02:55] least in in in this set of
[02:58] lectures so let's think about first
[03:02] consumption um and
[03:05] uh up to now we assume that consumption
[03:08] depended only on disposable income you
[03:10] know on current disposable income um but
[03:14] that's not the the way it works and one
[03:17] of the first in
[03:18] formulating ER more or less formally how
[03:21] consumption decisions are really made is
[03:24] Milton fitman and he call it the
[03:26] permanent income theory of consumption
[03:28] meaning what really matters to you in a
[03:30] consumption decision is not so much at
[03:32] your current income but it's what you
[03:34] expect to get on average during your
[03:36] lifetime and and you know you don't want
[03:38] to be moving consumption up and down
[03:39] like
[03:40] crazy you know once you realize sort of
[03:43] more or less what you'll get on average
[03:44] then you should consumption should be
[03:46] related to that
[03:48] concept and and in a sense it's
[03:51] also by thinking in this in these terms
[03:54] you're also drawing a big distinction
[03:56] between things that are temporary and
[03:58] that shouldn't matter a lot for your
[04:00] consumption decisions versus things that
[04:02] are permanent that clearly have a
[04:04] potential to have a much larger impact
[04:06] on your consumption of course you can
[04:08] have temporary things that are very
[04:09] large I mean you win the lottery that's
[04:11] a huge temporary shock but probably
[04:13] you're not going to spend the whole
[04:14] Lottery right away you're going to
[04:15] smooth it over your lifetime in any
[04:17] event okay and and that actually relates
[04:21] to more or less at the same time Milton
[04:25] fredman was at
[04:26] Chicago Franco modani at MIT
[04:30] we will develop sort of the life cycle
[04:31] theory of consumption who says look even
[04:33] at the level of an
[04:35] individual the day-to-day income is not
[04:38] really what pins down the level of
[04:39] consumption because people know early on
[04:41] life that they have a lower income than
[04:42] they will have later on so they will
[04:44] tend to spend and borrow more when
[04:46] they're young then in the middle when
[04:49] they're in the middle of their life
[04:50] cycle you know before retirement they
[04:52] panic and you tend to save more so you
[04:54] don't consume all you have because you
[04:55] know that there are many years ahead of
[04:57] you where income will be lower than your
[04:58] consumption needs so there's also a
[05:00] sense of inter temporary smoothing of
[05:03] your consumption you don't follow income
[05:05] second by second you sort of try to
[05:08] stabilize consumption over time more or
[05:11] less and that means that you know you
[05:13] have to think more about your permanent
[05:14] income but you'll get on average rather
[05:16] than what you get in the short ter so
[05:19] when you start thinking about
[05:21] consumption in those terms what really
[05:23] you think well what really matters then
[05:25] is is total wealth more than income okay
[05:28] how wealthy you are will pin down more
[05:30] or less the consumption you have more
[05:33] than than your current income and there
[05:35] are two senses of
[05:37] wealth one is financial wealth okay all
[05:40] the assets you may have you may expect
[05:42] to inherit or whatever minus the debts
[05:45] you have so very much as we discussed in
[05:48] the previous lecture in the context of
[05:49] asset pricing the expected present
[05:52] discounted value of the cash flows of
[05:54] all the assets you have okay that's your
[05:56] financial
[05:57] wealth uh and that's important you have
[06:00] more financial wealth even if you have
[06:02] no income today you will probably borrow
[06:05] against that wealth to the extent that
[06:06] you can and ER and probably the banks
[06:10] will be more willing to lend to you if
[06:11] they know that you have a lot of wealth
[06:14] H and and so you're going to fund the
[06:15] consumption which is above your current
[06:17] income just because you have more
[06:18] financial wealth
[06:24] okay in fact the very rich seldom sell
[06:29] assets they borrow against those assets
[06:31] to fund consumption that's the that's
[06:33] the way sort of it works there are tax
[06:36] advantages of doing that and so on but
[06:38] but that's the way it works and the very
[06:41] rich often have no
[06:43] income at least labor income all the
[06:45] income comes from from Returns on assets
[06:48] and uh and again we mostly
[06:50] borrow but
[06:52] inent the point there is that what
[06:55] really pins out your consumption is your
[06:56] wealth not not the current flow of
[06:59] income and the other very important
[07:01] concept which is a bigger thing for most
[07:04] individuals is human wealth I mean this
[07:06] is huge for all of you
[07:08] here it's obvious that your current
[07:10] income is a lot lower than what your
[07:12] income will be in the future you have a
[07:14] lot of human capital okay and and so
[07:17] that's also concept of expected present
[07:19] discounted value is you expect to end a
[07:23] lot of income in the future and
[07:25] therefore it makes sense that this stage
[07:27] of your life you borrow now now banks
[07:30] are a little bit more reluctant of
[07:31] lending you against your human capital
[07:33] than lending you against your financial
[07:36] assets it's easier to borrow against a
[07:37] house than against your future income
[07:40] but even there probably you're going to
[07:41] sort of not going to be saving a lot on
[07:44] this time of your
[07:45] life because you know that your income
[07:47] is a lot higher in the future that's
[07:49] that we call human wealth okay and total
[07:52] wealth is just a sum of financial wealth
[07:55] plus human wealth so at its most basic
[07:57] level and those are sorry just to relate
[07:59] to things we did in the previous two
[08:01] lectures those are two expected present
[08:04] discounted value you don't know exactly
[08:06] how much income you're going to get you
[08:07] get a sense of more or less what
[08:08] somebody like you does in the future
[08:10] more or less on average and so on so you
[08:12] have a sense you have an expected cash
[08:15] flow labor income flow in the future you
[08:17] don't know what the interest rates are
[08:19] exactly so you're going to guess more or
[08:21] less what the the future interest rate
[08:23] is and that gives you a sense of human
[08:25] wealth and I know that many of these
[08:28] things you're not calculating every what
[08:29] your human wealth is and then calculate
[08:32] in general consumes 5% of that or 3.5%
[08:35] of that but you know a lot of this is
[08:37] very Behavior it's really ingraining you
[08:40] and and and uh and uh you're probably
[08:43] more likely to spend more if you think
[08:45] that you're going to be doing well in
[08:47] the future but not maybe you're too busy
[08:49] now to spend a lot but you know at some
[08:51] point when you're given the
[08:53] opportunity that that will make a
[08:56] difference Traders very successful
[08:59] Traders they get a very low income so
[09:01] essentially they live out of the income
[09:03] that they
[09:04] get they couldn't afford what they
[09:06] normally afford but they spend a lot
[09:08] more than that income because they
[09:09] expect to get a big bonus and things
[09:11] like that that's income that comes in
[09:13] the
[09:14] future so in principle your consumption
[09:17] should be something that is not
[09:19] proportional to your disposable income
[09:21] but really proportional to your wealth
[09:24] okay and there are estimates of what
[09:26] that that proportionality factor is and
[09:29] that's I said it depends on the type of
[09:31] assets we're talking about that is about
[09:33] 03 that kind of thing okay
[09:37] now in reality that's just it's true
[09:41] this is a better economic concept than
[09:43] just putting income in there but in
[09:45] reality both things really matter so a
[09:48] more realistic consumption function is
[09:50] something that depends on both things
[09:52] for a variety of
[09:54] reasons that maybe we have no savings
[09:57] and really we call even them hand to
[09:59] 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