WEBVTT

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expectations play a huge role in

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economics so what I want to today not

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only in asset pricing I mean asset

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pricing obviously it's all about the

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future really H but but also in the kind

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of issues we have discussed ER in

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throughout the course and so that's what

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I want to do essentially is I want to uh

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give you a shortcut to think about the

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role of expectations in in the kind of

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models we have already discussed and so

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I'm going to do all that in the most

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basic mode we have discussed which is

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the eslm mod and and and I hope you

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you'll get sort of the yeast of what

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expectations can do in in economics so

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this is going to be a very compressed

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version

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adapted version of chapters 15 and 16

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but in terms of material mapping into

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the book those are the relevant chapters

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and the main idea here is that the islm

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model as we have described it up to now

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really it overweights h the present okay

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and uh and in practice expectations

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about future conditions play a big role

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in the decision of all economic actors

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we we look at you know investors as a

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pricing and so on but it's also true of

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consumers it's also true of firms I mean

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if you think about firms an investment

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decision we made a function of the

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interest rate and current output but

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it's quite clear that the reason firms

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invest is not because of the current

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condition it's because they anticipate

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making profits in the future so it's all

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about fre expectations and even

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governments and foreigners when they

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invest sort of do foreign direct

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investment they go and invest in a

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country is a lot about expectations of

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what the country will do H in in the

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future I mean political elections for

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example have huge impact on asset prices

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and so on precisely because they change

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what people think for good or for bad

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about future conditions okay so so

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expectations is just huge in economics

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so I want to do things in two steps the

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first I'm going to revisit sort of the

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the consumption function and the

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investment function now taking into

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account expectations and and motivate

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how how you should really think about

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consumption an investment in a more

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realistic mod than we have been dis

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discussing H and then I want to embed

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not the fully flesh out consumption and

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investment decisions but the flavor of

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of the role of the future into H the

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islm model okay and uh and by then sort

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of you you would have seen you will have

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seen all that I wanted to communicate at

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least in in in this set of

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lectures so let's think about first

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consumption um and

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uh up to now we assume that consumption

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depended only on disposable income you

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know on current disposable income um but

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that's not the the way it works and one

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of the first in

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formulating ER more or less formally how

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consumption decisions are really made is

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Milton fitman and he call it the

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permanent income theory of consumption

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meaning what really matters to you in a

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consumption decision is not so much at

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your current income but it's what you

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expect to get on average during your

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lifetime and and you know you don't want

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to be moving consumption up and down

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like

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crazy you know once you realize sort of

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more or less what you'll get on average

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then you should consumption should be

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related to that

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concept and and in a sense it's

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also by thinking in this in these terms

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you're also drawing a big distinction

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between things that are temporary and

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that shouldn't matter a lot for your

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consumption decisions versus things that

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are permanent that clearly have a

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potential to have a much larger impact

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on your consumption of course you can

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have temporary things that are very

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large I mean you win the lottery that's

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a huge temporary shock but probably

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you're not going to spend the whole

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Lottery right away you're going to

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smooth it over your lifetime in any

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event okay and and that actually relates

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to more or less at the same time Milton

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fredman was at

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Chicago Franco modani at MIT

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we will develop sort of the life cycle

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theory of consumption who says look even

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at the level of an

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individual the day-to-day income is not

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really what pins down the level of

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consumption because people know early on

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life that they have a lower income than

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they will have later on so they will

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tend to spend and borrow more when

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they're young then in the middle when

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they're in the middle of their life

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cycle you know before retirement they

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panic and you tend to save more so you

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don't consume all you have because you

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know that there are many years ahead of

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you where income will be lower than your

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consumption needs so there's also a

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sense of inter temporary smoothing of

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your consumption you don't follow income

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second by second you sort of try to

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stabilize consumption over time more or

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less and that means that you know you

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have to think more about your permanent

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income but you'll get on average rather

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than what you get in the short ter so

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when you start thinking about

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consumption in those terms what really

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you think well what really matters then

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is is total wealth more than income okay

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how wealthy you are will pin down more

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or less the consumption you have more

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than than your current income and there

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are two senses of

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wealth one is financial wealth okay all

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the assets you may have you may expect

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to inherit or whatever minus the debts

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you have so very much as we discussed in

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the previous lecture in the context of

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asset pricing the expected present

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discounted value of the cash flows of

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all the assets you have okay that's your

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financial

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wealth uh and that's important you have

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more financial wealth even if you have

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no income today you will probably borrow

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against that wealth to the extent that

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you can and ER and probably the banks

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will be more willing to lend to you if

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they know that you have a lot of wealth

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H and and so you're going to fund the

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consumption which is above your current

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income just because you have more

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financial wealth

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okay in fact the very rich seldom sell

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assets they borrow against those assets

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to fund consumption that's the that's

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the way sort of it works there are tax

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advantages of doing that and so on but

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but that's the way it works and the very

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rich often have no

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income at least labor income all the

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income comes from from Returns on assets

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and uh and again we mostly

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borrow but

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inent the point there is that what

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really pins out your consumption is your

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wealth not not the current flow of

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income and the other very important

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concept which is a bigger thing for most

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individuals is human wealth I mean this

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is huge for all of you

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here it's obvious that your current

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income is a lot lower than what your

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income will be in the future you have a

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lot of human capital okay and and so

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that's also concept of expected present

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discounted value is you expect to end a

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lot of income in the future and

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therefore it makes sense that this stage

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of your life you borrow now now banks

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are a little bit more reluctant of

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lending you against your human capital

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than lending you against your financial

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assets it's easier to borrow against a

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house than against your future income

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but even there probably you're going to

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sort of not going to be saving a lot on

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this time of your

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life because you know that your income

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is a lot higher in the future that's

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that we call human wealth okay and total

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wealth is just a sum of financial wealth

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plus human wealth so at its most basic

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level and those are sorry just to relate

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to things we did in the previous two

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lectures those are two expected present

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discounted value you don't know exactly

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how much income you're going to get you

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get a sense of more or less what

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somebody like you does in the future

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more or less on average and so on so you

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have a sense you have an expected cash

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flow labor income flow in the future you

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don't know what the interest rates are

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exactly so you're going to guess more or

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less what the the future interest rate

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is and that gives you a sense of human

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wealth and I know that many of these

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things you're not calculating every what

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your human wealth is and then calculate

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in general consumes 5% of that or 3.5%

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of that but you know a lot of this is

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very Behavior it's really ingraining you

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and and and uh and uh you're probably

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more likely to spend more if you think

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that you're going to be doing well in

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the future but not maybe you're too busy

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now to spend a lot but you know at some

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point when you're given the

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opportunity that that will make a

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difference Traders very successful

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Traders they get a very low income so

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essentially they live out of the income

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that they

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get they couldn't afford what they

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normally afford but they spend a lot

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more than that income because they

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expect to get a big bonus and things

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like that that's income that comes in

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the

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future so in principle your consumption

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should be something that is not

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proportional to your disposable income

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but really proportional to your wealth

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okay and there are estimates of what

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that that proportionality factor is and

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that's I said it depends on the type of

00:09:31.120 --> 00:09:37.480
assets we're talking about that is about

00:09:33.600 --> 00:09:41.040
03 that kind of thing okay

00:09:37.480 --> 00:09:43.200
now in reality that's just it's true

00:09:41.039 --> 00:09:45.759
this is a better economic concept than

00:09:43.200 --> 00:09:48.320
just putting income in there but in

00:09:45.759 --> 00:09:50.360
reality both things really matter so a

00:09:48.320 --> 00:09:52.800
more realistic consumption function is

00:09:50.360 --> 00:09:54.879
something that depends on both things

00:09:52.799 --> 00:09:57.240
for a variety of

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reasons that maybe we have no savings

00:09:57.240 --> 00:10:00.919
and really we call even them hand to

00:09:59.440 --> 00:10:02.399
mouth they leave by the income they're

00:10:00.919 --> 00:10:04.278
receiv receiving in every single period

00:10:02.399 --> 00:10:06.839
those those people are not thinking

00:10:04.278 --> 00:10:09.240
about smoothing consumption over time

00:10:06.839 --> 00:10:12.959
they're consuming whatever income they

00:10:09.240 --> 00:10:16.200
receive ER as I said before most banks

00:10:12.958 --> 00:10:18.039
are not likely to lend you a lot against

00:10:16.200 --> 00:10:20.360
your expected present discounted value

00:10:18.039 --> 00:10:22.439
of Labor income okay so you may be

00:10:20.360 --> 00:10:24.360
constrained in the short your your

00:10:22.440 --> 00:10:26.040
income you you think about how wealthy

00:10:24.360 --> 00:10:28.000
you'll be but you also think about sort

00:10:26.039 --> 00:10:30.078
of your flows the cash flow you're

00:10:28.000 --> 00:10:31.919
receiving that's also part of of your

00:10:30.078 --> 00:10:33.958
consideration so in reality it's a

00:10:31.919 --> 00:10:35.679
mixture of those two things when you

00:10:33.958 --> 00:10:38.039
look at the micro level at different

00:10:35.679 --> 00:10:40.399
individuals the composition changes the

00:10:38.039 --> 00:10:42.439
Richer you are the more this term

00:10:40.399 --> 00:10:45.559
matters the less this one matters the

00:10:42.440 --> 00:10:47.839
poorer you are you know this term

00:10:45.559 --> 00:10:50.199
overwhelms that term that's more or less

00:10:47.839 --> 00:10:54.360
how it works but on

00:10:50.200 --> 00:10:56.680
average it looks like that so you know

00:10:54.360 --> 00:10:58.360
we weren't wrong when we did islm and

00:10:56.679 --> 00:11:02.039
having the consumption function as

00:10:58.360 --> 00:11:03.720
increasing in in in in disposable income

00:11:02.039 --> 00:11:05.559
but I always told you there is a lot of

00:11:03.720 --> 00:11:08.000
interesting stuff hidden in that little

00:11:05.559 --> 00:11:09.799
CZ in the you know in that autonomous

00:11:08.000 --> 00:11:12.120
component of consumption well that lots

00:11:09.799 --> 00:11:15.278
of interesting things has a lot to do

00:11:12.120 --> 00:11:15.278
with wealth

00:11:16.759 --> 00:11:22.159
okay and again this term here is

00:11:20.639 --> 00:11:24.320
something that captures a lot s of

00:11:22.159 --> 00:11:26.480
things that are permanent well this one

00:11:24.320 --> 00:11:30.079
captures a lot cyclical components and

00:11:26.480 --> 00:11:30.079
things of that kind

00:11:30.360 --> 00:11:35.800
so interpreted this way you know the

00:11:33.519 --> 00:11:38.639
reason people during

00:11:35.799 --> 00:11:41.559
booms even though human wealth may not

00:11:38.639 --> 00:11:45.079
change much over time Financial wealth

00:11:41.559 --> 00:11:46.799
typically change in in a boom but it's

00:11:45.078 --> 00:11:48.559
also the case and in a boom you know

00:11:46.799 --> 00:11:51.479
wages are higher and all that and people

00:11:48.559 --> 00:11:53.159
tend to spend more okay even so this

00:11:51.480 --> 00:11:54.680
captures a lot the temporary component

00:11:53.159 --> 00:11:55.838
when you're in a in a boom you're going

00:11:54.679 --> 00:11:58.000
to like it's likely that you're going to

00:11:55.839 --> 00:12:00.560
consume more for any given level of

00:11:58.000 --> 00:12:02.958
wealth okay

00:12:00.559 --> 00:12:04.958
it's temporary but that's what it

00:12:02.958 --> 00:12:07.278
is what about

00:12:04.958 --> 00:12:08.719
investment that's a decision by The Firm

00:12:07.278 --> 00:12:10.600
how much physical capital I'm talking

00:12:08.720 --> 00:12:12.480
about physical investment real

00:12:10.600 --> 00:12:15.440
investment not Financial

00:12:12.480 --> 00:12:18.480
investment the decision also depend on

00:12:15.440 --> 00:12:20.600
current but particularly on expected

00:12:18.480 --> 00:12:22.159
profits and when you think about

00:12:20.600 --> 00:12:24.199
expected profits you need to think about

00:12:22.159 --> 00:12:25.679
interest rate as well we put the

00:12:24.198 --> 00:12:27.120
interest rate aside we say okay it's

00:12:25.679 --> 00:12:30.120
more expensive to borrow if the interest

00:12:27.120 --> 00:12:32.278
rate is high true but matters a lot more

00:12:30.120 --> 00:12:35.600
than just that because it matters also

00:12:32.278 --> 00:12:37.278
through the the the the expected present

00:12:35.600 --> 00:12:38.879
discounted value of your future cash

00:12:37.278 --> 00:12:41.120
flows the interests are very high and

00:12:38.879 --> 00:12:43.278
they're expect to remain very high that

00:12:41.120 --> 00:12:44.879
means a project that gives you lots of

00:12:43.278 --> 00:12:46.958
return in the future lots of cash flow

00:12:44.879 --> 00:12:48.600
in the future may not be worth a lot

00:12:46.958 --> 00:12:50.919
simply because interest rates are very

00:12:48.600 --> 00:12:52.680
high so the discounting of the future

00:12:50.919 --> 00:12:54.679
cash flows is very high in that

00:12:52.679 --> 00:12:56.799
environment you know Investments that

00:12:54.679 --> 00:12:58.958
give you return a quick return are worth

00:12:56.799 --> 00:13:00.759
more than things that give have a pay

00:12:58.958 --> 00:13:03.958
off very in the very long

00:13:00.759 --> 00:13:06.319
run so so the decision for example of

00:13:03.958 --> 00:13:06.319
buying a

00:13:06.360 --> 00:13:09.800
machine needs to look at the price of

00:13:08.360 --> 00:13:12.519
the machine right now and then

00:13:09.799 --> 00:13:16.359
unexpected present discounted value of

00:13:12.519 --> 00:13:19.399
the cash flows okay so let's think a bit

00:13:16.360 --> 00:13:21.480
more carefully about about that decision

00:13:19.399 --> 00:13:24.320
H so suppose you buy a machine for a

00:13:21.480 --> 00:13:26.639
price let's normalize that price to one

00:13:24.320 --> 00:13:28.360
the first thing you need to know is well

00:13:26.639 --> 00:13:30.320
how long will this machine last because

00:13:28.360 --> 00:13:31.759
I need to know you know for how many

00:13:30.320 --> 00:13:35.079
years I'm going to get a cash flow out

00:13:31.759 --> 00:13:38.480
of these things h and a reasonable

00:13:35.078 --> 00:13:39.879
assumption is is is for most machines

00:13:38.480 --> 00:13:42.519
it's have some sort of geometric

00:13:39.879 --> 00:13:45.320
depreciation so meaning you know it's

00:13:42.519 --> 00:13:47.480
not deterministic it's more or less

00:13:45.320 --> 00:13:48.839
machines break break break down

00:13:47.480 --> 00:13:50.920
occasionally but there's certain

00:13:48.839 --> 00:13:53.720
probability that they break down we

00:13:50.919 --> 00:13:56.198
typically call that notation in

00:13:53.720 --> 00:13:58.399
economics is we we refer to that as

00:13:56.198 --> 00:14:00.599
Delta that's the depreciation

00:13:58.399 --> 00:14:03.639
probability so if you think in terms of

00:14:00.600 --> 00:14:04.759
expected value you buy a machine today

00:14:03.639 --> 00:14:07.480
and you

00:14:04.759 --> 00:14:08.560
ask how much of a machine I'll have next

00:14:07.480 --> 00:14:11.399
year well it's going to be a weighted

00:14:08.559 --> 00:14:14.198
average of zero and one probably but on

00:14:11.399 --> 00:14:16.559
average it's going to be one minus Delta

00:14:14.198 --> 00:14:18.120
so it's a machine that Peres sort of the

00:14:16.559 --> 00:14:21.078
probability of the machine breaking down

00:14:18.120 --> 00:14:22.278
over a year is 5% then one minus Delta

00:14:21.078 --> 00:14:24.519
is

00:14:22.278 --> 00:14:26.720
095 what is the probability that machine

00:14:24.519 --> 00:14:29.240
is still producing two years from now

00:14:26.720 --> 00:14:30.720
well 1 minus Delta square and so on and

00:14:29.240 --> 00:14:32.879
so forth okay so that's the first thing

00:14:30.720 --> 00:14:34.680
you know I have this machine and it's

00:14:32.879 --> 00:14:38.159
likely to give me cash flows over these

00:14:34.679 --> 00:14:40.278
many years and so on and then I have to

00:14:38.159 --> 00:14:43.719
know how much I expected profits I

00:14:40.278 --> 00:14:45.958
expect to get in each of those years and

00:14:43.720 --> 00:14:47.440
then I need also to know what are the

00:14:45.958 --> 00:14:49.919
interest rates that are likely to

00:14:47.440 --> 00:14:52.360
Prevail during the lifetime of the

00:14:49.919 --> 00:14:54.319
machine and so on so at the end of the

00:14:52.360 --> 00:14:56.560
day when I calculate I do my little

00:14:54.320 --> 00:14:57.879
project and I need to decide whether one

00:14:56.559 --> 00:15:00.399
which was the price of the machine or

00:14:57.879 --> 00:15:02.120
not is too expensive or too cheap I need

00:15:00.399 --> 00:15:03.519
to compare it with the spec present

00:15:02.120 --> 00:15:06.879
discounted

00:15:03.519 --> 00:15:08.919
value that I have for that machine so

00:15:06.879 --> 00:15:10.958
here is an example this is a machine

00:15:08.919 --> 00:15:13.240
that gives the first expected cash flow

00:15:10.958 --> 00:15:15.518
comes next year I set it up today and I

00:15:13.240 --> 00:15:16.759
generate profit by the end of the the

00:15:15.519 --> 00:15:18.959
year or at the beginning of the next

00:15:16.759 --> 00:15:20.720
year thus expected profits for the first

00:15:18.958 --> 00:15:23.159
year of the machine which comes at the

00:15:20.720 --> 00:15:25.399
end of the first year is counted by an

00:15:23.159 --> 00:15:27.600
interest rate that I know today I know

00:15:25.399 --> 00:15:30.078
the interest rate for for one

00:15:27.600 --> 00:15:31.839
year what about the cash flow that I

00:15:30.078 --> 00:15:34.000
expect for two years from now well

00:15:31.839 --> 00:15:35.839
that's going to be that's expected cash

00:15:34.000 --> 00:15:38.039
flow if the M machine is working

00:15:35.839 --> 00:15:42.440
properly that's the probability that the

00:15:38.039 --> 00:15:45.240
machine last to the second year and and

00:15:42.440 --> 00:15:46.839
uh or or you can also assume that the

00:15:45.240 --> 00:15:49.480
machine sort of breaks down in little

00:15:46.839 --> 00:15:52.240
pieces every year you get 90 0 95 of the

00:15:49.480 --> 00:15:52.240
machine in second

00:15:53.360 --> 00:16:00.159
year 1 minus

00:15:56.639 --> 00:16:02.198
1.05 uh Square two years from now and so

00:16:00.159 --> 00:16:04.879
on so forth

00:16:02.198 --> 00:16:06.479
so but I also now when I think about the

00:16:04.879 --> 00:16:07.879
cash flow in the second year I don't

00:16:06.480 --> 00:16:11.639
know the interest rate for the second

00:16:07.879 --> 00:16:14.639
year so h i I need to have an expected

00:16:11.639 --> 00:16:14.639
interest rate

00:16:15.480 --> 00:16:20.440
here and so on so forth okay because the

00:16:18.480 --> 00:16:24.639
machine lasts for many many years that's

00:16:20.440 --> 00:16:26.880
what I get a question by the

00:16:24.639 --> 00:16:29.440
way I'm saying yeah I need to have

00:16:26.879 --> 00:16:32.879
expectations here and so on

00:16:29.440 --> 00:16:34.279
but the truth is that the guy that

00:16:32.879 --> 00:16:35.679
invests in the machine doesn't need to

00:16:34.278 --> 00:16:38.439
have that expectation because I could

00:16:35.679 --> 00:16:42.078
replace this for something that is known

00:16:38.440 --> 00:16:42.079
today what would that

00:16:48.198 --> 00:16:52.879
be I'm saying you know when I calculate

00:16:50.799 --> 00:16:55.278
the expected cash flow when I'm

00:16:52.879 --> 00:16:56.439
discounting the two years out cash flow

00:16:55.278 --> 00:16:59.318
I'm going to have an interest rate that

00:16:56.440 --> 00:17:01.519
I know the one from Time Zero to to the

00:16:59.318 --> 00:17:05.279
end of the first year but I don't know

00:17:01.519 --> 00:17:09.359
the interest rate that prevails H

00:17:05.279 --> 00:17:12.480
from the end of year one to the end of

00:17:09.359 --> 00:17:14.479
year two that's what I wrote here but I

00:17:12.480 --> 00:17:17.000
said but there is something in the

00:17:14.480 --> 00:17:19.838
market that I could look at and that I

00:17:17.000 --> 00:17:25.038
really know what is

00:17:19.838 --> 00:17:26.720
that exactly I could use one plus R2

00:17:25.038 --> 00:17:29.599
these are onee rates

00:17:26.720 --> 00:17:32.440
r2t Square

00:17:29.599 --> 00:17:33.839
okay so so when you have the ter

00:17:32.440 --> 00:17:37.038
structure when you see all the interest

00:17:33.839 --> 00:17:38.639
rates a a a firm deciding where invest

00:17:37.038 --> 00:17:41.038
on not has the interest it needs it

00:17:38.640 --> 00:17:42.679
doesn't need to have expectations form

00:17:41.038 --> 00:17:45.000
expectations about the interest rate the

00:17:42.679 --> 00:17:46.798
market is doing it for them now the guy

00:17:45.000 --> 00:17:48.359
may choose to be a Trader and decide

00:17:46.798 --> 00:17:51.119
that I doesn't like the interest rate

00:17:48.359 --> 00:17:52.519
that the market is is is pricing in but

00:17:51.119 --> 00:17:55.879
that's a different trade it's not the

00:17:52.519 --> 00:17:57.240
investment decision of the firm The Firm

00:17:55.880 --> 00:18:00.159
will have to make a forecast about

00:17:57.240 --> 00:18:03.279
expected cash flow and so on but that's

00:18:00.159 --> 00:18:07.280
it from the machine so on

00:18:03.279 --> 00:18:08.440
okay so obviously the larger disase the

00:18:07.279 --> 00:18:11.678
more you're going to invest the more

00:18:08.440 --> 00:18:13.440
machines you're going to buy and so on

00:18:11.679 --> 00:18:17.600
okay

00:18:13.440 --> 00:18:19.240
um so so in principle you know a better

00:18:17.599 --> 00:18:22.079
investment function we remember we wrote

00:18:19.240 --> 00:18:25.120
an investment function as investment a

00:18:22.079 --> 00:18:27.279
function of output current output which

00:18:25.119 --> 00:18:30.279
is said is approxim for sales and then

00:18:27.279 --> 00:18:32.480
the interest rate well a better concept

00:18:30.279 --> 00:18:34.079
is that one which does depend on

00:18:32.480 --> 00:18:37.319
aggregate activity depends on many

00:18:34.079 --> 00:18:40.839
things but not only today also the ones

00:18:37.319 --> 00:18:42.439
you expect for the future okay and it

00:18:40.839 --> 00:18:44.119
depends on the interest rate not only

00:18:42.440 --> 00:18:45.480
today's interest rate though also the

00:18:44.119 --> 00:18:50.000
interest rate of the

00:18:45.480 --> 00:18:51.720
future if I if I look at this expression

00:18:50.000 --> 00:18:53.119
you know if if even if the interest rate

00:18:51.720 --> 00:18:54.759
today doesn't change but I expect the

00:18:53.119 --> 00:18:57.119
interest rate to change in the future to

00:18:54.759 --> 00:18:59.679
go up that will lower the value of my

00:18:57.119 --> 00:19:01.959
project okay we have had no space for

00:18:59.679 --> 00:19:06.880
that when we posit the initial

00:19:01.960 --> 00:19:09.159
investment function but but here we have

00:19:06.880 --> 00:19:11.159
that and sorry and this is an increasing

00:19:09.159 --> 00:19:13.960
function of that the higher is

00:19:11.159 --> 00:19:17.640
V the highest expected per discounted

00:19:13.960 --> 00:19:20.880
value of buying a machine given the

00:19:17.640 --> 00:19:23.520
price the larger is investment now this

00:19:20.880 --> 00:19:27.600
is in principle in practice current cash

00:19:23.519 --> 00:19:29.000
flows also matter a lot okay H so in the

00:19:27.599 --> 00:19:31.119
same sense as in the case of of the

00:19:29.000 --> 00:19:32.880
consumption function we said yeah in

00:19:31.119 --> 00:19:34.599
principle it's only wealth that matters

00:19:32.880 --> 00:19:35.760
but in practice there's lots of

00:19:34.599 --> 00:19:37.599
consumers that are financially

00:19:35.759 --> 00:19:40.798
constrained they're have to mouth and so

00:19:37.599 --> 00:19:43.319
on so current income also matters but

00:19:40.798 --> 00:19:45.079
for firms the same is

00:19:43.319 --> 00:19:47.519
true

00:19:45.079 --> 00:19:49.279
because and and and the main the main

00:19:47.519 --> 00:19:52.400
reason for that really is Financial

00:19:49.279 --> 00:19:54.240
frictions in the case of the firm

00:19:52.400 --> 00:19:57.038
because a firm may arrive with a great

00:19:54.240 --> 00:19:58.440
project to a bank but the bank may

00:19:57.038 --> 00:20:00.759
decide that it doesn't trust as much

00:19:58.440 --> 00:20:03.400
it's or is not as optimistic as the firm

00:20:00.759 --> 00:20:05.440
is and so on so it may not

00:20:03.400 --> 00:20:07.600
borrow the firm may not be able to

00:20:05.440 --> 00:20:09.840
borrow as much as it would want given

00:20:07.599 --> 00:20:12.240
how optimistic that particular firm is

00:20:09.839 --> 00:20:14.240
you on its own project I may say no you

00:20:12.240 --> 00:20:18.038
know I'm going to be more conservative

00:20:14.240 --> 00:20:20.000
here since I'm lending you the money and

00:20:18.038 --> 00:20:22.798
one way that firms use actually to get

00:20:20.000 --> 00:20:24.079
around Financial constraints is simply

00:20:22.798 --> 00:20:26.558
by

00:20:24.079 --> 00:20:28.678
returning retaining their retaining

00:20:26.558 --> 00:20:31.759
earnings meaning they they generate a

00:20:28.679 --> 00:20:32.679
cash flow they save firms Save A Lot by

00:20:31.759 --> 00:20:35.679
the

00:20:32.679 --> 00:20:38.200
way you know companies like apple and so

00:20:35.679 --> 00:20:40.919
on save an enormous amount and huge

00:20:38.200 --> 00:20:43.200
deposits us treasuries and so on so

00:20:40.919 --> 00:20:45.159
forth in the case of Apple is not to

00:20:43.200 --> 00:20:48.600
relax Financial constraint although it

00:20:45.159 --> 00:20:51.000
is has something to do with being

00:20:48.599 --> 00:20:53.959
opportunistic ER having the opportunity

00:20:51.000 --> 00:20:56.640
to buy things that are in distress but

00:20:53.960 --> 00:20:59.279
many firms especially smaller firms have

00:20:56.640 --> 00:21:01.280
deposits and cash flow and so on mostly

00:20:59.279 --> 00:21:03.240
because uh if they get a good

00:21:01.279 --> 00:21:05.599
opportunity they they may face Financial

00:21:03.240 --> 00:21:07.880
constraint so if current activity is

00:21:05.599 --> 00:21:09.279
high sales are high firms are going to

00:21:07.880 --> 00:21:11.120
be less likely to be financially

00:21:09.279 --> 00:21:12.918
constrained and that's the reason

00:21:11.119 --> 00:21:15.158
current profits also

00:21:12.919 --> 00:21:17.880
end now current profit is going to be an

00:21:15.159 --> 00:21:21.360
increasing function of output over over

00:21:17.880 --> 00:21:23.960
Capital that you

00:21:21.359 --> 00:21:25.519
know for any given level of capital if

00:21:23.960 --> 00:21:28.600
output goes up that's going to generate

00:21:25.519 --> 00:21:31.440
more profit and so we can write our in

00:21:28.599 --> 00:21:34.879
mment function a little bit like we had

00:21:31.440 --> 00:21:38.320
in the in in in in the earlier lectures

00:21:34.880 --> 00:21:40.120
but now we put VT here why YT and the

00:21:38.319 --> 00:21:43.319
interest rate and interest interest and

00:21:40.119 --> 00:21:46.359
future output and future interest rates

00:21:43.319 --> 00:21:47.720
enter all through the ter here and again

00:21:46.359 --> 00:21:50.000
investment here is increasing with

00:21:47.720 --> 00:21:52.919
respect to VT and it's increasing with

00:21:50.000 --> 00:21:54.880
respect to YT okay so that's a far more

00:21:52.919 --> 00:21:58.120
realistic model so you go back

00:21:54.880 --> 00:22:00.559
tolm and and and uh and put this type of

00:21:58.119 --> 00:22:03.879
consumption function and investment

00:22:00.558 --> 00:22:05.200
functions and they're going to make a

00:22:03.880 --> 00:22:07.720
lot of

00:22:05.200 --> 00:22:09.519
sense again the concept of something

00:22:07.720 --> 00:22:11.519
persistent persistent things should

00:22:09.519 --> 00:22:15.038
matter a lot more than temporary things

00:22:11.519 --> 00:22:16.679
okay so naturally if if you expect

00:22:15.038 --> 00:22:18.158
profits to remain high for a very long

00:22:16.679 --> 00:22:20.880
period of time that machine is going to

00:22:18.159 --> 00:22:22.480
be worth a a lot more than if you only

00:22:20.880 --> 00:22:25.799
expect the machine to be very profitable

00:22:22.480 --> 00:22:28.200
for only one year okay and and and and

00:22:25.798 --> 00:22:30.480
and and so anything that's likely to be

00:22:28.200 --> 00:22:33.798
perceived system is also likely to have

00:22:30.480 --> 00:22:33.798
a much larger

00:22:33.880 --> 00:22:39.840
impact there are important exceptions

00:22:36.038 --> 00:22:41.400
but I'm not going to get into that now

00:22:39.839 --> 00:22:43.240
and the same is true for interest rates

00:22:41.400 --> 00:22:45.720
know if I expect if interest rat are

00:22:43.240 --> 00:22:48.319
high today but we expect them to go down

00:22:45.720 --> 00:22:51.200
in the near future then that's not going

00:22:48.319 --> 00:22:54.038
to affect a lot the discounting of very

00:22:51.200 --> 00:22:56.319
future profits but if I if I interest

00:22:54.038 --> 00:22:58.359
rate go up today and I expect them to

00:22:56.319 --> 00:23:00.839
remain high for a long time that's going

00:22:58.359 --> 00:23:02.359
to affect a lot more the present value

00:23:00.839 --> 00:23:06.199
of profits and therefore it's going to

00:23:02.359 --> 00:23:09.119
depress investment a lot more in

00:23:06.200 --> 00:23:11.679
fact central

00:23:09.119 --> 00:23:13.038
banks much more than playing with the

00:23:11.679 --> 00:23:15.600
current interest rate they play with

00:23:13.038 --> 00:23:17.200
your minds that's what they do they they

00:23:15.599 --> 00:23:19.359
are always telling you stories for why

00:23:17.200 --> 00:23:23.000
interest will remain high for why you

00:23:19.359 --> 00:23:24.719
know they don't want they want they only

00:23:23.000 --> 00:23:27.880
control an interest rate that is is an

00:23:24.720 --> 00:23:29.640
overnight interest rate really but they

00:23:27.880 --> 00:23:31.799
and with that nobody cares about the

00:23:29.640 --> 00:23:34.600
overnight rate except for some Traders

00:23:31.798 --> 00:23:36.079
out there no but since they want to

00:23:34.599 --> 00:23:37.359
influence aggregate demand that is they

00:23:36.079 --> 00:23:39.359
want to influence consumption and

00:23:37.359 --> 00:23:40.959
investment they need to convince you

00:23:39.359 --> 00:23:43.879
that this stuff will last for some time

00:23:40.960 --> 00:23:46.000
because otherwise it would be relevant

00:23:43.880 --> 00:23:48.440
because if you want to reduce aggregate

00:23:46.000 --> 00:23:51.200
demand you want to cons

00:23:48.440 --> 00:23:52.919
convince firms and households and so on

00:23:51.200 --> 00:23:54.759
that that the interest will remain high

00:23:52.919 --> 00:23:56.840
for a while otherwise you're going to

00:23:54.759 --> 00:23:59.200
get very little effect out of

00:23:56.839 --> 00:24:00.918
that one of the pro problem s they're

00:23:59.200 --> 00:24:03.038
having now actually you know with the

00:24:00.919 --> 00:24:04.640
FED is trying to cool the economy is

00:24:03.038 --> 00:24:07.278
that they keep hiking rates but the loan

00:24:04.640 --> 00:24:09.278
rates have began to decline already

00:24:07.278 --> 00:24:11.839
that's a problem you know they would

00:24:09.278 --> 00:24:13.720
like you not to believe Market not to

00:24:11.839 --> 00:24:16.079
believe that that will happen and that's

00:24:13.720 --> 00:24:20.798
that's a that's a big

00:24:16.079 --> 00:24:23.158
issue okay so let's think about this

00:24:20.798 --> 00:24:26.158
islm with expectations so what we said

00:24:23.159 --> 00:24:28.640
is you know what really we after in the

00:24:26.159 --> 00:24:30.120
slm model remember slm model is a model

00:24:28.640 --> 00:24:31.919
in which aggregate demand determines

00:24:30.119 --> 00:24:34.038
output and that's what happens in the

00:24:31.919 --> 00:24:37.000
short and the biggest components of

00:24:34.038 --> 00:24:38.440
aggregate demand as aside from the

00:24:37.000 --> 00:24:41.960
government which is something that moves

00:24:38.440 --> 00:24:43.399
more or less okay different behavioral

00:24:41.960 --> 00:24:45.440
functions we're not talking a lot about

00:24:43.398 --> 00:24:47.000
that here but the big drivers are

00:24:45.440 --> 00:24:48.960
consumption and investment those are at

00:24:47.000 --> 00:24:50.480
least the private sector drivers of

00:24:48.960 --> 00:24:52.679
aggregate demand consumption and

00:24:50.480 --> 00:24:57.278
investment and we have said now is that

00:24:52.679 --> 00:24:59.600
you know that H human wealth is affected

00:24:57.278 --> 00:25:02.200
not only by current income but future

00:24:59.599 --> 00:25:04.359
after future after Labor income future

00:25:02.200 --> 00:25:05.798
real interest rate that affects human

00:25:04.359 --> 00:25:09.199
wealth that affects

00:25:05.798 --> 00:25:12.319
consumption future real dividends plus

00:25:09.200 --> 00:25:14.038
future real interest rate affect the

00:25:12.319 --> 00:25:17.319
value of stocks that's a very important

00:25:14.038 --> 00:25:19.240
Financial well H future nominal interest

00:25:17.319 --> 00:25:22.038
rate affect the price of bonds so all

00:25:19.240 --> 00:25:23.759
these rates enter here the the price of

00:25:22.038 --> 00:25:27.319
nominal

00:25:23.759 --> 00:25:30.079
bonds ER for firms future after tax

00:25:27.319 --> 00:25:33.439
profits affect expected present value

00:25:30.079 --> 00:25:35.439
future real interest rate affect H also

00:25:33.440 --> 00:25:38.159
this expected present value okay so

00:25:35.440 --> 00:25:42.278
there's a lot that says future in this

00:25:38.159 --> 00:25:44.039
column here that enters into the

00:25:42.278 --> 00:25:45.720
consumption and investment decisions

00:25:44.038 --> 00:25:49.240
that we care about that's what I show

00:25:45.720 --> 00:25:49.240
you in in the previous

00:25:49.398 --> 00:25:54.759
slides so remember the basic islm model

00:25:52.880 --> 00:25:56.880
we wrote it this way output was

00:25:54.759 --> 00:25:58.879
determined by agre demand and close

00:25:56.880 --> 00:26:02.200
economy forget all that

00:25:58.880 --> 00:26:04.440
fully sticky prices and uh and we wrote

00:26:02.200 --> 00:26:07.120
consumption as this functions so

00:26:04.440 --> 00:26:09.399
aggregate demand was increasing in

00:26:07.119 --> 00:26:11.239
output and government expenditure

00:26:09.398 --> 00:26:12.879
decreasing in taxes and decreasing on

00:26:11.240 --> 00:26:16.200
the interest

00:26:12.880 --> 00:26:19.278
rate so a shortcut so what I want to do

00:26:16.200 --> 00:26:22.319
now is is give you a shortcut to

00:26:19.278 --> 00:26:24.720
integrate this views of expectations or

00:26:22.319 --> 00:26:29.278
the concept of expectations into this

00:26:24.720 --> 00:26:32.038
very basic isnm model Okay so think of

00:26:29.278 --> 00:26:34.519
now of aggregate demand rather than just

00:26:32.038 --> 00:26:36.679
being a function of current variables be

00:26:34.519 --> 00:26:37.879
also function of the same variables but

00:26:36.679 --> 00:26:41.919
in the

00:26:37.880 --> 00:26:44.600
future okay so aggregate demand is a

00:26:41.919 --> 00:26:47.159
function as before of current output

00:26:44.599 --> 00:26:50.359
current taxes current interest rate

00:26:47.159 --> 00:26:53.640
current expenditure but also function

00:26:50.359 --> 00:26:56.918
and with the same signs of future output

00:26:53.640 --> 00:26:59.720
so it's increasing a is increasing in

00:26:56.919 --> 00:27:02.600
expected future out output is decreasing

00:26:59.720 --> 00:27:04.319
unexpected future taxes is decreasing in

00:27:02.599 --> 00:27:06.599
expected future interest rate is

00:27:04.319 --> 00:27:07.759
increasing in expected future government

00:27:06.599 --> 00:27:10.599
expenditure although I'm not going to

00:27:07.759 --> 00:27:14.480
play with this here because of something

00:27:10.599 --> 00:27:18.639
very specific I'll discuss later on okay

00:27:14.480 --> 00:27:20.839
but so that's the shortcut okay the limb

00:27:18.640 --> 00:27:22.679
is going to be the same as before so

00:27:20.839 --> 00:27:25.720
what I want you to think about now is a

00:27:22.679 --> 00:27:28.679
mod that is like the one you had before

00:27:25.720 --> 00:27:31.558
H with the same LM but now that yes is a

00:27:28.679 --> 00:27:33.240
little bit richer it has more parameters

00:27:31.558 --> 00:27:36.720
these are parameters because I'm going

00:27:33.240 --> 00:27:37.919
to determine today's output uh but it's

00:27:36.720 --> 00:27:39.480
going to be a function of more

00:27:37.919 --> 00:27:41.519
parameters and all these parameters are

00:27:39.480 --> 00:27:44.159
essentially the same variables that we

00:27:41.519 --> 00:27:45.000
worry about today but are the variables

00:27:44.159 --> 00:27:47.679
we

00:27:45.000 --> 00:27:50.000
expect of those are the values we expect

00:27:47.679 --> 00:27:53.278
for those variables in the future and

00:27:50.000 --> 00:27:55.240
again with the same sign so if output so

00:27:53.278 --> 00:27:57.759
if taxes go up

00:27:55.240 --> 00:28:00.558
today aggregate demand will Decline and

00:27:57.759 --> 00:28:03.278
output will decline but if I expect

00:28:00.558 --> 00:28:04.319
future taxes to go up as well then

00:28:03.278 --> 00:28:06.359
that's going to the price aggregate

00:28:04.319 --> 00:28:09.599
demand even more okay that's the type of

00:28:06.359 --> 00:28:13.519
logic I want you to devel so that's the

00:28:09.599 --> 00:28:17.038
way our model will look so this is the

00:28:13.519 --> 00:28:20.278
the is in the same space I had before

00:28:17.038 --> 00:28:22.119
know interest rate and a output current

00:28:20.278 --> 00:28:25.038
output I'm trying to determine current

00:28:22.119 --> 00:28:28.319
output um but now I have lots of

00:28:25.038 --> 00:28:32.919
parameters that I didn't have before

00:28:28.319 --> 00:28:36.079
I have a you know things that shift the

00:28:32.919 --> 00:28:39.519
yes to the left if taxes go up today

00:28:36.079 --> 00:28:42.199
this will shift to the left do you think

00:28:39.519 --> 00:28:45.798
it will shift to the left more or less

00:28:42.200 --> 00:28:45.798
than it did in lecture three or

00:28:48.880 --> 00:28:57.320
four so suppose we increase taxes by you

00:28:53.278 --> 00:29:00.720
know 10% will that reduce output more or

00:28:57.319 --> 00:29:04.839
less than when we have the static islm

00:29:00.720 --> 00:29:06.360
mode yeah the expectation okay I haven't

00:29:04.839 --> 00:29:08.558
moved these are parameters for my curve

00:29:06.359 --> 00:29:12.119
so I I don't get the right to move

00:29:08.558 --> 00:29:13.599
them less no less because now we said

00:29:12.119 --> 00:29:15.000
it's not only the present that matter

00:29:13.599 --> 00:29:19.480
it's a combination of the present and

00:29:15.000 --> 00:29:21.278
the future so if if if I that means that

00:29:19.480 --> 00:29:24.399
anything that is just the present will

00:29:21.278 --> 00:29:27.119
matter less than in the in the past

00:29:24.398 --> 00:29:29.239
otherwise you see that and suppose we

00:29:27.119 --> 00:29:31.000
had a two period model and and I give

00:29:29.240 --> 00:29:33.240
equal weight to the present and the and

00:29:31.000 --> 00:29:35.398
the and the and the future then I'm

00:29:33.240 --> 00:29:38.480
going to cut the effect of the present

00:29:35.398 --> 00:29:41.558
in half that's I'm exaggerating there

00:29:38.480 --> 00:29:43.079
that's more or less the logic

00:29:41.558 --> 00:29:44.798
okay

00:29:43.079 --> 00:29:48.398
um

00:29:44.798 --> 00:29:50.240
so so the you you correctly said well it

00:29:48.398 --> 00:29:53.439
depends on whether I expect the future

00:29:50.240 --> 00:29:56.000
taxes to change or not fine that tells

00:29:53.440 --> 00:29:58.558
you there a difference between changing

00:29:56.000 --> 00:30:01.278
temporarily the taxes and

00:29:58.558 --> 00:30:03.398
and and and and and increasing taxes

00:30:01.278 --> 00:30:06.359
permanently permanently here means for

00:30:03.398 --> 00:30:08.798
the two periods so what happens with

00:30:06.359 --> 00:30:11.079
this curve so we decided that increasing

00:30:08.798 --> 00:30:13.359
increasing taxes reduces this to the

00:30:11.079 --> 00:30:15.639
left by a smaller amount than in the

00:30:13.359 --> 00:30:18.158
past what happens if you expect taxes to

00:30:15.640 --> 00:30:18.159
increase in the

00:30:20.038 --> 00:30:26.000
future which wealth goes

00:30:23.000 --> 00:30:27.359
down human wealth in particular your

00:30:26.000 --> 00:30:28.720
human wealth will go down because you

00:30:27.359 --> 00:30:30.879
expect your disos able income to be

00:30:28.720 --> 00:30:33.798
taxed more in the future so that will

00:30:30.880 --> 00:30:35.440
also shift the yes to the to the left

00:30:33.798 --> 00:30:37.480
okay and that's the reason that if you

00:30:35.440 --> 00:30:41.278
have a permanent expected permanent

00:30:37.480 --> 00:30:43.720
increase in taxes today and next year

00:30:41.278 --> 00:30:45.440
then that gets us back to the type of

00:30:43.720 --> 00:30:47.240
shift in the yes that we had when we had

00:30:45.440 --> 00:30:49.919
the static model okay it's the sum of

00:30:47.240 --> 00:30:53.519
the two it's a permanent so permanent

00:30:49.919 --> 00:30:56.919
changes will behave very similarly to

00:30:53.519 --> 00:31:00.480
the way sort of the the the static model

00:30:56.919 --> 00:31:03.080
work permanent

00:31:00.480 --> 00:31:05.480
okay in a sense that model was a very

00:31:03.079 --> 00:31:07.158
good summary of permanent changes

00:31:05.480 --> 00:31:09.679
permanent changes in taxes permanent

00:31:07.159 --> 00:31:13.480
changes in interest rate and so

00:31:09.679 --> 00:31:16.038
on ER changing go on expenditure same

00:31:13.480 --> 00:31:19.000
same idea it will also move aggregate

00:31:16.038 --> 00:31:21.759
demand to the right

00:31:19.000 --> 00:31:25.519
um

00:31:21.759 --> 00:31:27.440
but will it do it by more or

00:31:25.519 --> 00:31:30.480
less well think how government

00:31:27.440 --> 00:31:33.798
expenditure worked in in in the basic

00:31:30.480 --> 00:31:36.000
mod in the static model it increased

00:31:33.798 --> 00:31:38.158
aggregate demand and that then led to

00:31:36.000 --> 00:31:41.519
multiplier and we got a lot more income

00:31:38.159 --> 00:31:43.919
and so on now if we expect this govern

00:31:41.519 --> 00:31:45.638
to be temporary that multiplier also

00:31:43.919 --> 00:31:47.679
will be a lot smaller because yes it

00:31:45.638 --> 00:31:49.599
will increase income but people are not

00:31:47.679 --> 00:31:51.080
going to spend all day income today that

00:31:49.599 --> 00:31:54.199
depends on whether they expect future

00:31:51.079 --> 00:31:57.439
income to also go up as well or not okay

00:31:54.200 --> 00:31:59.480
and that's the reason that it is again

00:31:57.440 --> 00:32:01.798
it us expect this going expenditure to

00:31:59.480 --> 00:32:04.599
go up permanently and nothing else

00:32:01.798 --> 00:32:06.720
change then you can expect income to go

00:32:04.599 --> 00:32:09.319
up in the future as well and then you

00:32:06.720 --> 00:32:11.639
get more or less the same effect now

00:32:09.319 --> 00:32:13.200
that's a trick experiment because if you

00:32:11.638 --> 00:32:15.959
and it's very Rel for today if you

00:32:13.200 --> 00:32:17.519
govern exp goes out permanently it's

00:32:15.960 --> 00:32:20.079
unlikely that the central bank will

00:32:17.519 --> 00:32:21.679
remain and and move and so you also have

00:32:20.079 --> 00:32:24.319
to start thinking well where will the

00:32:21.679 --> 00:32:29.000
Central Bank do okay and that takes me

00:32:24.319 --> 00:32:31.879
to this variable here okay this variable

00:32:29.000 --> 00:32:34.398
here

00:32:31.880 --> 00:32:37.278
so well before I discuss this variable

00:32:34.398 --> 00:32:39.959
actually let me point out that it's not

00:32:37.278 --> 00:32:42.240
accidental that I made this curve a lot

00:32:39.960 --> 00:32:45.038
steeper than it used to look I mean this

00:32:42.240 --> 00:32:48.638
looks like a pretty steep I curve which

00:32:45.038 --> 00:32:50.359
is a way of saying that a given change

00:32:48.638 --> 00:32:52.278
in interest rate now has a very small

00:32:50.359 --> 00:32:54.879
effect on current

00:32:52.278 --> 00:32:56.839
output okay much smaller than we have in

00:32:54.880 --> 00:32:59.360
the static

00:32:56.839 --> 00:33:02.158
model and the reason is

00:32:59.359 --> 00:33:03.199
again this permanent investor transitory

00:33:02.159 --> 00:33:06.000
if you expect the interest rate to

00:33:03.200 --> 00:33:07.319
decline only for today and that's it

00:33:06.000 --> 00:33:08.839
that's not going to have a very large

00:33:07.319 --> 00:33:11.519
effect on consumption it's not going to

00:33:08.839 --> 00:33:13.558
have a very large effect on on on

00:33:11.519 --> 00:33:16.000
investment for the interest rate de

00:33:13.558 --> 00:33:18.079
client to have a very lasting effect a

00:33:16.000 --> 00:33:20.558
very large impact on consumption and

00:33:18.079 --> 00:33:21.918
investment it has to affect the expected

00:33:20.558 --> 00:33:24.638
present discounted values in a

00:33:21.919 --> 00:33:25.919
meaningful way and for that you want

00:33:24.638 --> 00:33:28.678
those changes to be more or less

00:33:25.919 --> 00:33:30.278
permanent persistent that you

00:33:28.679 --> 00:33:31.919
the private agents think that this

00:33:30.278 --> 00:33:36.000
change in the interet will

00:33:31.919 --> 00:33:37.759
be significant so so if they if so it

00:33:36.000 --> 00:33:40.240
good to separate two things so if the if

00:33:37.759 --> 00:33:44.000
the if the if the FED cuts the interest

00:33:40.240 --> 00:33:45.759
rate but doesn't persuade anyone that

00:33:44.000 --> 00:33:47.519
that that this rate will remain low in

00:33:45.759 --> 00:33:50.278
the future then it will is going to get

00:33:47.519 --> 00:33:52.880
very small effect on out however if you

00:33:50.278 --> 00:33:55.919
convince people that that there will be

00:33:52.880 --> 00:33:58.600
future changes that the the rates will

00:33:55.919 --> 00:34:01.600
remain lower for a long time that means

00:33:58.599 --> 00:34:04.759
that this is now will shift to the right

00:34:01.599 --> 00:34:04.759
okay that's what we have

00:34:04.880 --> 00:34:09.280
here so you have to distinguish is a

00:34:07.398 --> 00:34:11.598
move when the FED cuts the interest rate

00:34:09.280 --> 00:34:14.000
you get a small movement along the curve

00:34:11.599 --> 00:34:16.079
but if the fed persuades you that this a

00:34:14.000 --> 00:34:17.918
long lasting cut in interest rate then

00:34:16.079 --> 00:34:19.560
they yes shift to the right and you

00:34:17.918 --> 00:34:22.719
recover sort of the power of monetary

00:34:19.559 --> 00:34:25.639
policy monetary policy depends a lot on

00:34:22.719 --> 00:34:27.759
its ability to convince people that

00:34:25.639 --> 00:34:30.519
things will remain in the direction this

00:34:27.760 --> 00:34:33.119
they want okay if they fail there was a

00:34:30.519 --> 00:34:35.239
famous episode in US monetary policy

00:34:33.119 --> 00:34:37.358
during the times of Alan greensman Alan

00:34:35.239 --> 00:34:39.638
gensman is known as one of the biggest

00:34:37.358 --> 00:34:41.039
Central Bankers that the US has had at

00:34:39.639 --> 00:34:43.720
least in recent

00:34:41.039 --> 00:34:45.759
memory H he went through a period which

00:34:43.719 --> 00:34:48.199
was called was known as the Greenspan

00:34:45.760 --> 00:34:51.000
conu that is the economy was

00:34:48.199 --> 00:34:54.158
overheating he kept hiking interest

00:34:51.000 --> 00:34:56.159
rates but the long rates kept coming

00:34:54.159 --> 00:34:58.320
coming down so he couldn't cool off the

00:34:56.159 --> 00:35:00.400
economy there was no way around that

00:34:58.320 --> 00:35:02.838
because they couldn't persuade the

00:35:00.400 --> 00:35:04.599
markets that that this would be a longl

00:35:02.838 --> 00:35:05.759
lasting effect the reason was a

00:35:04.599 --> 00:35:07.079
different one it was not that you

00:35:05.760 --> 00:35:08.599
couldn't persuade the market it happens

00:35:07.079 --> 00:35:11.519
that at the same time you had china

00:35:08.599 --> 00:35:13.480
sending massive Capital flows to the US

00:35:11.519 --> 00:35:15.039
and so so but the point is that the FED

00:35:13.480 --> 00:35:17.240
had couldn't move the interest rate in

00:35:15.039 --> 00:35:19.239
the long run and and so it was very

00:35:17.239 --> 00:35:22.799
ineffective in terms of his monetary

00:35:19.239 --> 00:35:24.799
policy so again expectations matter

00:35:22.800 --> 00:35:27.880
quite a

00:35:24.800 --> 00:35:30.920
bit so let's think about our well this I

00:35:27.880 --> 00:35:33.880
was just discussing so monetary policy

00:35:30.920 --> 00:35:36.838
you know I should have this so you're

00:35:33.880 --> 00:35:40.000
not going to do a lot if if unless you

00:35:36.838 --> 00:35:42.679
persuade people that that the interest a

00:35:40.000 --> 00:35:46.039
will remain low for quite some time and

00:35:42.679 --> 00:35:49.039
notice that there like here this

00:35:46.039 --> 00:35:51.199
everything comes comes into line because

00:35:49.039 --> 00:35:53.559
if the FED convinced that the interest

00:35:51.199 --> 00:35:55.559
rate will be lower in the future as well

00:35:53.559 --> 00:35:58.159
then you get the yes to shift to the

00:35:55.559 --> 00:36:00.400
right but if inter will be low in the

00:35:58.159 --> 00:36:03.399
future that means output will be high in

00:36:00.400 --> 00:36:06.318
the future as well which further shift

00:36:03.400 --> 00:36:08.039
that yes to the right okay if you

00:36:06.318 --> 00:36:10.519
convince the markets that and the

00:36:08.039 --> 00:36:12.400
markets and cons consumers households

00:36:10.519 --> 00:36:13.920
and so on that that you're cutting

00:36:12.400 --> 00:36:16.680
interest rate and that with that you'll

00:36:13.920 --> 00:36:18.720
be successful in creating a getting out

00:36:16.679 --> 00:36:21.838
of a recession for example in the future

00:36:18.719 --> 00:36:24.519
that also increases human wealth

00:36:21.838 --> 00:36:27.078
expected percent value of cash flows of

00:36:24.519 --> 00:36:29.199
of profits and so on so forth because

00:36:27.079 --> 00:36:31.640
you you giving sort of better economic

00:36:29.199 --> 00:36:37.318
conditions in the future again for

00:36:31.639 --> 00:36:39.960
central banks is a lot like er it's it's

00:36:37.318 --> 00:36:43.079
mostly about expectations management

00:36:39.960 --> 00:36:45.039
that's the business of a central bank

00:36:43.079 --> 00:36:49.119
really I don't know how many of you are

00:36:45.039 --> 00:36:51.679
soccer fans but but um there was a

00:36:49.119 --> 00:36:53.240
famous story of Marvin King Marvin King

00:36:51.679 --> 00:36:55.799
was also one of the biggest Central

00:36:53.239 --> 00:37:00.639
Bankers that the UK has had fairly

00:36:55.800 --> 00:37:05.039
recent and he described he's British L

00:37:00.639 --> 00:37:06.920
nowadays and he described um good

00:37:05.039 --> 00:37:10.279
monetary policy very much like

00:37:06.920 --> 00:37:13.880
maradona's go score against the

00:37:10.280 --> 00:37:16.079
UK England in in in in in some World cap

00:37:13.880 --> 00:37:18.640
I don't remember which

00:37:16.079 --> 00:37:20.519
one and it's essentially Maradona picked

00:37:18.639 --> 00:37:23.480
the ball you know in his side of the

00:37:20.519 --> 00:37:27.079
field and he essentially RW a straight

00:37:23.480 --> 00:37:29.000
line H to the goal and a score but but

00:37:27.079 --> 00:37:30.880
he persu Ed everyone around to move away

00:37:29.000 --> 00:37:32.960
from his path and that was a successful

00:37:30.880 --> 00:37:35.760
strategy and central banks do a lot of

00:37:32.960 --> 00:37:37.318
that lots of talking and you know at the

00:37:35.760 --> 00:37:39.040
end of the day the true actions of

00:37:37.318 --> 00:37:41.719
moving the interest rate are the least

00:37:39.039 --> 00:37:43.759
important part of really the a monetary

00:37:41.719 --> 00:37:46.239
policy

00:37:43.760 --> 00:37:48.680
strategy fiscal policy can be quite

00:37:46.239 --> 00:37:52.159
tricky here actually

00:37:48.679 --> 00:37:53.480
um so we know that that you know that

00:37:52.159 --> 00:37:56.239
the fiscal

00:37:53.480 --> 00:37:59.039
contraction a reduction in government

00:37:56.239 --> 00:38:02.519
expenditure ER if you just think about

00:37:59.039 --> 00:38:04.719
the basic islm model what happens it's a

00:38:02.519 --> 00:38:07.039
fiscal contraction you reduce go in

00:38:04.719 --> 00:38:09.519
expenditure that will

00:38:07.039 --> 00:38:13.119
certainly reduce

00:38:09.519 --> 00:38:15.960
output all the slm you reduce govern

00:38:13.119 --> 00:38:18.800
expenditure just shift the to the left

00:38:15.960 --> 00:38:21.199
and that reduces

00:38:18.800 --> 00:38:22.400
output when you have expectations things

00:38:21.199 --> 00:38:25.239
are a little

00:38:22.400 --> 00:38:26.960
trickier because it depends a lot of

00:38:25.239 --> 00:38:28.159
what you expect the central bank to do

00:38:26.960 --> 00:38:31.838
in the future

00:38:28.159 --> 00:38:34.519
and it expects a lot on what you

00:38:31.838 --> 00:38:38.880
know the private sector how the private

00:38:34.519 --> 00:38:43.559
sector responds to that so for example

00:38:38.880 --> 00:38:45.400
if you have a a um fiscal contraction

00:38:43.559 --> 00:38:48.519
that leads to an anticipation of a big

00:38:45.400 --> 00:38:51.079
cutting interest rate in the future that

00:38:48.519 --> 00:38:53.039
may be expansionary or is it can ofset

00:38:51.079 --> 00:38:55.079
quite a bit of the fiscal contraction

00:38:53.039 --> 00:38:58.039
side and in fact most of the time when

00:38:55.079 --> 00:39:00.519
you have episodes of fiscal consolid

00:38:58.039 --> 00:39:02.719
solation H in environments that are not

00:39:00.519 --> 00:39:06.480
of very high distress financial crisis

00:39:02.719 --> 00:39:08.118
and so on H it typically sort of how

00:39:06.480 --> 00:39:10.318
successful that is depends a lot on

00:39:08.119 --> 00:39:12.519
whether people expect to be a sort of

00:39:10.318 --> 00:39:15.358
implicit deal between the central bank

00:39:12.519 --> 00:39:17.159
and the treasury okay if people expect

00:39:15.358 --> 00:39:18.759
that that fiscal contraction will come

00:39:17.159 --> 00:39:21.399
with much looser monetary policy

00:39:18.760 --> 00:39:22.079
conditions then the fiscal contraction

00:39:21.400 --> 00:39:25.680
is

00:39:22.079 --> 00:39:27.960
not as contraction as could be otherwise

00:39:25.679 --> 00:39:30.118
and if for some reason you know know the

00:39:27.960 --> 00:39:31.760
fiscal deficit sort of the perception of

00:39:30.119 --> 00:39:33.920
fiscal deficit was really dragging the

00:39:31.760 --> 00:39:35.599
economy down because people didn't know

00:39:33.920 --> 00:39:38.599
when there could be a financial crisis

00:39:35.599 --> 00:39:40.079
in the near future and so on then you

00:39:38.599 --> 00:39:42.440
can get a situation in which the

00:39:40.079 --> 00:39:44.800
contraction fiscal contraction today

00:39:42.440 --> 00:39:46.920
improves the perception of a stability

00:39:44.800 --> 00:39:49.519
of the country in the future which in

00:39:46.920 --> 00:39:51.480
turn may increase expected future income

00:39:49.519 --> 00:39:54.318
and and and be expansionary

00:39:51.480 --> 00:39:56.440
so you know most of the fiscal

00:39:54.318 --> 00:39:58.199
contractions are contractionary but

00:39:56.440 --> 00:40:01.039
there are some famous

00:39:58.199 --> 00:40:02.879
of what they of called expansionary

00:40:01.039 --> 00:40:04.920
fiscal

00:40:02.880 --> 00:40:07.960
contractions one of the most classic

00:40:04.920 --> 00:40:12.318
cases was known case is

00:40:07.960 --> 00:40:14.838
Ireland in the late 80s Ireland had

00:40:12.318 --> 00:40:17.079
massive fiscal deficit and and and all

00:40:14.838 --> 00:40:18.960
they talk about was fiscal deficits okay

00:40:17.079 --> 00:40:22.318
because they had very large fiscal

00:40:18.960 --> 00:40:25.358
deficits related to GDP and and the

00:40:22.318 --> 00:40:27.838
economy was really sort of stagnating

00:40:25.358 --> 00:40:29.759
and going through cycles and so on and

00:40:27.838 --> 00:40:33.000
it was all around this fiscal deficit

00:40:29.760 --> 00:40:36.040
and so so towards the late 80s they

00:40:33.000 --> 00:40:39.920
began a a deliberate plan

00:40:36.039 --> 00:40:41.519
of of U of fiscal consolidation fiscal

00:40:39.920 --> 00:40:43.280
consolidation means essentially reducing

00:40:41.519 --> 00:40:46.000
the deficit and they were very

00:40:43.280 --> 00:40:48.560
successful as you can see but contrary

00:40:46.000 --> 00:40:50.800
to expectations at least output growth

00:40:48.559 --> 00:40:54.358
did not declin actually they finally

00:40:50.800 --> 00:40:57.039
sort of they had a very good period like

00:40:54.358 --> 00:40:58.880
that so that's that's all it was all

00:40:57.039 --> 00:41:02.159
about expectations notice that

00:40:58.880 --> 00:41:03.800
unemployment though did go up okay so

00:41:02.159 --> 00:41:06.399
despite the fact that you know you got

00:41:03.800 --> 00:41:09.800
more unemployment and so on output began

00:41:06.400 --> 00:41:12.119
to grow okay because firms began to

00:41:09.800 --> 00:41:13.960
invest more consumers became more

00:41:12.119 --> 00:41:15.920
optimistic in fact you see the house

00:41:13.960 --> 00:41:18.960
household saving rate declined

00:41:15.920 --> 00:41:21.280
dramatically this all consumption and

00:41:18.960 --> 00:41:23.559
investment did that

00:41:21.280 --> 00:41:26.040
okay consumption and investment people

00:41:23.559 --> 00:41:28.159
consume more invested more because sort

00:41:26.039 --> 00:41:29.599
of everything looks a lot better they

00:41:28.159 --> 00:41:32.879
have been struggling with this for very

00:41:29.599 --> 00:41:34.480
long and they finally they had gotten

00:41:32.880 --> 00:41:37.519
that

00:41:34.480 --> 00:41:39.519
behind now this example is Abus by

00:41:37.519 --> 00:41:43.199
almost anyone that wants to cut taxes

00:41:39.519 --> 00:41:46.199
and things like that but

00:41:43.199 --> 00:41:46.199
but

00:41:48.159 --> 00:41:56.159
um um no sorry by almost anyone that

00:41:52.000 --> 00:41:58.559
wants to cut fiscal expenditure um but

00:41:56.159 --> 00:42:00.358
there are experiences there's a whole

00:41:58.559 --> 00:42:03.880
spectrum of experiences but in

00:42:00.358 --> 00:42:08.440
situations that as Extreme as this

00:42:03.880 --> 00:42:11.318
one it it clearly prove to be very

00:42:08.440 --> 00:42:14.760
effective so that's that so let me take

00:42:11.318 --> 00:42:18.960
a stock so so the role of this lecture

00:42:14.760 --> 00:42:20.319
was ER to say something that I sort of

00:42:18.960 --> 00:42:22.440
should have said earlier on but I would

00:42:20.318 --> 00:42:24.079
have been a bit confusing so I decided

00:42:22.440 --> 00:42:26.159
not to talk too much about it but it's

00:42:24.079 --> 00:42:28.519
very important expectations plays play a

00:42:26.159 --> 00:42:31.759
central role in economic

00:42:28.519 --> 00:42:33.559
in particular H expectations influence

00:42:31.760 --> 00:42:35.160
aggregate demand and for us this course

00:42:33.559 --> 00:42:37.960
was a lot about aggregate demand except

00:42:35.159 --> 00:42:40.358
for the part on growth it was a lot

00:42:37.960 --> 00:42:42.318
about agre demand now we did talk about

00:42:40.358 --> 00:42:43.838
expectations but we did talk about

00:42:42.318 --> 00:42:46.000
expectations mostly in the context of

00:42:43.838 --> 00:42:47.719
agre Supply remember when we talk about

00:42:46.000 --> 00:42:49.760
the Philips curve we did have

00:42:47.719 --> 00:42:52.078
expectations because weight setting was

00:42:49.760 --> 00:42:53.920
a function of expected prices and so on

00:42:52.079 --> 00:42:57.680
so forth so we did talk about the role

00:42:53.920 --> 00:43:00.800
of expectation Supply very quickly uh

00:42:57.679 --> 00:43:03.000
but I think a much bigger role is play

00:43:00.800 --> 00:43:05.280
of expectation is really on on aggregate

00:43:03.000 --> 00:43:06.440
demand and certainly on asset prices but

00:43:05.280 --> 00:43:08.359
aggregate demand asset prices are

00:43:06.440 --> 00:43:10.838
connected because agre asset pric is

00:43:08.358 --> 00:43:13.239
about wealth and you know and and the

00:43:10.838 --> 00:43:16.119
value of future cash flows which are

00:43:13.239 --> 00:43:19.679
more or less the same drivers as for

00:43:16.119 --> 00:43:22.280
investment and and and and consumption

00:43:19.679 --> 00:43:25.519
and finally I want to say the many times

00:43:22.280 --> 00:43:27.519
when you find sort of episodes of

00:43:25.519 --> 00:43:29.000
fiscally even sometimes monetary policy

00:43:27.519 --> 00:43:31.759
that are

00:43:29.000 --> 00:43:33.599
counterintuitive is entirely due to the

00:43:31.760 --> 00:43:36.119
the expectations part so this case of

00:43:33.599 --> 00:43:37.559
fiscal consolation is not that the C the

00:43:36.119 --> 00:43:39.760
cutting in fiscal

00:43:37.559 --> 00:43:42.000
expenditure was expansionary that was

00:43:39.760 --> 00:43:45.680
not that was contractionary but it was

00:43:42.000 --> 00:43:47.960
overwhelmed or offset more than upset by

00:43:45.679 --> 00:43:51.000
the out the Improvement in the

00:43:47.960 --> 00:43:52.760
Outlook that that uh that you had and

00:43:51.000 --> 00:43:54.920
that also happens with monetary policy

00:43:52.760 --> 00:43:58.559
countries that have high inflation

00:43:54.920 --> 00:44:02.358
problems and so on er er

00:43:58.559 --> 00:44:04.800
sometimes ER get and they have to go

00:44:02.358 --> 00:44:06.880
through dramatic tightenings and so on

00:44:04.800 --> 00:44:08.119
yes most of them get sort of very short

00:44:06.880 --> 00:44:09.480
lead recession but sometimes they're

00:44:08.119 --> 00:44:12.640
very short lead recessions because

00:44:09.480 --> 00:44:16.039
eventually sort of the the the reduction

00:44:12.639 --> 00:44:18.838
of the in the instability caused by by

00:44:16.039 --> 00:44:21.519
high and unstable inflation sort of ends

00:44:18.838 --> 00:44:25.159
up dominating any direct contractional

00:44:21.519 --> 00:44:25.159
effect of monetary

00:44:26.039 --> 00:44:30.079
a e