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48:36
Transcript
0:18
okay let's uh let's start so by now uh
0:22
you know the is Mo and if you don't
0:26
fully control it please spend a lot of
0:29
time on it um as I said two third of
0:32
your quiz will be about that but uh
0:35
we're going to start adding a few it's a
0:37
very basic model but still H we can
0:41
squeeze a lot of insight from it and uh
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0:45
and there are some very natural
0:46
extensions that that I think we should
0:48
also go over and and cover because uh
0:53
again they have a high return in terms
0:55
of investment to to knowledge you acquir
0:58
from them and today I want to extend
1:00
this islm model along two realistic
1:05
Dimensions the first one ER is H is to
1:11
make a distinction between nominal and
1:13
real interest rate now
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1:16
nominal up to now since we assume in the
1:18
mod since we assume that prices were
1:20
completely fixed constant there's no
1:23
inflation and then there is no
1:25
distinction between nominal and real
1:26
interest rates but needless to say we
1:29
live in an environment with inflation is
1:31
positive typically not always but
1:32
typically and in fact nowadays we're
1:35
having very high inflation and that's
1:36
part of one of the big macroeconomic
1:38
headaches that we have at this moment is
1:40
the very high inflation rate we're
1:42
experiencing now we're not going to talk
1:44
about the determination of inflation
1:46
until later in the course I'm going to
1:48
start talking about that in the next
1:50
lecture and it will not be part of your
1:52
quiz though sorry not in the next next
1:54
week but will not be part of your of of
1:57
your quiz it will be very important part
1:59
of quiz to but not of quiz one but I
2:01
still can we can still say a few things
2:04
about what happens to the framework we
2:07
have conditional or taking as a
2:10
parameter inflation we're not going to
2:12
determine inflation the M but we say
2:14
well what happens is inflation is not
2:15
really zero more importantly what
2:17
happens if people don't expect inflation
2:19
to be really zero and and and we'll see
2:22
how that modifies the
2:24
analysis the second the second extension
2:28
is is that
2:30
that you know we simplify financial
2:32
markets enormously and and and the and
2:36
we targeted we customiz it to we could
2:39
have simplified along many dimensions
2:41
but the simplification that we had is we
2:44
look at something that
2:46
that that is closest to what central
2:48
banks do in setting monetary policy and
2:51
that's really the trade between cash
2:54
deposit at the central bank and
2:57
bonds US government bonds in the case of
3:00
the US typically of very short maturity
3:03
and that's what we had in mind H and
3:06
that's that's the way we determine the
3:08
interest rate now needless to say there
3:10
are many many interest rates in the
3:12
economy different duration you know one
3:15
year rate twoe rate three 10 30 year
3:18
rates some countries have 100 Year rates
3:22
er er but there is also another
3:25
dimension which is very important as the
3:27
want to highlight there which is
3:29
riskiness US Treasury bonds especially
3:32
of short duration are riskless assets
3:34
there no risk associated to it now we
3:36
have a little event with the with the
3:38
dead ceiling fight in in that may happen
3:41
in August September but I mean nobody's
3:44
really concerned that something major
3:46
will happen except for a few disruptions
3:48
for a few days let's hope that's true up
3:52
to now if you look at all the risk
3:53
markets there behaving as nothing will
3:55
happen there um but but corporations
3:58
don't typically borrow at those rates
4:01
Corporation issue their own bonds or
4:03
take loans from the banks and those
4:05
bonds often have a risk premium that is
4:08
they're equal to the safe interest rate
4:10
the treasury rate if you want plus
4:12
something else okay and and and so that
4:16
you can anticipate that that will be
4:17
important because interest rate enter
4:21
into our islm analysis precisely through
4:24
the borrowing cost of firms in the
4:26
investment function so if there is a
4:28
wtge there if there's a spread between
4:31
what the rate we been talking about and
4:35
the rate at which firms can actually
4:36
borrow then that W will matter okay and
4:41
uh and so that's that's what we're want
4:43
to do so we're going to introduce this
4:44
I'm want to explain what these things
4:45
are and then I'm going to modify our
4:48
islm model to take into consideration
4:51
these extensions
4:53
okay H so what is the nominal interest
4:57
rate well we have been talking about the
4:58
nominal interest rate we which we
5:01
typically denote by little I is the
5:04
interest rate in terms of dollars say if
5:06
the interest rate is 10% no you buy a
5:10
bond today that Bond will give you 10%
5:12
of whatever amount of money you invest
5:14
in the bond at the end of the year say
5:16
it's a onee b okay that's a nominal
5:19
interest
5:20
rate um so if you buy 100 in bonds today
5:25
and the interest rate is 10 the nominal
5:27
interest rate 10% you receive $10 of
5:31
interest payments one year from now $10
5:34
of Interest payment okay a real interest
5:38
rate is the interest rate in terms of a
5:40
basket of
5:42
goods
5:44
okay so the CPI or something like that
5:48
will will be important in that okay
5:51
exante that is at the moment in which
5:53
you decided were to invest in the real
5:55
Bond or the nominal
5:57
Bond the difference between the two the
5:59
main difference there are other issues
6:01
that have to do with Reem I'm not going
6:03
to talk about but the main difference
6:04
between these two is expected
6:07
inflation okay in other words if you
6:10
expect no inflation then the distinction
6:12
between goods that is if you expect P to
6:15
remain constant the distinction between
6:17
an interest rate in dollars or in h
6:21
Goods is inexistent they're the same but
6:25
if you expect inflation then that's not
6:27
the case because the goods are going to
6:28
become more expensive over time and if
6:30
the goods become more expensive over
6:32
time that means something that pays you
6:34
in dollars is paying you
6:36
more per equal units so if the r little
6:39
r which is the interest rate is equal to
6:41
I and you expect inflation to be 10%
6:45
really you're expecting the real
6:46
instrument to pay you 10% more than the
6:48
other that cannot happen in equilibrium
6:51
but that's what it means no because one
6:52
is paying you in dollars and the other
6:54
one is paying you in Goods that will be
6:55
10% more expensive next year okay
7:00
good so why do we care about this
7:02
distinction between nominal and real
7:04
interest rate well because the private
7:07
sector ER important decisions of the
7:09
private sector like the purchase of
7:11
durable goods for consumers we're not
7:12
modeling that in this course but
7:15
investment in the case of phisical
7:17
investment not Financial investment
7:18
phisical investment depends on real
7:20
rates not nominal rates okay so what
7:24
what what determines whether H the
7:27
opportunity cost of a real investment is
7:29
high or low is the real interest rate
7:30
not the nominal interest
7:35
rate why do you think that's the
7:47
case why do you think it's the real not
7:50
the nominal interest rate that
7:58
matters not really I mean most of the
8:00
borrowing in the US is done in nominal
8:05
rates so it has to come from something
8:08
else why why do you
8:11
invest you invest to produce more Goods
8:13
in the
8:14
future so if those goods are going to be
8:17
more expensive in the future because of
8:20
inflation then what matters to you is
8:22
the difference between the cost of
8:23
borrowing and what you'll get for those
8:25
goods and the goods are going to be 10%
8:27
more expensive so what really matter is
8:29
the net for you you know if then if in
8:32
other words if the real interest remains
8:33
constant and now you give me interest
8:35
rates are 10% higher but you also tell
8:37
me that the goods I'm going to be
8:38
selling are going to be 10% more
8:39
expensive I I don't change my decision
8:42
if it was a good project with zero
8:44
inflation it's also a good project with
8:46
10 10% inflation that hasn't changed I
8:49
tell you 30% the same thing no because
8:54
I'm going to be investing now in order
8:55
to get things are going to be 30% more
8:57
expensive a year from now so the de
8:59
ision that doesn't depend on that so
9:02
that's the reason the real interest rate
9:04
is what you really care about in the
9:06
case of real investment and remember
9:08
we're talking about real investment at
9:10
the aggregate level obious can make a
9:11
difference at the level of individual
9:13
Goods because you know when inflation
9:15
goes up not every Goods price go up by
9:17
the same amount some some goods go up by
9:20
more some some Goods prices go up by
9:23
less but on average it's what I just
9:27
said so let's let's try to look at this
9:30
equivalence more formally how to derive
9:32
the real interest
9:33
rate
9:35
well in I said not in the US but in many
9:38
places you do re borrow in real terms
9:41
for example in in Chile we have a a unit
9:43
of account because we had very high
9:45
inflation many years back which is
9:47
called unid fomento and that in that
9:50
unit of account is indexed to inflation
9:53
okay so you borrow you know uh $10
9:57
million equivalent in a formento and
10:00
those 10 million pesos equivalent
10:03
formento that means the interest rate is
10:05
is indexed to that but in the US that
10:07
happens very rarely the US government
10:10
does do
10:11
that it's called tips so so you have
10:15
nominal bonds the great majority of the
10:17
US Treasury bonds are nominal bonds but
10:19
there are also some real bonds and those
10:21
are indexed to inflation but but but
10:24
firms very rarely can issue Bonds in the
10:27
US that are in real terms okay that's so
10:31
let's sometimes this is even a so but
10:35
the point the reason I I made that
10:37
clarification here is I'm going to
10:39
derive the real interest rate but that
10:41
doesn't mean that the instrument exists
10:43
you know I'm saying given a nominal rate
10:46
that I see out
10:47
there how do I construct a real interest
10:51
rate from that nominal interest rate
10:52
that's what I want to hear it doesn't
10:54
mean that there's an instrument that is
10:56
traded in in real terms but when I go to
10:59
the the bank as a firm and I borrow a
11:02
10% nominal I need to calculate well
11:05
what does that imply in real
11:06
terms and that's what I'm going to
11:08
illustrate now okay
11:11
so good so or maybe I shouldn't use the
11:16
word good since we're going to do this
11:18
so what we want to pin down this this
11:20
this real interest rate R okay so the
11:24
real interest rate in terms of goods
11:26
means if I borrow say one unit or if I
11:29
buy a a an instrument that if I spend
11:32
one unit of the good the aggregate good
11:35
in a bond then I I receive one plus RT
11:39
units of goods H one year from now then
11:43
RT is the real interest rate no it's an
11:45
interest rate in terms of
11:48
goods now suppose that that I go this
11:51
route instead say okay that's what I
11:53
want to get to but um let me do it
11:57
through the only instrument I have say
11:59
the nominal interest rate the nominal
12:00
bonds so if I buy one unit of goods
12:05
today that means I'm really buying
12:09
PT dollars in that Bond okay PT is the
12:13
deflator we have we have PT
12:16
dollars well PT dollars invested in a
12:19
nominal Bond will give me 1 plus it the
12:23
nominal interest rate times those PT
12:25
dollars okay so say the price index here
12:29
is is two then uh and the interest rate
12:32
is 10 the nominal interest rate 10% then
12:35
next period I get a two * 1.1 okay
12:39
that's the number of dollars I get now
12:42
that's
12:43
still I cannot compare this with the
12:47
with this up here because at this point
12:48
I have dollars and really I want to
12:50
convert it into Goods I want to go from
12:52
Goods to Goods so how do I convert
12:55
dollars into Goods
13:01
I divide by the price of the goods but
13:02
not here by the price of the goods at t
13:04
plus one because I'm going to get this
13:06
amount of dollars at t+1 one year from
13:09
now I have to divide by the price of
13:11
goods at t+ one in order to get the
13:14
number of goods I'm getting a t plus one
13:16
so I have to divide by p+ one but the
13:18
problem is that time T I don't know what
13:21
pt+ one will
13:23
be okay the best I can do and here's
13:27
where I'm I'm simplifying things a lot
13:29
is to is to have an expectation of what
13:32
the price level will be one year from
13:34
now so the best I can do when I want to
13:37
compare things today whether I want to
13:39
go this way or that way is to a er use
13:43
suspected price here okay so these two
13:48
things are equivalent in the sense that
13:49
they require exactly the same investment
13:52
I'm now I'm going this way and then in
13:54
expectation at least these two things
13:56
are also equivalent okay
13:59
because this is what I'm going to get in
14:01
terms of goods from having invested a
14:02
good this what I expect to get in terms
14:04
of goods but I'm ignoring all that
14:06
uncertainty around that H and this is
14:09
what I get if I go directly the route
14:12
the the Goods Route and and this is two
14:14
things are to be equal by indifference
14:16
okay I if I two things give me the same
14:18
they have to be priced equally they have
14:20
to have the same price and so these two
14:22
things have to be the same because here
14:24
I'm going from Goods to Goods here I'm
14:26
going through this channel but also from
14:28
Goods to Goods these two things should
14:30
give us more or less the same return
14:32
okay and we're going to assume strictly
14:34
that they give us the same expected
14:37
return okay so this relationship
14:41
holds is this di clear diagram
14:44
clear okay good because what I'm going
14:47
to do now is I'm going to take this
14:48
expression here and play with it a
14:52
little so we arve in the previous slide
14:55
to the conclusion that 1 plus the real
14:57
interest rate is equal to 1 plus plus
14:59
the nominal interest rate time PT over
15:01
PT + one expected I'm going to denote
15:06
expected inflation the inflation we
15:09
expect the change in the the the log
15:11
change in the price level or the rate of
15:13
change of the price level from year T to
15:15
year t+1 as Pi e t+1 is equal to that
15:20
okay so this is expected inflation at t+
15:24
one see
15:26
that well do a little algebra and I can
15:29
rewrite this guy here as 1 plus expected
15:32
inflation between t and t plus one okay
15:35
I just I just replace this for one one
15:39
over 1+ pi+ one okay just algebra I got
15:44
that so now I have relationship and
15:47
these things if they if this interest
15:49
rate is not too high this in expected
15:51
inflation is not too high not too large
15:53
as it happens in most countries but a
15:55
few around the world then this is
15:59
approximate implies approximately that
16:01
the real interest rate is approximately
16:03
equal to the nominal interest rate minus
16:06
expected
16:08
inflation okay I'm just taking
16:10
approximations
16:17
here okay and that's is an intuitive
16:20
expression the real interest rate is
16:22
equal to the nominal rate minus expected
16:26
inflation so
16:30
if if the interest rate is is
16:33
6% and expected inflation is 3% well the
16:36
real interest rate is only 3% okay in
16:39
terms of good you're going to get 3%
16:41
less because that's inflation
16:43
rate good or if you're borrowing in
16:47
terms of your borrowing cost well it's
16:48
going to cost you 3% less effectively
16:51
because the goods you're going to be in
16:53
selling out of your investment are Al
16:56
are going to be 3% more expensive
16:59
good so look this is what happened I'm
17:02
showing you what happened around the
17:04
years of the Great Recession remember
17:06
the Great Recession happened 20 end of
17:08
2008 2009
17:10
2010 several things you can see in this
17:13
picture ER the white line here is the
17:16
nominal interest rate and the yellow is
17:18
the real interest rate in the US okay
17:22
and and this is a since in the US you
17:25
can actually trade real and nominal
17:27
bonds the difference between these two
17:30
is expected inflation okay as as priced
17:34
by financial
17:35
markets they're called in the US they're
17:38
called inflation break evens these are
17:40
swaps inflation swaps okay inflation
17:42
break evens but anyways so several
17:45
things you can see in this picture the
17:46
first one is that typically typically
17:50
the unless you're in Japan probably the
17:53
the the the white line that is a nominal
17:56
rate is above the orange line which is
18:00
or the yellow line which is the real
18:03
interest rate why do you think that's
18:04
the case or what does it tell
18:07
you the fact that on average sort of
18:12
er the nominal interest rate is above
18:14
the real interest
18:17
rate yeah on average in most advanced
18:20
economies and even more so in Emerging
18:22
Markets inflation is positive and
18:24
therefore people expect inflation to be
18:26
positive okay yeah in Japan went through
18:29
these long periods of deflation but
18:30
that's a rarity that was an anomaly what
18:33
was going on in Japan but you see
18:36
something else here there's an episode
18:39
very clearly when the opposite was
18:41
holding no when the real interet went
18:43
much higher than the nominal interest
18:45
rate and this is despite the fact that
18:47
you see even they cross in opposite
18:49
direction here there was a sharp decline
18:51
in the nominal interest rate and a sharp
18:54
rise in the real interest rate what
18:56
happened what was happening there
19:07
first of all forget about the picture
19:09
what was happening around 2008
19:13
2009 the Great Recession okay so that's
19:17
one observation typically especially
19:19
modern recession certainly recessions
19:21
caused by financial crisis as this one
19:24
was a a um real interest
19:29
go above nominal interest rate can go
19:32
above nominal interest rates what does
19:34
it
19:35
mean in terms of
19:38
inflation I mean remember what the FED
19:40
is setting is this is this one more or
19:43
less this I think is a one-ear rate so
19:45
it's not exactly what the FED said but
19:46
more or less okay so why do you think
19:50
the FED cut interest rate there very
19:53
aggressively yeah we were in the middle
19:55
of a big financial crisis so we wanted
19:57
to boost the economy no so interest rate
19:59
and this is when you map it into into
20:02
the very short rate this is effectively
20:04
they hit the zero lower bound they
20:05
couldn't lower it more they lower it as
20:07
much as they could and that was it so
20:10
what must have happened for this real
20:13
interest rate to go up like
20:17
crazy how can it be there the FED
20:20
Bringing Down the nominal interest rate
20:22
and the real rate boom jumps
20:26
up expected inflation went down and L so
20:29
what I was saying is in expected
20:31
inflation is typically positive in in in
20:34
sort of developed economies around 2%
20:36
two and a half perc that's the type of
20:38
numbers but in deep recessions it can go
20:41
even negative okay and that's what
20:44
happen there is the expected inflation
20:46
as extracted from inflation break evens
20:49
from these swaps and you see you know
20:51
typically it's around 2% and so on
20:54
because that's more or less the the the
20:56
FED inflation Target in the US
20:59
okay but during this episode here we
21:02
enter into a very deflationary
21:05
episode expected inflation close to
21:07
minus 4% that was very deflationary was
21:10
very scary deflations can be very
21:12
complicated objects to deal with ER
21:15
we'll say more about that later okay but
21:19
that's that's what happened
21:22
there good so that's that's nominal
21:25
versus real interest rate now let me
21:27
talk about credit spread and then we're
21:29
going to put everything together
21:32
so most bonds issued by corporations are
21:36
risky they are not us Treasures are as
21:38
safe as it gets that's consider the
21:40
safest Assets in the world together with
21:44
German bond market bonds you know
21:48
government bonds and SS and there are a
21:50
few but but the US in terms of liquidity
21:52
everything is the Premier safe asset in
21:55
the world okay but most corporations
21:58
don't issue at those rates they have to
21:59
pay a premium because they're not as
22:01
safe as as those as the treasury
22:05
instrument so let me call that the real
22:08
interest rate paid by this uh bonds by
22:12
issues by firms on average be equal to
22:15
the safe real interest rate plus a
22:17
premium
22:18
XT
22:20
okay
22:22
now the point and is important is that
22:25
this risk premium moves a lot over the
22:27
business cycle especially when you have
22:29
a financial crisis you know people
22:31
really want to run away from
22:34
risk
22:35
now and and and so it tends to be higher
22:38
during recessions especially when
22:40
recessions are caused by financial
22:42
crisis and things of that kind now why
22:45
do we care about the risk premium again
22:47
because important private sector
22:49
decisions depend on that real interest
22:51
rate on the on on the on the risk
22:54
adjusted interest rate okay if a firm
22:58
has lots of credibility problems and is
23:01
considered very risky the cost of
23:02
borrowing is going to be very high and
23:04
therefore it's going to have to have a
23:05
higher threshold for any physical
23:07
investment no it's more costly for that
23:09
firm to
23:11
borrow so that's a reason to worry so
23:14
the risk premium is that X there is
23:16
determined by two things essentially in
23:19
in the case of bonds there's also risk
23:21
premiums in equity but in the case of
23:22
bonds one thing is the priority of
23:24
theault I mean it may be that the firm
23:27
doesn't honor those BS and defaults on
23:29
them okay so one thing is a primary
23:32
default the other one is the degree of
23:34
risk aversion of bone bone holders there
23:36
are sometime times in which you say look
23:38
I don't want to hold any risk here or
23:40
very little risk because you know
23:41
everything looks very complicated to me
23:43
I rather go safe I go to treasury bonds
23:45
I don't want this stuff so those two
23:47
reasons make that spread grow the second
23:50
reason on average to me is the most
23:53
important reason but it's easier to
23:55
model all this stuff as a priority of
23:57
the fault so that's what I'm going to
23:59
assuming what I'm going to do here is
24:00
I'm going to ignore this the degree of
24:02
risk aversion of bond holders and I'm
24:04
going to just concentrate on the
24:05
probability of theault of a bond but in
24:08
a sense you can model both as the same
24:11
because you can think of risk aversion
24:14
as somebody exaggerating the probability
24:15
of the fault of a bond if I if I get
24:18
very nervous about investing in Risky
24:20
stuff there is some true probability of
24:22
the fault that some agenci is
24:24
calculating out there but if I'm very
24:26
nervous about that I may as well put a
24:28
markup say well you know these guys have
24:31
messed up in the past they may think
24:33
that the probility def fall of this bond
24:34
is 5% during the next year I'm going to
24:38
treat it as 10% okay because I want to
24:41
penalize for the risk I'm incurring so
24:44
so think of this P here as a probity of
24:46
theault but as perceived by in you don't
24:49
know the what is the true probity of
24:51
theault that's a abstract concept
24:55
no but it's whatever you use in your
24:57
investment decisions that I'm modeling
25:00
here so by the same principle we had
25:02
before between nominal and real bonds
25:05
what we need to have is is I need to be
25:07
different in equilibrium I need to be
25:09
different between H investing in in in
25:13
treasury bonds the safe bonds that pay
25:16
an interest RT and investing in Risky
25:19
bonds that are paying an interest rate
25:21
RF which is greater than a RT no so I
25:25
have to be indiffer between these two
25:27
things and the and the the spread here
25:29
will have to adjust so I'm indifferent
25:31
between these two things indeed it's
25:33
obvious if the probability of default is
25:35
greater than zero that this RF is going
25:38
to have to be greater than R because
25:39
otherwise I don't you know I don't want
25:41
to invest in a bond that pays me the
25:42
same as that and on top of that I I I
25:45
can experience a default occasion don't
25:48
get my money back okay so what we have
25:50
here this indifference condition means
25:53
okay during the next
25:55
year there's a probability to the fall p
25:58
that means with probability one minus P
26:01
I'm going to get this High interest rate
26:03
I'm going to get my money back I invest
26:05
one in a bond I get my money back plus
26:07
an interest rate Which is higher than
26:08
the safe interest rate is our F okay
26:10
that's a good thing against that is
26:13
there's a probability that the bone
26:15
there's a default and I'm going to
26:17
assume always in practice there is some
26:19
recovery of a bone which is much less
26:20
than the principal I'm going to assume
26:21
it's zero okay so if p is positive as I
26:26
said before then it better be the case
26:27
that this f is greater than R otherwise
26:30
I'm not going to invest anything in the
26:32
risky
26:33
Bond so I'm going to replace just this
26:35
RF by RT plus X just to calculate XT and
26:39
you can solve this out here and you get
26:41
that this risk premium is XT is an
26:45
increasing function of P okay naturally
26:48
if this if I perceive bonds to be more
26:50
likely to default and when I require a
26:53
higher compensation if the bond doesn't
26:56
default okay and that's what we we have
26:59
here now during what happens is that
27:02
during severe
27:03
recessions actual defaults go up so the
27:06
probability of theault objectively goes
27:07
up and people get a lot more scared also
27:10
that this will happen and so P tends to
27:12
go up a lot okay so during SE severe
27:15
recessions but is is always almost in
27:18
recession but especially in severe
27:19
recessions P can rise a lot okay it can
27:24
rise a lot R may fall or not we shall
27:27
see but but this stuff dominates
27:30
actually okay so this credit this x can
27:34
move up a lot during recessions and in
27:37
fact if I show you what happened during
27:40
the gr
27:41
recession same episode as before there
27:44
you have it this is our X really okay
27:47
look how it jump during 2008 okay so uh
27:52
the average and this is for I think it's
27:54
high yield I think but it's not junk
27:56
it's high yield though
27:59
ER I think it's a it's a it's a weighted
28:02
average of things
28:04
but think of this as the median bond out
28:07
there corporate bond ER it had to pay
28:11
20% more than a treasury bond okay so
28:15
big difference if you are in the private
28:16
sector and wanted to borrow than if the
28:19
government wanted to
28:20
borrow big thing this was a big
28:25
issue good now it's all almost always oh
28:29
but that level this is high yield H so
28:32
you see typically because this high
28:35
yield these are not the the primest
28:37
companies H they have a vary of default
28:40
there's a risk out there they typically
28:41
have to pay a spread 3% 4% things like
28:45
that but during severe events that can
28:48
go very very high so if you're a
28:50
corporation and you're trying to borrow
28:52
here it's going to be pretty difficult
28:54
to borrow that's the point okay not a
28:57
good time to invest in that sense it's
29:01
going to be pretty
29:03
expensive so that takes me to the slm
29:06
mod I want to sort of now bring in these
29:09
two
29:11
ingredients so the two modifications I
29:15
introduce are relevant for the is the LM
29:19
doesn't change the Central Bank keeps
29:20
setting the nominal interest rate and
29:23
that's what it does okay so that's not
29:25
changing and that's the target of the
29:26
Central Bank
29:29
the the Central Bank may decide to react
29:31
to things that happen in expected
29:32
inflation and cre spread but the LM is
29:36
is the same as it used to be in the book
29:38
at some point make the book makes a
29:41
simplification and it starts setting the
29:42
interest rate in terms of the real
29:44
interest rate I think that's a bad idea
29:45
so I'm not going to do that okay I'm
29:47
going to keep our is our LM as it was
29:50
but now with this extensions we have to
29:54
modify well the only place where
29:56
interest rate enters for us
29:59
which is in the investment function and
30:01
so the investment function now is not a
30:02
function of the nominal interest rate
30:04
it's a function of the real interest
30:05
rate adjusted by credit risk because
30:07
that's the relevant opportunity cost of
30:11
that's a real cost of borrowing if you
30:12
will of firms when they want to invest
30:17
okay so that's a modification now for
30:20
this part of the course as I said I'm
30:23
going to take this as two new
30:25
parameters we're not going to look at
30:27
equilibrium determination of that when
30:29
we get into the next part of the course
30:32
then we're never going to do much about
30:34
that but yes about this but for now
30:36
these are just two new parameters so in
30:38
our equilibrium in lecture three in the
30:41
goods market equilibrium now we have two
30:43
more parameters expected
30:45
inflation and in the remember the ZZ
30:48
curve where we have GT interest rate all
30:51
those things has constant well now we
30:52
have two new parameters expected
30:55
inflation and the credited spread
30:58
okay so that's it that's lecture three
31:02
now so what I'm showing you here is what
31:05
happened in lecture three if the credit
31:09
spreads comes down or expected inflation
31:12
Rises for any given nominal interest
31:15
rate okay then that shift the ZZ curve
31:19
up why is
31:24
that and sorry and if aggregate demand
31:27
goes up then the multiply it kicks in
31:28
and we end up with an expansion in
31:30
output so I'm saying for a given nominal
31:33
interest rate if now expected inflation
31:36
goes up or H the credit spreads spreads
31:41
go down then we that's act acts almost
31:45
like an expansionary monetary policy you
31:46
see you get an expansion in aggregate
31:49
demand yes
31:58
for RIS deine they can they can borrow
32:02
exactly that's it yes because of
32:04
borrowing went up for down for firms
32:06
okay so that's what I'm saying those two
32:09
things operate almost as monetary policy
32:11
that is not been done by the fed by the
32:12
way by the central bank but they have
32:14
the same effect because that's the way
32:16
they enter they enter exactly the same
32:18
as as an interest rate so saying that
32:21
this guy is going up or this guy is
32:22
going down leads to the same analysis as
32:27
as as when we lower I because they're
32:31
identical they enter exactly in the same
32:33
place no so what I showed you here I had
32:38
done diagrams like this before that's
32:40
what you get when you lower the interest
32:42
rate well the the two shocks I describ
32:45
is effectively like lowering the
32:46
interest rate that is the relevant
32:48
interest rate for a a the firms because
32:54
lower CR spreads higher expected
32:56
inflation means lower re interest rate
33:00
okay now the the episode I describe you
33:04
in in in in during the global financial
33:06
crisis was exact opposite of this no in
33:10
the global financial crisis we had this
33:13
x boom
33:15
jumping and I had shown you
33:17
before that expected inflation came down
33:21
a
33:22
lot okay remember expected inflation
33:25
came down a lot when negative
33:28
no from around 2% to minus four that's a
33:31
big shock for the real cost of borrowing
33:35
for
33:35
firms
33:37
and the X went up like
33:41
crazy that's the reason in the global
33:44
financial crisis what we got is exactly
33:46
the opposite of this we got a massive
33:48
shift down in the zzer for the reasons
33:51
we just described
33:54
okay because this again this is the case
33:57
for x going down or Pi going up in the
34:00
global financial crisis we' got exactly
34:01
the opposite and in massive amounts no
34:04
massive increase in X massive decline in
34:07
expected inflation so it's exact
34:09
opposite of this and in a much larger
34:12
scale that was a massive
34:14
shock
34:18
good so that's the case I was just
34:20
describing that's what happened in the
34:21
global financial crisis so the first
34:24
thing is so if x goes up as it did in
34:27
the global financial crisis and the
34:28
Great Recession I I by the way when I
34:31
say the global financial crisis or the
34:32
Great Recession those are the same
34:34
episode end up being it started from a
34:36
financial crisis and it turned out ended
34:38
up being a recession everywhere and a
34:41
financial crisis everywhere as well okay
34:44
but uh anyway so what I just described
34:47
is this is the in the islm space the is
34:51
is shifting inwards a lot no for any
34:54
given nominal interest rate if x goes up
34:57
a lot that means there is less
34:59
investment and that means that the LM
35:02
shift to the sorry the is shift to the
35:04
left okay and the same would happen if
35:07
there's a fallen expected inflation so
35:09
for the great session we had two reasons
35:11
why this thing move inward a lot one
35:13
expected inflation came down and the
35:15
other one X went up a lot massive
35:17
movement to the left now what do you
35:19
think a central bank should do face with
35:21
a situation like
35:24
this drop interest rate no why you you
35:27
do that because this shocks enter like
35:29
negative interest rate like shocks to
35:31
the interest rate effectively it's like
35:33
you had increased the interest rate a
35:35
lot and so the central bank will try to
35:37
offset that by lowering the interest
35:39
rate what problem May the Central Bank
35:42
face in doing
35:47
this yeah reaching the zero lower bound
35:50
effective lower one liquidity trap
35:51
exactly it's a limit of how much you can
35:53
do and I show you that that's what
35:54
happened really
35:56
here you see if effectively this is like
35:59
it's the reason looks so flat it doesn't
36:01
move is because it's against a lower
36:03
bound it cannot
36:05
move let me tell you a little bit about
36:07
what is happening now so this is now
36:10
remember the other one was for the
36:12
period from 2008 to 2013 I show you now
36:16
I'm shifting everything by 10 years okay
36:19
so still you see on average the the the
36:24
the white line which is the nominal
36:25
interest rate is above the um the Orange
36:29
Line the Orange Line the yellow line
36:31
which is the
36:33
um the real interest rate why is
36:40
that
36:42
yeah yeah posi inflation posit INF
36:46
expected inflation but they're
36:48
correlated when inflation is on average
36:50
positive then expected inflation is also
36:52
an average
36:53
positive there's an exception there why
36:56
is that what when does it
37:02
happen there's one point
37:06
where the real interest rate went above
37:08
the nominal interest
37:12
rate
37:13
sorry recession yeah exactly the covid
37:16
recession so as I said before that was a
37:19
massive shock a scary shock and initial
37:21
reaction of expected inflation was to
37:22
come down enormously and that's so
37:24
that's what we saw and also see that
37:27
this biggest step here in the in the
37:30
nominal interest
37:32
rate and then flat so what do you think
37:35
happened
37:37
there yep again they went all the way
37:41
down at to at the maximum they could do
37:43
they said the the shortterm interest
37:45
rate to zero effectively effect it's not
37:47
exactly zero but to zero and they stay
37:50
there for a very long period of time now
37:53
why do you think and this I think help a
37:55
lot the recovery of the US economy and
37:59
it also a a a big reason for the rally
38:03
that you saw in the equity Market in
38:05
2021 you can see in this picture which
38:08
is this notice that the real interest
38:11
rate went very very
38:15
low you see that the real interest went
38:18
very very low that's a reason Equity
38:21
markets were flying I mean you have
38:22
effectively very low real interest rates
38:25
so what happened there how did that
38:27
happened what must have happened in this
38:30
episode yeah the central bank was
38:32
putting injecting everything possible to
38:34
it but even more than monetary policy
38:37
conventional monetary but but what can
38:40
prod what is the reason let me say this
38:43
wedge reflects
38:53
what what is the what is that W as a
38:56
matter of accounting
38:59
expected inflation yeah it's expected
39:01
inflation so this tells you this
39:02
interest was at zero the real interest
39:04
was at at minus four here it means that
39:07
expected inflation must have been
39:10
4% okay that means so we had a
39:13
combination in which the nominal
39:15
interest remain at zero but inflation
39:17
was high which is not the typical
39:19
combination we get in recessions like
39:21
the previous one demand recessions
39:23
financial crisis where inflation is goes
39:25
down when you are in a recession this
39:27
was a different shock and after the
39:29
initial shock we got lots of bottlenecks
39:31
on the supply side of the economy which
39:33
we don't have a good mod yet later we
39:36
want to have to model here and when you
39:38
have prod in the supply side you can get
39:40
a situation which it feels recessionary
39:42
because there's low activity and so on
39:44
but inflation is high and that's exactly
39:47
what we had here okay the inflation was
39:50
high now at some
39:53
point H you know for a while we
39:56
tolerated this inflation thinking that
39:58
this was going to be a transitory
40:00
phenomenon and so on but then it began
40:01
to last for too long okay and when it
40:04
began to last for too long then the the
40:08
FED reacted and that's when you see they
40:10
began to hike interest rate okay and
40:13
they began to hike interest rate and
40:16
that initially didn't do much er er to
40:20
the real rates because expected
40:21
inflation kept
40:23
rising and then eventually they
40:25
convinced everyone that they were
40:27
serious about this and so real interest
40:29
rate began to H rise a lot here and
40:33
that's when the equity Market Collapse
40:35
by the way you don't know that yet but
40:37
I'm going to talk about Equity Market
40:38
later on but but I believe me that's
40:40
what essentially brought down the NASDAQ
40:43
for sure primarily and all these M
40:46
stocks and all that well that's that's
40:48
that
40:51
okay um what about today well Houston we
40:56
have a problem because because you see
40:57
the FED keeps Rising interest rate and
40:59
inflation is not coming
41:01
down as much as we expected in fact
41:03
expected inflation initially looked like
41:05
what's going to decline and and now it's
41:06
beginning to pick up again so you have a
41:09
situation here where the FED wants to be
41:11
restrictive but the real interest is
41:13
declining not going up that's a problem
41:16
okay it's a problem that's that's what
41:18
is happening at this very moment fed has
41:21
a big problem because of that they're
41:22
trying to tighten interest rate but
41:24
Financial conditions are relaxing in a
41:26
sense
41:28
because of an increase in expected
41:29
inflation and even credit spreads were
41:32
declining like so here is what I just
41:35
said in terms of
41:36
inflation ER expected inflation and you
41:39
see here the big collapse during covid
41:42
early on in covid but then it recovered
41:44
very strongly and went very
41:47
high and and actually the middle of 2022
41:50
it really went up a lot and that's when
41:51
the FED really got a scar and that's
41:53
when they began to increase interest
41:55
rate by 75 basis points in in a hurry
41:58
okay and this is what you see recently I
42:00
told you that we have a problem now
42:03
because expected inflation they they
42:05
were able there a famous conference
42:08
Jackson happens in Jackson Hall ER and
42:12
it's famous mostly because ER you know
42:15
most
42:16
Central chairs of presidents of central
42:19
banks governors of central banks around
42:21
the world sort of meet for a few days
42:23
there but there is one speech that
42:25
everyone looks at which is a speech of
42:28
the of the um chair of the US Central
42:33
Bank the FED okay and they were very
42:36
worried that that conference happened
42:38
around here and they were very worried
42:40
because suspected inflation was just
42:42
exploding I mean 6% or so that's those
42:44
are unheard of numbers for the us since
42:47
the
42:47
80s and and so they came up with a very
42:50
tough speech very Hwy speech saying look
42:53
this is unacceptable we're going to do
42:55
whatever it takes to bring this stuff
42:57
down and and and they were very
42:58
successful persuading people in fact
43:01
expected inflation began to decline a
43:03
lot very quickly which is one of the
43:05
reasons you see real rates Rising very
43:08
fast in fact faster than than the
43:10
nominal rates because nominal rates were
43:13
rising and on top of that expected
43:15
inflation began to plummet and that led
43:17
to a very sharp rise in real interest
43:19
rate and the collapse in the stock
43:20
market as a result
43:24
okay what about credit spreads in in
43:27
this
43:30
episode ER well here you
43:33
see we had during the covid shock again
43:37
we got a Bigg Spike here it was not as
43:39
large as in in the other one which was a
43:41
financial crisis per se but it was a
43:43
very large Spike and then eventually
43:46
sort of came down and it came down a lot
43:49
that's again when you're seeing rallying
43:50
and all the markets and so
43:52
on H but then began to go up and and
43:55
again here we began to a problem because
43:57
the fair wanted to tighten and this
43:59
credit spreads were coming down this got
44:02
this is I think I did this on Sunday or
44:04
something
44:04
so today's 27 yeah I did it yesterday
44:07
there it is okay so so this this pickup
44:11
here is very recent this last
44:14
week but great spreads were declining
44:16
and that again goes against to to what
44:19
the FED wants to do which is to tighten
44:22
Financial conditions for firms okay now
44:27
ER as I said before central banks
44:30
typically intervene only the monetary
44:33
policy they they involves very short
44:37
duration treasury bonds so their own
44:40
bonds okay the bonds of that government
44:43
in most places like that but this shock
44:46
was so disconcerting and so large and it
44:49
did affect corporations a lot no because
44:52
you get imagine you are in the irland
44:54
industry and then suddenly you get covid
44:56
so really was a a major shock to
44:59
corporate to
45:01
corporations and um so they went beyond
45:05
traditional conventional monetary policy
45:07
they certainly something that had done
45:09
already in the global financial crisis
45:10
they began to buy sort of very long
45:12
duration US Treasury bonds so 10 year
45:15
bonds and so on treasur but they went
45:18
beyond that and they created a facility
45:19
to buy corporate bonds okay that
45:22
facility was meant to deal with XS okay
45:25
you're getting a huge huge X shock and
45:28
they went directly to that to try to
45:30
bring that X shock down why do they want
45:33
to do that well because of the reasons
45:34
we have explained here H you
45:39
know that amounted the X shock which
45:42
came together with expected inflation
45:44
coming down amount of big shift there
45:46
they did all they could with
45:48
conventional monetary policy they
45:49
brought this down so you can think of
45:51
their policies of intervention it's
45:53
called they're called large scale asset
45:55
purchases that's a generic number of
45:56
that
45:57
well what they were trying to do really
45:59
is to act on those interest rates that
46:01
do not show up in the LM that show up in
46:02
here know x x is a parameter of here if
46:07
I go out there and I buy a a corporate
46:10
bonds then I'm reducing X which is a way
46:13
of Shifting the yes back okay
46:15
corporations can borrow more cheaply if
46:17
the government is buying their bonds
46:20
that's the whole idea in in in in Japan
46:24
they even bought
46:25
Equity okay the Equity interventions in
46:28
the equity market so happened in Hong
46:30
Kong in 1997 there was a massive
46:32
intervention in the equity Market
46:34
typically central banks don't do that
46:36
but when situations get desperate and
46:39
and you are against the zero lower bound
46:41
so you you lost your conventional
46:42
monetary tool ER they tend to be a
46:46
little more creative and and that's what
46:48
they've been
46:52
doing okay any questions that's it for
46:56
today
46:57
from the yeah you have a question could
46:59
you put X into like more tangible terms
47:02
I think I'm still sort of like trying to
47:04
figure out what a create spr for example
47:07
a uh if if boing I don't think Bo is a
47:12
high yield maybe maybe
47:16
ER well let's say boing it's okay if
47:19
boing borrows they're not going to be
47:20
able to borrow the say that the 10e rate
47:23
I'm showing it here in 10e rate spread
47:25
the 10e rate the us at this moment is
47:28
you know close to 4% if boing wants to
47:32
borrow 10 years he's not going to be
47:34
able to borrow at 4% they going to have
47:36
to borrow at 7% so there's a 3%
47:38
difference that's
47:40
X that's X that's great SP spread which
47:44
is linked to the perceived probability
47:46
of the fault I said it's more than it's
47:48
perceived when you say perceive is is
47:50
the say the actual probability of
47:52
theault who who knows who can measure
47:55
that there are again agencies that try
47:56
to meure measure them plus whatever
47:58
extra risk premium you want to put on
48:00
top of
48:01
that
48:04
Rel reliability of americ yeah how
48:08
unattractive it looks to lend to a
48:11
corporate versus lending to the US
48:13
government and when this LM is very high
48:15
it looks very unattractive to lend to
48:16
corporations and therefore you need to
48:17
be compensated a lot for
48:22
that
48:25
okay e
— end of transcript —
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