1 00:00:18,359 --> 00:00:26,560 okay let's uh let's start so by now uh 2 00:00:22,679 --> 00:00:29,359 you know the is Mo and if you don't 3 00:00:26,559 --> 00:00:32,278 fully control it please spend a lot of 4 00:00:29,359 --> 00:00:35,600 time on it um as I said two third of 5 00:00:32,279 --> 00:00:37,879 your quiz will be about that but uh 6 00:00:35,600 --> 00:00:41,280 we're going to start adding a few it's a 7 00:00:37,878 --> 00:00:45,000 very basic model but still H we can 8 00:00:41,280 --> 00:00:46,520 squeeze a lot of insight from it and uh 9 00:00:45,000 --> 00:00:48,960 and there are some very natural 10 00:00:46,520 --> 00:00:53,280 extensions that that I think we should 11 00:00:48,960 --> 00:00:55,120 also go over and and cover because uh 12 00:00:53,280 --> 00:00:58,679 again they have a high return in terms 13 00:00:55,119 --> 00:01:00,759 of investment to to knowledge you acquir 14 00:00:58,679 --> 00:01:05,879 from them and today I want to extend 15 00:01:00,759 --> 00:01:11,118 this islm model along two realistic 16 00:01:05,879 --> 00:01:13,079 Dimensions the first one ER is H is to 17 00:01:11,118 --> 00:01:16,079 make a distinction between nominal and 18 00:01:13,079 --> 00:01:18,798 real interest rate now 19 00:01:16,079 --> 00:01:20,719 nominal up to now since we assume in the 20 00:01:18,799 --> 00:01:23,159 mod since we assume that prices were 21 00:01:20,719 --> 00:01:25,039 completely fixed constant there's no 22 00:01:23,159 --> 00:01:26,640 inflation and then there is no 23 00:01:25,040 --> 00:01:29,200 distinction between nominal and real 24 00:01:26,640 --> 00:01:31,040 interest rates but needless to say we 25 00:01:29,200 --> 00:01:32,960 live in an environment with inflation is 26 00:01:31,040 --> 00:01:35,240 positive typically not always but 27 00:01:32,959 --> 00:01:36,839 typically and in fact nowadays we're 28 00:01:35,239 --> 00:01:38,920 having very high inflation and that's 29 00:01:36,840 --> 00:01:40,680 part of one of the big macroeconomic 30 00:01:38,920 --> 00:01:42,478 headaches that we have at this moment is 31 00:01:40,680 --> 00:01:44,920 the very high inflation rate we're 32 00:01:42,478 --> 00:01:46,679 experiencing now we're not going to talk 33 00:01:44,920 --> 00:01:48,239 about the determination of inflation 34 00:01:46,680 --> 00:01:50,118 until later in the course I'm going to 35 00:01:48,239 --> 00:01:52,158 start talking about that in the next 36 00:01:50,118 --> 00:01:54,680 lecture and it will not be part of your 37 00:01:52,159 --> 00:01:57,680 quiz though sorry not in the next next 38 00:01:54,680 --> 00:01:59,320 week but will not be part of your of of 39 00:01:57,680 --> 00:02:01,840 your quiz it will be very important part 40 00:01:59,319 --> 00:02:04,758 of quiz to but not of quiz one but I 41 00:02:01,840 --> 00:02:07,920 still can we can still say a few things 42 00:02:04,759 --> 00:02:10,159 about what happens to the framework we 43 00:02:07,920 --> 00:02:12,800 have conditional or taking as a 44 00:02:10,159 --> 00:02:14,359 parameter inflation we're not going to 45 00:02:12,800 --> 00:02:15,519 determine inflation the M but we say 46 00:02:14,360 --> 00:02:17,680 well what happens is inflation is not 47 00:02:15,519 --> 00:02:19,800 really zero more importantly what 48 00:02:17,680 --> 00:02:22,680 happens if people don't expect inflation 49 00:02:19,800 --> 00:02:24,800 to be really zero and and and we'll see 50 00:02:22,680 --> 00:02:28,800 how that modifies the 51 00:02:24,800 --> 00:02:30,360 analysis the second the second extension 52 00:02:28,800 --> 00:02:32,640 is is that 53 00:02:30,360 --> 00:02:36,360 that you know we simplify financial 54 00:02:32,639 --> 00:02:39,958 markets enormously and and and the and 55 00:02:36,360 --> 00:02:41,599 we targeted we customiz it to we could 56 00:02:39,959 --> 00:02:44,080 have simplified along many dimensions 57 00:02:41,598 --> 00:02:46,119 but the simplification that we had is we 58 00:02:44,080 --> 00:02:48,920 look at something that 59 00:02:46,120 --> 00:02:51,080 that that is closest to what central 60 00:02:48,919 --> 00:02:54,158 banks do in setting monetary policy and 61 00:02:51,080 --> 00:02:57,840 that's really the trade between cash 62 00:02:54,158 --> 00:03:00,878 deposit at the central bank and 63 00:02:57,840 --> 00:03:03,680 bonds US government bonds in the case of 64 00:03:00,878 --> 00:03:06,679 the US typically of very short maturity 65 00:03:03,680 --> 00:03:08,040 and that's what we had in mind H and 66 00:03:06,680 --> 00:03:10,760 that's that's the way we determine the 67 00:03:08,039 --> 00:03:12,120 interest rate now needless to say there 68 00:03:10,759 --> 00:03:15,560 are many many interest rates in the 69 00:03:12,120 --> 00:03:18,360 economy different duration you know one 70 00:03:15,560 --> 00:03:22,080 year rate twoe rate three 10 30 year 71 00:03:18,360 --> 00:03:25,920 rates some countries have 100 Year rates 72 00:03:22,080 --> 00:03:27,440 er er but there is also another 73 00:03:25,919 --> 00:03:29,839 dimension which is very important as the 74 00:03:27,439 --> 00:03:32,438 want to highlight there which is 75 00:03:29,840 --> 00:03:34,920 riskiness US Treasury bonds especially 76 00:03:32,438 --> 00:03:36,878 of short duration are riskless assets 77 00:03:34,919 --> 00:03:38,919 there no risk associated to it now we 78 00:03:36,878 --> 00:03:41,759 have a little event with the with the 79 00:03:38,919 --> 00:03:44,359 dead ceiling fight in in that may happen 80 00:03:41,759 --> 00:03:46,719 in August September but I mean nobody's 81 00:03:44,360 --> 00:03:48,640 really concerned that something major 82 00:03:46,719 --> 00:03:52,000 will happen except for a few disruptions 83 00:03:48,639 --> 00:03:53,238 for a few days let's hope that's true up 84 00:03:52,000 --> 00:03:55,039 to now if you look at all the risk 85 00:03:53,239 --> 00:03:58,799 markets there behaving as nothing will 86 00:03:55,039 --> 00:04:01,239 happen there um but but corporations 87 00:03:58,799 --> 00:04:03,079 don't typically borrow at those rates 88 00:04:01,239 --> 00:04:05,599 Corporation issue their own bonds or 89 00:04:03,079 --> 00:04:08,480 take loans from the banks and those 90 00:04:05,598 --> 00:04:10,359 bonds often have a risk premium that is 91 00:04:08,479 --> 00:04:12,479 they're equal to the safe interest rate 92 00:04:10,360 --> 00:04:16,519 the treasury rate if you want plus 93 00:04:12,479 --> 00:04:17,879 something else okay and and and so that 94 00:04:16,519 --> 00:04:21,120 you can anticipate that that will be 95 00:04:17,879 --> 00:04:24,279 important because interest rate enter 96 00:04:21,120 --> 00:04:26,079 into our islm analysis precisely through 97 00:04:24,279 --> 00:04:28,839 the borrowing cost of firms in the 98 00:04:26,079 --> 00:04:31,879 investment function so if there is a 99 00:04:28,839 --> 00:04:35,319 wtge there if there's a spread between 100 00:04:31,879 --> 00:04:36,918 what the rate we been talking about and 101 00:04:35,319 --> 00:04:41,399 the rate at which firms can actually 102 00:04:36,918 --> 00:04:43,000 borrow then that W will matter okay and 103 00:04:41,399 --> 00:04:44,279 uh and so that's that's what we're want 104 00:04:43,000 --> 00:04:45,680 to do so we're going to introduce this 105 00:04:44,279 --> 00:04:48,198 I'm want to explain what these things 106 00:04:45,680 --> 00:04:51,360 are and then I'm going to modify our 107 00:04:48,199 --> 00:04:53,960 islm model to take into consideration 108 00:04:51,360 --> 00:04:57,439 these extensions 109 00:04:53,959 --> 00:04:58,918 okay H so what is the nominal interest 110 00:04:57,439 --> 00:05:01,399 rate well we have been talking about the 111 00:04:58,918 --> 00:05:04,279 nominal interest rate we which we 112 00:05:01,399 --> 00:05:06,560 typically denote by little I is the 113 00:05:04,279 --> 00:05:10,478 interest rate in terms of dollars say if 114 00:05:06,560 --> 00:05:12,720 the interest rate is 10% no you buy a 115 00:05:10,478 --> 00:05:14,319 bond today that Bond will give you 10% 116 00:05:12,720 --> 00:05:16,880 of whatever amount of money you invest 117 00:05:14,319 --> 00:05:19,279 in the bond at the end of the year say 118 00:05:16,879 --> 00:05:20,719 it's a onee b okay that's a nominal 119 00:05:19,279 --> 00:05:25,839 interest 120 00:05:20,720 --> 00:05:27,479 rate um so if you buy 100 in bonds today 121 00:05:25,839 --> 00:05:31,119 and the interest rate is 10 the nominal 122 00:05:27,478 --> 00:05:34,839 interest rate 10% you receive $10 of 123 00:05:31,120 --> 00:05:38,319 interest payments one year from now $10 124 00:05:34,839 --> 00:05:40,439 of Interest payment okay a real interest 125 00:05:38,319 --> 00:05:42,319 rate is the interest rate in terms of a 126 00:05:40,439 --> 00:05:44,399 basket of 127 00:05:42,319 --> 00:05:48,639 goods 128 00:05:44,399 --> 00:05:51,959 okay so the CPI or something like that 129 00:05:48,639 --> 00:05:53,960 will will be important in that okay 130 00:05:51,959 --> 00:05:55,638 exante that is at the moment in which 131 00:05:53,959 --> 00:05:57,198 you decided were to invest in the real 132 00:05:55,639 --> 00:05:59,439 Bond or the nominal 133 00:05:57,199 --> 00:06:01,560 Bond the difference between the two the 134 00:05:59,439 --> 00:06:03,079 main difference there are other issues 135 00:06:01,560 --> 00:06:04,800 that have to do with Reem I'm not going 136 00:06:03,079 --> 00:06:07,159 to talk about but the main difference 137 00:06:04,800 --> 00:06:10,199 between these two is expected 138 00:06:07,160 --> 00:06:12,400 inflation okay in other words if you 139 00:06:10,199 --> 00:06:15,080 expect no inflation then the distinction 140 00:06:12,399 --> 00:06:17,239 between goods that is if you expect P to 141 00:06:15,079 --> 00:06:21,120 remain constant the distinction between 142 00:06:17,240 --> 00:06:25,240 an interest rate in dollars or in h 143 00:06:21,120 --> 00:06:27,280 Goods is inexistent they're the same but 144 00:06:25,240 --> 00:06:28,840 if you expect inflation then that's not 145 00:06:27,279 --> 00:06:30,918 the case because the goods are going to 146 00:06:28,839 --> 00:06:32,519 become more expensive over time and if 147 00:06:30,918 --> 00:06:34,359 the goods become more expensive over 148 00:06:32,519 --> 00:06:36,318 time that means something that pays you 149 00:06:34,360 --> 00:06:39,439 in dollars is paying you 150 00:06:36,319 --> 00:06:41,759 more per equal units so if the r little 151 00:06:39,439 --> 00:06:45,319 r which is the interest rate is equal to 152 00:06:41,759 --> 00:06:46,840 I and you expect inflation to be 10% 153 00:06:45,319 --> 00:06:48,639 really you're expecting the real 154 00:06:46,839 --> 00:06:51,119 instrument to pay you 10% more than the 155 00:06:48,639 --> 00:06:52,960 other that cannot happen in equilibrium 156 00:06:51,120 --> 00:06:54,199 but that's what it means no because one 157 00:06:52,959 --> 00:06:55,680 is paying you in dollars and the other 158 00:06:54,199 --> 00:07:00,160 one is paying you in Goods that will be 159 00:06:55,680 --> 00:07:02,800 10% more expensive next year okay 160 00:07:00,160 --> 00:07:04,280 good so why do we care about this 161 00:07:02,800 --> 00:07:07,160 distinction between nominal and real 162 00:07:04,279 --> 00:07:09,799 interest rate well because the private 163 00:07:07,160 --> 00:07:11,280 sector ER important decisions of the 164 00:07:09,800 --> 00:07:12,919 private sector like the purchase of 165 00:07:11,279 --> 00:07:15,038 durable goods for consumers we're not 166 00:07:12,918 --> 00:07:17,120 modeling that in this course but 167 00:07:15,038 --> 00:07:18,439 investment in the case of phisical 168 00:07:17,120 --> 00:07:20,439 investment not Financial investment 169 00:07:18,439 --> 00:07:24,279 phisical investment depends on real 170 00:07:20,439 --> 00:07:27,160 rates not nominal rates okay so what 171 00:07:24,279 --> 00:07:29,079 what what determines whether H the 172 00:07:27,160 --> 00:07:30,879 opportunity cost of a real investment is 173 00:07:29,079 --> 00:07:33,959 high or low is the real interest rate 174 00:07:30,879 --> 00:07:33,960 not the nominal interest 175 00:07:35,240 --> 00:07:39,160 rate why do you think that's the 176 00:07:47,879 --> 00:07:53,280 case why do you think it's the real not 177 00:07:50,199 --> 00:07:53,280 the nominal interest rate that 178 00:07:58,439 --> 00:08:05,839 matters not really I mean most of the 179 00:08:00,959 --> 00:08:08,439 borrowing in the US is done in nominal 180 00:08:05,839 --> 00:08:11,318 rates so it has to come from something 181 00:08:08,439 --> 00:08:13,918 else why why do you 182 00:08:11,319 --> 00:08:14,960 invest you invest to produce more Goods 183 00:08:13,918 --> 00:08:17,318 in the 184 00:08:14,959 --> 00:08:20,079 future so if those goods are going to be 185 00:08:17,319 --> 00:08:22,120 more expensive in the future because of 186 00:08:20,079 --> 00:08:23,318 inflation then what matters to you is 187 00:08:22,120 --> 00:08:25,759 the difference between the cost of 188 00:08:23,319 --> 00:08:27,560 borrowing and what you'll get for those 189 00:08:25,759 --> 00:08:29,840 goods and the goods are going to be 10% 190 00:08:27,560 --> 00:08:32,320 more expensive so what really matter is 191 00:08:29,839 --> 00:08:33,679 the net for you you know if then if in 192 00:08:32,320 --> 00:08:35,599 other words if the real interest remains 193 00:08:33,679 --> 00:08:37,319 constant and now you give me interest 194 00:08:35,599 --> 00:08:38,320 rates are 10% higher but you also tell 195 00:08:37,320 --> 00:08:39,640 me that the goods I'm going to be 196 00:08:38,320 --> 00:08:42,080 selling are going to be 10% more 197 00:08:39,639 --> 00:08:44,038 expensive I I don't change my decision 198 00:08:42,080 --> 00:08:46,000 if it was a good project with zero 199 00:08:44,038 --> 00:08:49,039 inflation it's also a good project with 200 00:08:46,000 --> 00:08:54,000 10 10% inflation that hasn't changed I 201 00:08:49,039 --> 00:08:55,799 tell you 30% the same thing no because 202 00:08:54,000 --> 00:08:57,399 I'm going to be investing now in order 203 00:08:55,799 --> 00:08:59,559 to get things are going to be 30% more 204 00:08:57,399 --> 00:09:02,159 expensive a year from now so the de 205 00:08:59,559 --> 00:09:04,359 ision that doesn't depend on that so 206 00:09:02,159 --> 00:09:06,078 that's the reason the real interest rate 207 00:09:04,360 --> 00:09:08,759 is what you really care about in the 208 00:09:06,078 --> 00:09:10,000 case of real investment and remember 209 00:09:08,759 --> 00:09:11,720 we're talking about real investment at 210 00:09:10,000 --> 00:09:13,078 the aggregate level obious can make a 211 00:09:11,720 --> 00:09:15,120 difference at the level of individual 212 00:09:13,078 --> 00:09:17,838 Goods because you know when inflation 213 00:09:15,120 --> 00:09:20,679 goes up not every Goods price go up by 214 00:09:17,839 --> 00:09:23,839 the same amount some some goods go up by 215 00:09:20,679 --> 00:09:27,199 more some some Goods prices go up by 216 00:09:23,839 --> 00:09:30,360 less but on average it's what I just 217 00:09:27,200 --> 00:09:32,278 said so let's let's try to look at this 218 00:09:30,360 --> 00:09:33,639 equivalence more formally how to derive 219 00:09:32,278 --> 00:09:35,200 the real interest 220 00:09:33,639 --> 00:09:38,559 rate 221 00:09:35,200 --> 00:09:41,440 well in I said not in the US but in many 222 00:09:38,559 --> 00:09:43,679 places you do re borrow in real terms 223 00:09:41,440 --> 00:09:45,399 for example in in Chile we have a a unit 224 00:09:43,679 --> 00:09:47,319 of account because we had very high 225 00:09:45,399 --> 00:09:50,320 inflation many years back which is 226 00:09:47,320 --> 00:09:53,320 called unid fomento and that in that 227 00:09:50,320 --> 00:09:57,600 unit of account is indexed to inflation 228 00:09:53,320 --> 00:10:00,800 okay so you borrow you know uh $10 229 00:09:57,600 --> 00:10:03,480 million equivalent in a formento and 230 00:10:00,799 --> 00:10:05,199 those 10 million pesos equivalent 231 00:10:03,480 --> 00:10:07,440 formento that means the interest rate is 232 00:10:05,200 --> 00:10:10,240 is indexed to that but in the US that 233 00:10:07,440 --> 00:10:11,800 happens very rarely the US government 234 00:10:10,240 --> 00:10:15,720 does do 235 00:10:11,799 --> 00:10:17,639 that it's called tips so so you have 236 00:10:15,720 --> 00:10:19,519 nominal bonds the great majority of the 237 00:10:17,639 --> 00:10:21,519 US Treasury bonds are nominal bonds but 238 00:10:19,519 --> 00:10:24,679 there are also some real bonds and those 239 00:10:21,519 --> 00:10:27,480 are indexed to inflation but but but 240 00:10:24,679 --> 00:10:31,599 firms very rarely can issue Bonds in the 241 00:10:27,480 --> 00:10:35,480 US that are in real terms okay that's so 242 00:10:31,600 --> 00:10:37,120 let's sometimes this is even a so but 243 00:10:35,480 --> 00:10:39,240 the point the reason I I made that 244 00:10:37,120 --> 00:10:41,440 clarification here is I'm going to 245 00:10:39,240 --> 00:10:43,839 derive the real interest rate but that 246 00:10:41,440 --> 00:10:46,240 doesn't mean that the instrument exists 247 00:10:43,839 --> 00:10:47,959 you know I'm saying given a nominal rate 248 00:10:46,240 --> 00:10:51,000 that I see out 249 00:10:47,958 --> 00:10:52,838 there how do I construct a real interest 250 00:10:51,000 --> 00:10:54,919 rate from that nominal interest rate 251 00:10:52,839 --> 00:10:56,160 that's what I want to hear it doesn't 252 00:10:54,919 --> 00:10:59,120 mean that there's an instrument that is 253 00:10:56,159 --> 00:11:02,439 traded in in real terms but when I go to 254 00:10:59,120 --> 00:11:05,000 the the bank as a firm and I borrow a 255 00:11:02,440 --> 00:11:06,959 10% nominal I need to calculate well 256 00:11:05,000 --> 00:11:08,958 what does that imply in real 257 00:11:06,958 --> 00:11:11,879 terms and that's what I'm going to 258 00:11:08,958 --> 00:11:16,078 illustrate now okay 259 00:11:11,879 --> 00:11:18,278 so good so or maybe I shouldn't use the 260 00:11:16,078 --> 00:11:20,519 word good since we're going to do this 261 00:11:18,278 --> 00:11:24,320 so what we want to pin down this this 262 00:11:20,519 --> 00:11:26,039 this real interest rate R okay so the 263 00:11:24,320 --> 00:11:29,360 real interest rate in terms of goods 264 00:11:26,039 --> 00:11:32,919 means if I borrow say one unit or if I 265 00:11:29,360 --> 00:11:35,959 buy a a an instrument that if I spend 266 00:11:32,919 --> 00:11:39,919 one unit of the good the aggregate good 267 00:11:35,958 --> 00:11:43,559 in a bond then I I receive one plus RT 268 00:11:39,919 --> 00:11:45,838 units of goods H one year from now then 269 00:11:43,559 --> 00:11:48,239 RT is the real interest rate no it's an 270 00:11:45,839 --> 00:11:51,760 interest rate in terms of 271 00:11:48,240 --> 00:11:53,720 goods now suppose that that I go this 272 00:11:51,759 --> 00:11:57,559 route instead say okay that's what I 273 00:11:53,720 --> 00:11:59,079 want to get to but um let me do it 274 00:11:57,559 --> 00:12:00,838 through the only instrument I have say 275 00:11:59,078 --> 00:12:05,679 the nominal interest rate the nominal 276 00:12:00,839 --> 00:12:09,079 bonds so if I buy one unit of goods 277 00:12:05,679 --> 00:12:13,278 today that means I'm really buying 278 00:12:09,078 --> 00:12:16,519 PT dollars in that Bond okay PT is the 279 00:12:13,278 --> 00:12:19,720 deflator we have we have PT 280 00:12:16,519 --> 00:12:23,000 dollars well PT dollars invested in a 281 00:12:19,720 --> 00:12:25,600 nominal Bond will give me 1 plus it the 282 00:12:23,000 --> 00:12:29,000 nominal interest rate times those PT 283 00:12:25,600 --> 00:12:32,879 dollars okay so say the price index here 284 00:12:29,000 --> 00:12:35,320 is is two then uh and the interest rate 285 00:12:32,879 --> 00:12:39,958 is 10 the nominal interest rate 10% then 286 00:12:35,320 --> 00:12:42,680 next period I get a two * 1.1 okay 287 00:12:39,958 --> 00:12:43,879 that's the number of dollars I get now 288 00:12:42,679 --> 00:12:47,039 that's 289 00:12:43,879 --> 00:12:48,958 still I cannot compare this with the 290 00:12:47,039 --> 00:12:50,679 with this up here because at this point 291 00:12:48,958 --> 00:12:52,319 I have dollars and really I want to 292 00:12:50,679 --> 00:12:55,000 convert it into Goods I want to go from 293 00:12:52,320 --> 00:12:59,040 Goods to Goods so how do I convert 294 00:12:55,000 --> 00:12:59,039 dollars into Goods 295 00:13:01,278 --> 00:13:04,799 I divide by the price of the goods but 296 00:13:02,919 --> 00:13:06,639 not here by the price of the goods at t 297 00:13:04,799 --> 00:13:09,479 plus one because I'm going to get this 298 00:13:06,639 --> 00:13:11,799 amount of dollars at t+1 one year from 299 00:13:09,480 --> 00:13:14,320 now I have to divide by the price of 300 00:13:11,799 --> 00:13:16,958 goods at t+ one in order to get the 301 00:13:14,320 --> 00:13:18,920 number of goods I'm getting a t plus one 302 00:13:16,958 --> 00:13:21,958 so I have to divide by p+ one but the 303 00:13:18,919 --> 00:13:23,719 problem is that time T I don't know what 304 00:13:21,958 --> 00:13:27,439 pt+ one will 305 00:13:23,720 --> 00:13:29,800 be okay the best I can do and here's 306 00:13:27,440 --> 00:13:32,639 where I'm I'm simplifying things a lot 307 00:13:29,799 --> 00:13:34,719 is to is to have an expectation of what 308 00:13:32,639 --> 00:13:37,320 the price level will be one year from 309 00:13:34,720 --> 00:13:39,440 now so the best I can do when I want to 310 00:13:37,320 --> 00:13:43,560 compare things today whether I want to 311 00:13:39,440 --> 00:13:48,279 go this way or that way is to a er use 312 00:13:43,559 --> 00:13:49,799 suspected price here okay so these two 313 00:13:48,278 --> 00:13:52,000 things are equivalent in the sense that 314 00:13:49,799 --> 00:13:54,958 they require exactly the same investment 315 00:13:52,000 --> 00:13:56,720 I'm now I'm going this way and then in 316 00:13:54,958 --> 00:13:59,879 expectation at least these two things 317 00:13:56,720 --> 00:14:01,120 are also equivalent okay 318 00:13:59,879 --> 00:14:02,759 because this is what I'm going to get in 319 00:14:01,120 --> 00:14:04,799 terms of goods from having invested a 320 00:14:02,759 --> 00:14:06,320 good this what I expect to get in terms 321 00:14:04,799 --> 00:14:09,799 of goods but I'm ignoring all that 322 00:14:06,320 --> 00:14:12,199 uncertainty around that H and this is 323 00:14:09,799 --> 00:14:14,758 what I get if I go directly the route 324 00:14:12,198 --> 00:14:16,919 the the Goods Route and and this is two 325 00:14:14,759 --> 00:14:18,839 things are to be equal by indifference 326 00:14:16,919 --> 00:14:20,399 okay I if I two things give me the same 327 00:14:18,839 --> 00:14:22,680 they have to be priced equally they have 328 00:14:20,399 --> 00:14:24,559 to have the same price and so these two 329 00:14:22,679 --> 00:14:26,758 things have to be the same because here 330 00:14:24,559 --> 00:14:28,319 I'm going from Goods to Goods here I'm 331 00:14:26,759 --> 00:14:30,360 going through this channel but also from 332 00:14:28,320 --> 00:14:32,720 Goods to Goods these two things should 333 00:14:30,360 --> 00:14:34,720 give us more or less the same return 334 00:14:32,720 --> 00:14:37,440 okay and we're going to assume strictly 335 00:14:34,720 --> 00:14:41,360 that they give us the same expected 336 00:14:37,440 --> 00:14:44,639 return okay so this relationship 337 00:14:41,360 --> 00:14:47,159 holds is this di clear diagram 338 00:14:44,639 --> 00:14:48,519 clear okay good because what I'm going 339 00:14:47,159 --> 00:14:52,078 to do now is I'm going to take this 340 00:14:48,519 --> 00:14:52,078 expression here and play with it a 341 00:14:52,320 --> 00:14:57,240 little so we arve in the previous slide 342 00:14:55,198 --> 00:14:59,399 to the conclusion that 1 plus the real 343 00:14:57,240 --> 00:15:01,720 interest rate is equal to 1 plus plus 344 00:14:59,399 --> 00:15:06,639 the nominal interest rate time PT over 345 00:15:01,720 --> 00:15:09,199 PT + one expected I'm going to denote 346 00:15:06,639 --> 00:15:11,560 expected inflation the inflation we 347 00:15:09,198 --> 00:15:13,399 expect the change in the the the log 348 00:15:11,559 --> 00:15:15,638 change in the price level or the rate of 349 00:15:13,399 --> 00:15:20,519 change of the price level from year T to 350 00:15:15,639 --> 00:15:24,159 year t+1 as Pi e t+1 is equal to that 351 00:15:20,519 --> 00:15:26,039 okay so this is expected inflation at t+ 352 00:15:24,159 --> 00:15:29,078 one see 353 00:15:26,039 --> 00:15:32,919 that well do a little algebra and I can 354 00:15:29,078 --> 00:15:35,519 rewrite this guy here as 1 plus expected 355 00:15:32,919 --> 00:15:39,599 inflation between t and t plus one okay 356 00:15:35,519 --> 00:15:44,318 I just I just replace this for one one 357 00:15:39,600 --> 00:15:47,440 over 1+ pi+ one okay just algebra I got 358 00:15:44,318 --> 00:15:49,159 that so now I have relationship and 359 00:15:47,440 --> 00:15:51,319 these things if they if this interest 360 00:15:49,159 --> 00:15:53,719 rate is not too high this in expected 361 00:15:51,318 --> 00:15:55,879 inflation is not too high not too large 362 00:15:53,720 --> 00:15:59,240 as it happens in most countries but a 363 00:15:55,879 --> 00:16:01,879 few around the world then this is 364 00:15:59,240 --> 00:16:03,799 approximate implies approximately that 365 00:16:01,879 --> 00:16:06,759 the real interest rate is approximately 366 00:16:03,799 --> 00:16:08,039 equal to the nominal interest rate minus 367 00:16:06,759 --> 00:16:10,199 expected 368 00:16:08,039 --> 00:16:13,039 inflation okay I'm just taking 369 00:16:10,198 --> 00:16:13,039 approximations 370 00:16:17,480 --> 00:16:22,399 here okay and that's is an intuitive 371 00:16:20,879 --> 00:16:26,439 expression the real interest rate is 372 00:16:22,399 --> 00:16:30,440 equal to the nominal rate minus expected 373 00:16:26,440 --> 00:16:30,440 inflation so 374 00:16:30,720 --> 00:16:36,319 if if the interest rate is is 375 00:16:33,120 --> 00:16:39,600 6% and expected inflation is 3% well the 376 00:16:36,318 --> 00:16:41,240 real interest rate is only 3% okay in 377 00:16:39,600 --> 00:16:43,639 terms of good you're going to get 3% 378 00:16:41,240 --> 00:16:47,318 less because that's inflation 379 00:16:43,639 --> 00:16:48,959 rate good or if you're borrowing in 380 00:16:47,318 --> 00:16:51,879 terms of your borrowing cost well it's 381 00:16:48,958 --> 00:16:53,838 going to cost you 3% less effectively 382 00:16:51,879 --> 00:16:56,198 because the goods you're going to be in 383 00:16:53,839 --> 00:16:59,839 selling out of your investment are Al 384 00:16:56,198 --> 00:17:02,958 are going to be 3% more expensive 385 00:16:59,839 --> 00:17:04,759 good so look this is what happened I'm 386 00:17:02,958 --> 00:17:06,480 showing you what happened around the 387 00:17:04,759 --> 00:17:08,480 years of the Great Recession remember 388 00:17:06,480 --> 00:17:10,759 the Great Recession happened 20 end of 389 00:17:08,480 --> 00:17:13,360 2008 2009 390 00:17:10,759 --> 00:17:16,038 2010 several things you can see in this 391 00:17:13,359 --> 00:17:18,759 picture ER the white line here is the 392 00:17:16,038 --> 00:17:22,078 nominal interest rate and the yellow is 393 00:17:18,759 --> 00:17:25,558 the real interest rate in the US okay 394 00:17:22,078 --> 00:17:27,599 and and this is a since in the US you 395 00:17:25,558 --> 00:17:30,279 can actually trade real and nominal 396 00:17:27,599 --> 00:17:34,399 bonds the difference between these two 397 00:17:30,279 --> 00:17:35,960 is expected inflation okay as as priced 398 00:17:34,400 --> 00:17:38,120 by financial 399 00:17:35,960 --> 00:17:40,558 markets they're called in the US they're 400 00:17:38,119 --> 00:17:42,558 called inflation break evens these are 401 00:17:40,558 --> 00:17:45,240 swaps inflation swaps okay inflation 402 00:17:42,558 --> 00:17:46,480 break evens but anyways so several 403 00:17:45,240 --> 00:17:50,120 things you can see in this picture the 404 00:17:46,480 --> 00:17:53,480 first one is that typically typically 405 00:17:50,119 --> 00:17:56,879 the unless you're in Japan probably the 406 00:17:53,480 --> 00:18:00,079 the the the white line that is a nominal 407 00:17:56,880 --> 00:18:03,120 rate is above the orange line which is 408 00:18:00,079 --> 00:18:04,599 or the yellow line which is the real 409 00:18:03,119 --> 00:18:07,279 interest rate why do you think that's 410 00:18:04,599 --> 00:18:12,279 the case or what does it tell 411 00:18:07,279 --> 00:18:14,798 you the fact that on average sort of 412 00:18:12,279 --> 00:18:17,240 er the nominal interest rate is above 413 00:18:14,798 --> 00:18:20,200 the real interest 414 00:18:17,240 --> 00:18:22,480 rate yeah on average in most advanced 415 00:18:20,200 --> 00:18:24,640 economies and even more so in Emerging 416 00:18:22,480 --> 00:18:26,759 Markets inflation is positive and 417 00:18:24,640 --> 00:18:29,240 therefore people expect inflation to be 418 00:18:26,759 --> 00:18:30,879 positive okay yeah in Japan went through 419 00:18:29,240 --> 00:18:33,839 these long periods of deflation but 420 00:18:30,880 --> 00:18:36,039 that's a rarity that was an anomaly what 421 00:18:33,839 --> 00:18:39,199 was going on in Japan but you see 422 00:18:36,038 --> 00:18:41,558 something else here there's an episode 423 00:18:39,200 --> 00:18:43,679 very clearly when the opposite was 424 00:18:41,558 --> 00:18:45,038 holding no when the real interet went 425 00:18:43,679 --> 00:18:47,480 much higher than the nominal interest 426 00:18:45,038 --> 00:18:49,038 rate and this is despite the fact that 427 00:18:47,480 --> 00:18:51,480 you see even they cross in opposite 428 00:18:49,038 --> 00:18:54,158 direction here there was a sharp decline 429 00:18:51,480 --> 00:18:56,599 in the nominal interest rate and a sharp 430 00:18:54,159 --> 00:19:00,640 rise in the real interest rate what 431 00:18:56,599 --> 00:19:00,639 happened what was happening there 432 00:19:07,440 --> 00:19:13,279 first of all forget about the picture 433 00:19:09,519 --> 00:19:17,000 what was happening around 2008 434 00:19:13,279 --> 00:19:19,480 2009 the Great Recession okay so that's 435 00:19:17,000 --> 00:19:21,359 one observation typically especially 436 00:19:19,480 --> 00:19:24,279 modern recession certainly recessions 437 00:19:21,359 --> 00:19:29,839 caused by financial crisis as this one 438 00:19:24,279 --> 00:19:32,119 was a a um real interest 439 00:19:29,839 --> 00:19:34,519 go above nominal interest rate can go 440 00:19:32,119 --> 00:19:35,839 above nominal interest rates what does 441 00:19:34,519 --> 00:19:38,480 it 442 00:19:35,839 --> 00:19:40,959 mean in terms of 443 00:19:38,480 --> 00:19:43,798 inflation I mean remember what the FED 444 00:19:40,960 --> 00:19:45,480 is setting is this is this one more or 445 00:19:43,798 --> 00:19:46,960 less this I think is a one-ear rate so 446 00:19:45,480 --> 00:19:50,360 it's not exactly what the FED said but 447 00:19:46,960 --> 00:19:53,600 more or less okay so why do you think 448 00:19:50,359 --> 00:19:55,639 the FED cut interest rate there very 449 00:19:53,599 --> 00:19:57,359 aggressively yeah we were in the middle 450 00:19:55,640 --> 00:19:59,759 of a big financial crisis so we wanted 451 00:19:57,359 --> 00:20:02,319 to boost the economy no so interest rate 452 00:19:59,759 --> 00:20:04,038 and this is when you map it into into 453 00:20:02,319 --> 00:20:05,399 the very short rate this is effectively 454 00:20:04,038 --> 00:20:07,119 they hit the zero lower bound they 455 00:20:05,400 --> 00:20:10,480 couldn't lower it more they lower it as 456 00:20:07,119 --> 00:20:13,000 much as they could and that was it so 457 00:20:10,480 --> 00:20:16,759 what must have happened for this real 458 00:20:13,000 --> 00:20:16,759 interest rate to go up like 459 00:20:17,759 --> 00:20:22,400 crazy how can it be there the FED 460 00:20:20,839 --> 00:20:26,079 Bringing Down the nominal interest rate 461 00:20:22,400 --> 00:20:29,360 and the real rate boom jumps 462 00:20:26,079 --> 00:20:31,599 up expected inflation went down and L so 463 00:20:29,359 --> 00:20:34,558 what I was saying is in expected 464 00:20:31,599 --> 00:20:36,719 inflation is typically positive in in in 465 00:20:34,558 --> 00:20:38,678 sort of developed economies around 2% 466 00:20:36,720 --> 00:20:41,839 two and a half perc that's the type of 467 00:20:38,679 --> 00:20:44,400 numbers but in deep recessions it can go 468 00:20:41,839 --> 00:20:46,519 even negative okay and that's what 469 00:20:44,400 --> 00:20:49,120 happen there is the expected inflation 470 00:20:46,519 --> 00:20:51,679 as extracted from inflation break evens 471 00:20:49,119 --> 00:20:54,479 from these swaps and you see you know 472 00:20:51,679 --> 00:20:56,519 typically it's around 2% and so on 473 00:20:54,480 --> 00:20:59,159 because that's more or less the the the 474 00:20:56,519 --> 00:21:02,200 FED inflation Target in the US 475 00:20:59,159 --> 00:21:05,559 okay but during this episode here we 476 00:21:02,200 --> 00:21:07,720 enter into a very deflationary 477 00:21:05,558 --> 00:21:10,599 episode expected inflation close to 478 00:21:07,720 --> 00:21:12,720 minus 4% that was very deflationary was 479 00:21:10,599 --> 00:21:15,839 very scary deflations can be very 480 00:21:12,720 --> 00:21:19,720 complicated objects to deal with ER 481 00:21:15,839 --> 00:21:22,798 we'll say more about that later okay but 482 00:21:19,720 --> 00:21:25,839 that's that's what happened 483 00:21:22,798 --> 00:21:27,319 there good so that's that's nominal 484 00:21:25,839 --> 00:21:29,199 versus real interest rate now let me 485 00:21:27,319 --> 00:21:32,918 talk about credit spread and then we're 486 00:21:29,200 --> 00:21:36,240 going to put everything together 487 00:21:32,919 --> 00:21:38,520 so most bonds issued by corporations are 488 00:21:36,240 --> 00:21:40,359 risky they are not us Treasures are as 489 00:21:38,519 --> 00:21:44,240 safe as it gets that's consider the 490 00:21:40,359 --> 00:21:48,038 safest Assets in the world together with 491 00:21:44,240 --> 00:21:50,120 German bond market bonds you know 492 00:21:48,038 --> 00:21:52,759 government bonds and SS and there are a 493 00:21:50,119 --> 00:21:55,199 few but but the US in terms of liquidity 494 00:21:52,759 --> 00:21:58,240 everything is the Premier safe asset in 495 00:21:55,200 --> 00:21:59,919 the world okay but most corporations 496 00:21:58,240 --> 00:22:01,519 don't issue at those rates they have to 497 00:21:59,919 --> 00:22:05,480 pay a premium because they're not as 498 00:22:01,519 --> 00:22:08,558 safe as as those as the treasury 499 00:22:05,480 --> 00:22:12,960 instrument so let me call that the real 500 00:22:08,558 --> 00:22:15,678 interest rate paid by this uh bonds by 501 00:22:12,960 --> 00:22:17,360 issues by firms on average be equal to 502 00:22:15,679 --> 00:22:18,559 the safe real interest rate plus a 503 00:22:17,359 --> 00:22:20,639 premium 504 00:22:18,558 --> 00:22:22,200 XT 505 00:22:20,640 --> 00:22:25,520 okay 506 00:22:22,200 --> 00:22:27,319 now the point and is important is that 507 00:22:25,519 --> 00:22:29,519 this risk premium moves a lot over the 508 00:22:27,319 --> 00:22:31,960 business cycle especially when you have 509 00:22:29,519 --> 00:22:34,240 a financial crisis you know people 510 00:22:31,960 --> 00:22:35,919 really want to run away from 511 00:22:34,240 --> 00:22:38,880 risk 512 00:22:35,919 --> 00:22:40,799 now and and and so it tends to be higher 513 00:22:38,880 --> 00:22:42,360 during recessions especially when 514 00:22:40,798 --> 00:22:45,639 recessions are caused by financial 515 00:22:42,359 --> 00:22:47,599 crisis and things of that kind now why 516 00:22:45,640 --> 00:22:49,840 do we care about the risk premium again 517 00:22:47,599 --> 00:22:51,798 because important private sector 518 00:22:49,839 --> 00:22:54,319 decisions depend on that real interest 519 00:22:51,798 --> 00:22:58,639 rate on the on on the on the risk 520 00:22:54,319 --> 00:23:01,158 adjusted interest rate okay if a firm 521 00:22:58,640 --> 00:23:02,759 has lots of credibility problems and is 522 00:23:01,159 --> 00:23:04,200 considered very risky the cost of 523 00:23:02,759 --> 00:23:05,480 borrowing is going to be very high and 524 00:23:04,200 --> 00:23:07,440 therefore it's going to have to have a 525 00:23:05,480 --> 00:23:09,798 higher threshold for any physical 526 00:23:07,440 --> 00:23:11,360 investment no it's more costly for that 527 00:23:09,798 --> 00:23:14,400 firm to 528 00:23:11,359 --> 00:23:16,918 borrow so that's a reason to worry so 529 00:23:14,400 --> 00:23:19,200 the risk premium is that X there is 530 00:23:16,919 --> 00:23:21,278 determined by two things essentially in 531 00:23:19,200 --> 00:23:22,840 in the case of bonds there's also risk 532 00:23:21,278 --> 00:23:24,919 premiums in equity but in the case of 533 00:23:22,839 --> 00:23:27,079 bonds one thing is the priority of 534 00:23:24,919 --> 00:23:29,559 theault I mean it may be that the firm 535 00:23:27,079 --> 00:23:32,079 doesn't honor those BS and defaults on 536 00:23:29,558 --> 00:23:34,359 them okay so one thing is a primary 537 00:23:32,079 --> 00:23:36,519 default the other one is the degree of 538 00:23:34,359 --> 00:23:38,158 risk aversion of bone bone holders there 539 00:23:36,519 --> 00:23:40,000 are sometime times in which you say look 540 00:23:38,159 --> 00:23:41,240 I don't want to hold any risk here or 541 00:23:40,000 --> 00:23:43,278 very little risk because you know 542 00:23:41,240 --> 00:23:45,640 everything looks very complicated to me 543 00:23:43,278 --> 00:23:47,400 I rather go safe I go to treasury bonds 544 00:23:45,640 --> 00:23:50,640 I don't want this stuff so those two 545 00:23:47,400 --> 00:23:53,159 reasons make that spread grow the second 546 00:23:50,640 --> 00:23:55,480 reason on average to me is the most 547 00:23:53,159 --> 00:23:57,559 important reason but it's easier to 548 00:23:55,480 --> 00:23:59,038 model all this stuff as a priority of 549 00:23:57,558 --> 00:24:00,399 the fault so that's what I'm going to 550 00:23:59,038 --> 00:24:02,519 assuming what I'm going to do here is 551 00:24:00,400 --> 00:24:04,720 I'm going to ignore this the degree of 552 00:24:02,519 --> 00:24:05,918 risk aversion of bond holders and I'm 553 00:24:04,720 --> 00:24:08,558 going to just concentrate on the 554 00:24:05,919 --> 00:24:11,600 probability of theault of a bond but in 555 00:24:08,558 --> 00:24:14,000 a sense you can model both as the same 556 00:24:11,599 --> 00:24:15,839 because you can think of risk aversion 557 00:24:14,000 --> 00:24:18,640 as somebody exaggerating the probability 558 00:24:15,839 --> 00:24:20,519 of the fault of a bond if I if I get 559 00:24:18,640 --> 00:24:22,799 very nervous about investing in Risky 560 00:24:20,519 --> 00:24:24,400 stuff there is some true probability of 561 00:24:22,798 --> 00:24:26,480 the fault that some agenci is 562 00:24:24,400 --> 00:24:28,679 calculating out there but if I'm very 563 00:24:26,480 --> 00:24:31,000 nervous about that I may as well put a 564 00:24:28,679 --> 00:24:33,480 markup say well you know these guys have 565 00:24:31,000 --> 00:24:34,839 messed up in the past they may think 566 00:24:33,480 --> 00:24:38,319 that the probility def fall of this bond 567 00:24:34,839 --> 00:24:41,519 is 5% during the next year I'm going to 568 00:24:38,319 --> 00:24:44,398 treat it as 10% okay because I want to 569 00:24:41,519 --> 00:24:46,599 penalize for the risk I'm incurring so 570 00:24:44,398 --> 00:24:49,519 so think of this P here as a probity of 571 00:24:46,599 --> 00:24:51,319 theault but as perceived by in you don't 572 00:24:49,519 --> 00:24:55,639 know the what is the true probity of 573 00:24:51,319 --> 00:24:57,960 theault that's a abstract concept 574 00:24:55,640 --> 00:25:00,000 no but it's whatever you use in your 575 00:24:57,960 --> 00:25:02,960 investment decisions that I'm modeling 576 00:25:00,000 --> 00:25:05,038 here so by the same principle we had 577 00:25:02,960 --> 00:25:07,640 before between nominal and real bonds 578 00:25:05,038 --> 00:25:09,599 what we need to have is is I need to be 579 00:25:07,640 --> 00:25:13,520 different in equilibrium I need to be 580 00:25:09,599 --> 00:25:16,359 different between H investing in in in 581 00:25:13,519 --> 00:25:19,119 treasury bonds the safe bonds that pay 582 00:25:16,359 --> 00:25:21,759 an interest RT and investing in Risky 583 00:25:19,119 --> 00:25:25,519 bonds that are paying an interest rate 584 00:25:21,759 --> 00:25:27,200 RF which is greater than a RT no so I 585 00:25:25,519 --> 00:25:29,240 have to be indiffer between these two 586 00:25:27,200 --> 00:25:31,679 things and the and the the spread here 587 00:25:29,240 --> 00:25:33,640 will have to adjust so I'm indifferent 588 00:25:31,679 --> 00:25:35,480 between these two things indeed it's 589 00:25:33,640 --> 00:25:38,240 obvious if the probability of default is 590 00:25:35,480 --> 00:25:39,759 greater than zero that this RF is going 591 00:25:38,240 --> 00:25:41,278 to have to be greater than R because 592 00:25:39,759 --> 00:25:42,720 otherwise I don't you know I don't want 593 00:25:41,278 --> 00:25:45,679 to invest in a bond that pays me the 594 00:25:42,720 --> 00:25:48,038 same as that and on top of that I I I 595 00:25:45,679 --> 00:25:50,720 can experience a default occasion don't 596 00:25:48,038 --> 00:25:53,398 get my money back okay so what we have 597 00:25:50,720 --> 00:25:55,640 here this indifference condition means 598 00:25:53,398 --> 00:25:58,599 okay during the next 599 00:25:55,640 --> 00:26:01,399 year there's a probability to the fall p 600 00:25:58,599 --> 00:26:03,119 that means with probability one minus P 601 00:26:01,398 --> 00:26:05,278 I'm going to get this High interest rate 602 00:26:03,119 --> 00:26:07,278 I'm going to get my money back I invest 603 00:26:05,278 --> 00:26:08,599 one in a bond I get my money back plus 604 00:26:07,278 --> 00:26:10,880 an interest rate Which is higher than 605 00:26:08,599 --> 00:26:13,798 the safe interest rate is our F okay 606 00:26:10,880 --> 00:26:15,278 that's a good thing against that is 607 00:26:13,798 --> 00:26:17,000 there's a probability that the bone 608 00:26:15,278 --> 00:26:19,000 there's a default and I'm going to 609 00:26:17,000 --> 00:26:20,798 assume always in practice there is some 610 00:26:19,000 --> 00:26:21,919 recovery of a bone which is much less 611 00:26:20,798 --> 00:26:26,278 than the principal I'm going to assume 612 00:26:21,919 --> 00:26:27,799 it's zero okay so if p is positive as I 613 00:26:26,278 --> 00:26:30,038 said before then it better be the case 614 00:26:27,798 --> 00:26:32,119 that this f is greater than R otherwise 615 00:26:30,038 --> 00:26:33,000 I'm not going to invest anything in the 616 00:26:32,119 --> 00:26:35,359 risky 617 00:26:33,000 --> 00:26:39,200 Bond so I'm going to replace just this 618 00:26:35,359 --> 00:26:41,119 RF by RT plus X just to calculate XT and 619 00:26:39,200 --> 00:26:45,399 you can solve this out here and you get 620 00:26:41,119 --> 00:26:48,278 that this risk premium is XT is an 621 00:26:45,398 --> 00:26:50,879 increasing function of P okay naturally 622 00:26:48,278 --> 00:26:53,359 if this if I perceive bonds to be more 623 00:26:50,880 --> 00:26:56,080 likely to default and when I require a 624 00:26:53,359 --> 00:26:59,240 higher compensation if the bond doesn't 625 00:26:56,079 --> 00:27:02,278 default okay and that's what we we have 626 00:26:59,240 --> 00:27:03,599 here now during what happens is that 627 00:27:02,278 --> 00:27:06,240 during severe 628 00:27:03,599 --> 00:27:07,918 recessions actual defaults go up so the 629 00:27:06,240 --> 00:27:10,278 probability of theault objectively goes 630 00:27:07,919 --> 00:27:12,320 up and people get a lot more scared also 631 00:27:10,278 --> 00:27:15,200 that this will happen and so P tends to 632 00:27:12,319 --> 00:27:18,079 go up a lot okay so during SE severe 633 00:27:15,200 --> 00:27:19,798 recessions but is is always almost in 634 00:27:18,079 --> 00:27:24,079 recession but especially in severe 635 00:27:19,798 --> 00:27:27,480 recessions P can rise a lot okay it can 636 00:27:24,079 --> 00:27:30,319 rise a lot R may fall or not we shall 637 00:27:27,480 --> 00:27:34,120 see but but this stuff dominates 638 00:27:30,319 --> 00:27:37,359 actually okay so this credit this x can 639 00:27:34,119 --> 00:27:40,038 move up a lot during recessions and in 640 00:27:37,359 --> 00:27:41,359 fact if I show you what happened during 641 00:27:40,038 --> 00:27:44,440 the gr 642 00:27:41,359 --> 00:27:47,759 recession same episode as before there 643 00:27:44,440 --> 00:27:52,159 you have it this is our X really okay 644 00:27:47,759 --> 00:27:54,480 look how it jump during 2008 okay so uh 645 00:27:52,159 --> 00:27:56,960 the average and this is for I think it's 646 00:27:54,480 --> 00:27:59,798 high yield I think but it's not junk 647 00:27:56,960 --> 00:28:02,278 it's high yield though 648 00:27:59,798 --> 00:28:04,599 ER I think it's a it's a it's a weighted 649 00:28:02,278 --> 00:28:07,599 average of things 650 00:28:04,599 --> 00:28:11,519 but think of this as the median bond out 651 00:28:07,599 --> 00:28:15,278 there corporate bond ER it had to pay 652 00:28:11,519 --> 00:28:16,960 20% more than a treasury bond okay so 653 00:28:15,278 --> 00:28:19,159 big difference if you are in the private 654 00:28:16,960 --> 00:28:20,558 sector and wanted to borrow than if the 655 00:28:19,159 --> 00:28:25,000 government wanted to 656 00:28:20,558 --> 00:28:29,038 borrow big thing this was a big 657 00:28:25,000 --> 00:28:32,119 issue good now it's all almost always oh 658 00:28:29,038 --> 00:28:35,000 but that level this is high yield H so 659 00:28:32,119 --> 00:28:37,239 you see typically because this high 660 00:28:35,000 --> 00:28:40,038 yield these are not the the primest 661 00:28:37,240 --> 00:28:41,399 companies H they have a vary of default 662 00:28:40,038 --> 00:28:45,240 there's a risk out there they typically 663 00:28:41,398 --> 00:28:48,398 have to pay a spread 3% 4% things like 664 00:28:45,240 --> 00:28:50,839 that but during severe events that can 665 00:28:48,398 --> 00:28:52,839 go very very high so if you're a 666 00:28:50,839 --> 00:28:54,240 corporation and you're trying to borrow 667 00:28:52,839 --> 00:28:57,720 here it's going to be pretty difficult 668 00:28:54,240 --> 00:29:01,000 to borrow that's the point okay not a 669 00:28:57,720 --> 00:29:03,519 good time to invest in that sense it's 670 00:29:01,000 --> 00:29:03,519 going to be pretty 671 00:29:03,679 --> 00:29:09,399 expensive so that takes me to the slm 672 00:29:06,119 --> 00:29:11,158 mod I want to sort of now bring in these 673 00:29:09,398 --> 00:29:15,839 two 674 00:29:11,159 --> 00:29:19,240 ingredients so the two modifications I 675 00:29:15,839 --> 00:29:20,759 introduce are relevant for the is the LM 676 00:29:19,240 --> 00:29:23,120 doesn't change the Central Bank keeps 677 00:29:20,759 --> 00:29:25,440 setting the nominal interest rate and 678 00:29:23,119 --> 00:29:26,759 that's what it does okay so that's not 679 00:29:25,440 --> 00:29:29,360 changing and that's the target of the 680 00:29:26,759 --> 00:29:31,480 Central Bank 681 00:29:29,359 --> 00:29:32,959 the the Central Bank may decide to react 682 00:29:31,480 --> 00:29:36,079 to things that happen in expected 683 00:29:32,960 --> 00:29:38,798 inflation and cre spread but the LM is 684 00:29:36,079 --> 00:29:41,158 is the same as it used to be in the book 685 00:29:38,798 --> 00:29:42,759 at some point make the book makes a 686 00:29:41,159 --> 00:29:44,120 simplification and it starts setting the 687 00:29:42,759 --> 00:29:45,519 interest rate in terms of the real 688 00:29:44,119 --> 00:29:47,839 interest rate I think that's a bad idea 689 00:29:45,519 --> 00:29:50,960 so I'm not going to do that okay I'm 690 00:29:47,839 --> 00:29:54,439 going to keep our is our LM as it was 691 00:29:50,960 --> 00:29:56,840 but now with this extensions we have to 692 00:29:54,440 --> 00:29:59,159 modify well the only place where 693 00:29:56,839 --> 00:30:01,319 interest rate enters for us 694 00:29:59,159 --> 00:30:02,960 which is in the investment function and 695 00:30:01,319 --> 00:30:04,079 so the investment function now is not a 696 00:30:02,960 --> 00:30:05,480 function of the nominal interest rate 697 00:30:04,079 --> 00:30:07,678 it's a function of the real interest 698 00:30:05,480 --> 00:30:11,360 rate adjusted by credit risk because 699 00:30:07,679 --> 00:30:12,880 that's the relevant opportunity cost of 700 00:30:11,359 --> 00:30:17,558 that's a real cost of borrowing if you 701 00:30:12,880 --> 00:30:20,840 will of firms when they want to invest 702 00:30:17,558 --> 00:30:23,398 okay so that's a modification now for 703 00:30:20,839 --> 00:30:25,439 this part of the course as I said I'm 704 00:30:23,398 --> 00:30:27,439 going to take this as two new 705 00:30:25,440 --> 00:30:29,919 parameters we're not going to look at 706 00:30:27,440 --> 00:30:32,480 equilibrium determination of that when 707 00:30:29,919 --> 00:30:34,399 we get into the next part of the course 708 00:30:32,480 --> 00:30:36,278 then we're never going to do much about 709 00:30:34,398 --> 00:30:38,398 that but yes about this but for now 710 00:30:36,278 --> 00:30:41,599 these are just two new parameters so in 711 00:30:38,398 --> 00:30:43,239 our equilibrium in lecture three in the 712 00:30:41,599 --> 00:30:45,278 goods market equilibrium now we have two 713 00:30:43,240 --> 00:30:48,399 more parameters expected 714 00:30:45,278 --> 00:30:51,398 inflation and in the remember the ZZ 715 00:30:48,398 --> 00:30:52,798 curve where we have GT interest rate all 716 00:30:51,398 --> 00:30:55,038 those things has constant well now we 717 00:30:52,798 --> 00:30:58,798 have two new parameters expected 718 00:30:55,038 --> 00:31:02,798 inflation and the credited spread 719 00:30:58,798 --> 00:31:05,440 okay so that's it that's lecture three 720 00:31:02,798 --> 00:31:09,319 now so what I'm showing you here is what 721 00:31:05,440 --> 00:31:12,840 happened in lecture three if the credit 722 00:31:09,319 --> 00:31:15,119 spreads comes down or expected inflation 723 00:31:12,839 --> 00:31:19,678 Rises for any given nominal interest 724 00:31:15,119 --> 00:31:23,038 rate okay then that shift the ZZ curve 725 00:31:19,679 --> 00:31:23,038 up why is 726 00:31:24,440 --> 00:31:28,919 that and sorry and if aggregate demand 727 00:31:27,200 --> 00:31:30,600 goes up then the multiply it kicks in 728 00:31:28,919 --> 00:31:33,519 and we end up with an expansion in 729 00:31:30,599 --> 00:31:36,398 output so I'm saying for a given nominal 730 00:31:33,519 --> 00:31:41,278 interest rate if now expected inflation 731 00:31:36,398 --> 00:31:45,199 goes up or H the credit spreads spreads 732 00:31:41,278 --> 00:31:46,880 go down then we that's act acts almost 733 00:31:45,200 --> 00:31:49,038 like an expansionary monetary policy you 734 00:31:46,880 --> 00:31:53,000 see you get an expansion in aggregate 735 00:31:49,038 --> 00:31:53,000 demand yes 736 00:31:58,038 --> 00:32:04,158 for RIS deine they can they can borrow 737 00:32:02,319 --> 00:32:06,918 exactly that's it yes because of 738 00:32:04,159 --> 00:32:09,080 borrowing went up for down for firms 739 00:32:06,919 --> 00:32:11,278 okay so that's what I'm saying those two 740 00:32:09,079 --> 00:32:12,960 things operate almost as monetary policy 741 00:32:11,278 --> 00:32:14,599 that is not been done by the fed by the 742 00:32:12,960 --> 00:32:16,000 way by the central bank but they have 743 00:32:14,599 --> 00:32:18,398 the same effect because that's the way 744 00:32:16,000 --> 00:32:21,079 they enter they enter exactly the same 745 00:32:18,398 --> 00:32:22,959 as as an interest rate so saying that 746 00:32:21,079 --> 00:32:27,319 this guy is going up or this guy is 747 00:32:22,960 --> 00:32:31,399 going down leads to the same analysis as 748 00:32:27,319 --> 00:32:33,038 as as when we lower I because they're 749 00:32:31,398 --> 00:32:38,558 identical they enter exactly in the same 750 00:32:33,038 --> 00:32:40,200 place no so what I showed you here I had 751 00:32:38,558 --> 00:32:42,158 done diagrams like this before that's 752 00:32:40,200 --> 00:32:45,159 what you get when you lower the interest 753 00:32:42,159 --> 00:32:46,639 rate well the the two shocks I describ 754 00:32:45,159 --> 00:32:48,880 is effectively like lowering the 755 00:32:46,638 --> 00:32:54,359 interest rate that is the relevant 756 00:32:48,880 --> 00:32:56,559 interest rate for a a the firms because 757 00:32:54,359 --> 00:33:00,158 lower CR spreads higher expected 758 00:32:56,558 --> 00:33:04,038 inflation means lower re interest rate 759 00:33:00,159 --> 00:33:06,960 okay now the the episode I describe you 760 00:33:04,038 --> 00:33:10,679 in in in in during the global financial 761 00:33:06,960 --> 00:33:13,399 crisis was exact opposite of this no in 762 00:33:10,679 --> 00:33:15,360 the global financial crisis we had this 763 00:33:13,398 --> 00:33:17,839 x boom 764 00:33:15,359 --> 00:33:21,079 jumping and I had shown you 765 00:33:17,839 --> 00:33:22,038 before that expected inflation came down 766 00:33:21,079 --> 00:33:25,158 a 767 00:33:22,038 --> 00:33:28,398 lot okay remember expected inflation 768 00:33:25,159 --> 00:33:31,519 came down a lot when negative 769 00:33:28,398 --> 00:33:35,079 no from around 2% to minus four that's a 770 00:33:31,519 --> 00:33:35,798 big shock for the real cost of borrowing 771 00:33:35,079 --> 00:33:37,519 for 772 00:33:35,798 --> 00:33:41,000 firms 773 00:33:37,519 --> 00:33:44,278 and the X went up like 774 00:33:41,000 --> 00:33:46,119 crazy that's the reason in the global 775 00:33:44,278 --> 00:33:48,558 financial crisis what we got is exactly 776 00:33:46,119 --> 00:33:51,759 the opposite of this we got a massive 777 00:33:48,558 --> 00:33:54,759 shift down in the zzer for the reasons 778 00:33:51,759 --> 00:33:57,240 we just described 779 00:33:54,759 --> 00:34:00,158 okay because this again this is the case 780 00:33:57,240 --> 00:34:01,798 for x going down or Pi going up in the 781 00:34:00,159 --> 00:34:04,559 global financial crisis we' got exactly 782 00:34:01,798 --> 00:34:07,440 the opposite and in massive amounts no 783 00:34:04,558 --> 00:34:09,838 massive increase in X massive decline in 784 00:34:07,440 --> 00:34:12,159 expected inflation so it's exact 785 00:34:09,838 --> 00:34:14,559 opposite of this and in a much larger 786 00:34:12,159 --> 00:34:17,559 scale that was a massive 787 00:34:14,559 --> 00:34:17,559 shock 788 00:34:18,398 --> 00:34:21,878 good so that's the case I was just 789 00:34:20,679 --> 00:34:24,119 describing that's what happened in the 790 00:34:21,878 --> 00:34:27,199 global financial crisis so the first 791 00:34:24,119 --> 00:34:28,679 thing is so if x goes up as it did in 792 00:34:27,199 --> 00:34:31,118 the global financial crisis and the 793 00:34:28,679 --> 00:34:32,918 Great Recession I I by the way when I 794 00:34:31,119 --> 00:34:34,079 say the global financial crisis or the 795 00:34:32,918 --> 00:34:36,679 Great Recession those are the same 796 00:34:34,079 --> 00:34:38,599 episode end up being it started from a 797 00:34:36,679 --> 00:34:41,320 financial crisis and it turned out ended 798 00:34:38,599 --> 00:34:44,519 up being a recession everywhere and a 799 00:34:41,320 --> 00:34:47,679 financial crisis everywhere as well okay 800 00:34:44,519 --> 00:34:51,320 but uh anyway so what I just described 801 00:34:47,679 --> 00:34:54,240 is this is the in the islm space the is 802 00:34:51,320 --> 00:34:57,000 is shifting inwards a lot no for any 803 00:34:54,239 --> 00:34:59,078 given nominal interest rate if x goes up 804 00:34:57,000 --> 00:35:02,039 a lot that means there is less 805 00:34:59,079 --> 00:35:04,440 investment and that means that the LM 806 00:35:02,039 --> 00:35:07,320 shift to the sorry the is shift to the 807 00:35:04,440 --> 00:35:09,400 left okay and the same would happen if 808 00:35:07,320 --> 00:35:11,280 there's a fallen expected inflation so 809 00:35:09,400 --> 00:35:13,800 for the great session we had two reasons 810 00:35:11,280 --> 00:35:15,200 why this thing move inward a lot one 811 00:35:13,800 --> 00:35:17,480 expected inflation came down and the 812 00:35:15,199 --> 00:35:19,838 other one X went up a lot massive 813 00:35:17,480 --> 00:35:21,838 movement to the left now what do you 814 00:35:19,838 --> 00:35:24,039 think a central bank should do face with 815 00:35:21,838 --> 00:35:27,199 a situation like 816 00:35:24,039 --> 00:35:29,759 this drop interest rate no why you you 817 00:35:27,199 --> 00:35:31,799 do that because this shocks enter like 818 00:35:29,760 --> 00:35:33,760 negative interest rate like shocks to 819 00:35:31,800 --> 00:35:35,079 the interest rate effectively it's like 820 00:35:33,760 --> 00:35:37,359 you had increased the interest rate a 821 00:35:35,079 --> 00:35:39,839 lot and so the central bank will try to 822 00:35:37,358 --> 00:35:42,719 offset that by lowering the interest 823 00:35:39,838 --> 00:35:46,199 rate what problem May the Central Bank 824 00:35:42,719 --> 00:35:46,199 face in doing 825 00:35:47,440 --> 00:35:51,800 this yeah reaching the zero lower bound 826 00:35:50,039 --> 00:35:53,279 effective lower one liquidity trap 827 00:35:51,800 --> 00:35:54,800 exactly it's a limit of how much you can 828 00:35:53,280 --> 00:35:56,000 do and I show you that that's what 829 00:35:54,800 --> 00:35:59,920 happened really 830 00:35:56,000 --> 00:36:01,960 here you see if effectively this is like 831 00:35:59,920 --> 00:36:03,440 it's the reason looks so flat it doesn't 832 00:36:01,960 --> 00:36:05,000 move is because it's against a lower 833 00:36:03,440 --> 00:36:07,358 bound it cannot 834 00:36:05,000 --> 00:36:10,920 move let me tell you a little bit about 835 00:36:07,358 --> 00:36:12,598 what is happening now so this is now 836 00:36:10,920 --> 00:36:16,159 remember the other one was for the 837 00:36:12,599 --> 00:36:19,000 period from 2008 to 2013 I show you now 838 00:36:16,159 --> 00:36:24,239 I'm shifting everything by 10 years okay 839 00:36:19,000 --> 00:36:25,800 so still you see on average the the the 840 00:36:24,239 --> 00:36:29,959 the white line which is the nominal 841 00:36:25,800 --> 00:36:31,880 interest rate is above the um the Orange 842 00:36:29,960 --> 00:36:33,559 Line the Orange Line the yellow line 843 00:36:31,880 --> 00:36:38,240 which is the 844 00:36:33,559 --> 00:36:38,239 um the real interest rate why is 845 00:36:40,440 --> 00:36:46,400 that 846 00:36:42,800 --> 00:36:48,119 yeah yeah posi inflation posit INF 847 00:36:46,400 --> 00:36:50,400 expected inflation but they're 848 00:36:48,119 --> 00:36:52,039 correlated when inflation is on average 849 00:36:50,400 --> 00:36:53,838 positive then expected inflation is also 850 00:36:52,039 --> 00:36:56,559 an average 851 00:36:53,838 --> 00:37:00,000 positive there's an exception there why 852 00:36:56,559 --> 00:37:00,000 is that what when does it 853 00:37:02,159 --> 00:37:06,039 happen there's one point 854 00:37:06,119 --> 00:37:11,280 where the real interest rate went above 855 00:37:08,480 --> 00:37:11,280 the nominal interest 856 00:37:12,039 --> 00:37:16,480 rate 857 00:37:13,559 --> 00:37:19,000 sorry recession yeah exactly the covid 858 00:37:16,480 --> 00:37:21,240 recession so as I said before that was a 859 00:37:19,000 --> 00:37:22,880 massive shock a scary shock and initial 860 00:37:21,239 --> 00:37:24,879 reaction of expected inflation was to 861 00:37:22,880 --> 00:37:27,640 come down enormously and that's so 862 00:37:24,880 --> 00:37:30,240 that's what we saw and also see that 863 00:37:27,639 --> 00:37:32,239 this biggest step here in the in the 864 00:37:30,239 --> 00:37:35,159 nominal interest 865 00:37:32,239 --> 00:37:37,358 rate and then flat so what do you think 866 00:37:35,159 --> 00:37:41,318 happened 867 00:37:37,358 --> 00:37:43,759 there yep again they went all the way 868 00:37:41,318 --> 00:37:45,199 down at to at the maximum they could do 869 00:37:43,760 --> 00:37:47,800 they said the the shortterm interest 870 00:37:45,199 --> 00:37:50,639 rate to zero effectively effect it's not 871 00:37:47,800 --> 00:37:53,440 exactly zero but to zero and they stay 872 00:37:50,639 --> 00:37:55,639 there for a very long period of time now 873 00:37:53,440 --> 00:37:59,000 why do you think and this I think help a 874 00:37:55,639 --> 00:38:03,598 lot the recovery of the US economy and 875 00:37:59,000 --> 00:38:05,880 it also a a a big reason for the rally 876 00:38:03,599 --> 00:38:08,920 that you saw in the equity Market in 877 00:38:05,880 --> 00:38:11,280 2021 you can see in this picture which 878 00:38:08,920 --> 00:38:14,880 is this notice that the real interest 879 00:38:11,280 --> 00:38:14,880 rate went very very 880 00:38:15,480 --> 00:38:21,039 low you see that the real interest went 881 00:38:18,079 --> 00:38:22,560 very very low that's a reason Equity 882 00:38:21,039 --> 00:38:25,440 markets were flying I mean you have 883 00:38:22,559 --> 00:38:27,799 effectively very low real interest rates 884 00:38:25,440 --> 00:38:30,039 so what happened there how did that 885 00:38:27,800 --> 00:38:32,720 happened what must have happened in this 886 00:38:30,039 --> 00:38:34,920 episode yeah the central bank was 887 00:38:32,719 --> 00:38:37,679 putting injecting everything possible to 888 00:38:34,920 --> 00:38:40,400 it but even more than monetary policy 889 00:38:37,679 --> 00:38:43,919 conventional monetary but but what can 890 00:38:40,400 --> 00:38:46,880 prod what is the reason let me say this 891 00:38:43,920 --> 00:38:46,880 wedge reflects 892 00:38:53,039 --> 00:38:59,000 what what is the what is that W as a 893 00:38:56,719 --> 00:39:01,239 matter of accounting 894 00:38:59,000 --> 00:39:02,679 expected inflation yeah it's expected 895 00:39:01,239 --> 00:39:04,919 inflation so this tells you this 896 00:39:02,679 --> 00:39:07,480 interest was at zero the real interest 897 00:39:04,920 --> 00:39:10,480 was at at minus four here it means that 898 00:39:07,480 --> 00:39:13,719 expected inflation must have been 899 00:39:10,480 --> 00:39:15,240 4% okay that means so we had a 900 00:39:13,719 --> 00:39:17,480 combination in which the nominal 901 00:39:15,239 --> 00:39:19,479 interest remain at zero but inflation 902 00:39:17,480 --> 00:39:21,240 was high which is not the typical 903 00:39:19,480 --> 00:39:23,599 combination we get in recessions like 904 00:39:21,239 --> 00:39:25,719 the previous one demand recessions 905 00:39:23,599 --> 00:39:27,400 financial crisis where inflation is goes 906 00:39:25,719 --> 00:39:29,199 down when you are in a recession this 907 00:39:27,400 --> 00:39:31,838 was a different shock and after the 908 00:39:29,199 --> 00:39:33,960 initial shock we got lots of bottlenecks 909 00:39:31,838 --> 00:39:36,078 on the supply side of the economy which 910 00:39:33,960 --> 00:39:38,519 we don't have a good mod yet later we 911 00:39:36,079 --> 00:39:40,240 want to have to model here and when you 912 00:39:38,519 --> 00:39:42,599 have prod in the supply side you can get 913 00:39:40,239 --> 00:39:44,358 a situation which it feels recessionary 914 00:39:42,599 --> 00:39:47,000 because there's low activity and so on 915 00:39:44,358 --> 00:39:50,799 but inflation is high and that's exactly 916 00:39:47,000 --> 00:39:53,318 what we had here okay the inflation was 917 00:39:50,800 --> 00:39:56,599 high now at some 918 00:39:53,318 --> 00:39:58,639 point H you know for a while we 919 00:39:56,599 --> 00:40:00,000 tolerated this inflation thinking that 920 00:39:58,639 --> 00:40:01,960 this was going to be a transitory 921 00:40:00,000 --> 00:40:04,838 phenomenon and so on but then it began 922 00:40:01,960 --> 00:40:08,159 to last for too long okay and when it 923 00:40:04,838 --> 00:40:10,719 began to last for too long then the the 924 00:40:08,159 --> 00:40:13,960 FED reacted and that's when you see they 925 00:40:10,719 --> 00:40:16,039 began to hike interest rate okay and 926 00:40:13,960 --> 00:40:20,199 they began to hike interest rate and 927 00:40:16,039 --> 00:40:21,759 that initially didn't do much er er to 928 00:40:20,199 --> 00:40:23,318 the real rates because expected 929 00:40:21,760 --> 00:40:25,720 inflation kept 930 00:40:23,318 --> 00:40:27,519 rising and then eventually they 931 00:40:25,719 --> 00:40:29,480 convinced everyone that they were 932 00:40:27,519 --> 00:40:33,920 serious about this and so real interest 933 00:40:29,480 --> 00:40:35,838 rate began to H rise a lot here and 934 00:40:33,920 --> 00:40:37,119 that's when the equity Market Collapse 935 00:40:35,838 --> 00:40:38,480 by the way you don't know that yet but 936 00:40:37,119 --> 00:40:40,720 I'm going to talk about Equity Market 937 00:40:38,480 --> 00:40:43,599 later on but but I believe me that's 938 00:40:40,719 --> 00:40:46,639 what essentially brought down the NASDAQ 939 00:40:43,599 --> 00:40:48,838 for sure primarily and all these M 940 00:40:46,639 --> 00:40:51,358 stocks and all that well that's that's 941 00:40:48,838 --> 00:40:56,000 that 942 00:40:51,358 --> 00:40:57,679 okay um what about today well Houston we 943 00:40:56,000 --> 00:40:59,318 have a problem because because you see 944 00:40:57,679 --> 00:41:01,000 the FED keeps Rising interest rate and 945 00:40:59,318 --> 00:41:03,719 inflation is not coming 946 00:41:01,000 --> 00:41:05,519 down as much as we expected in fact 947 00:41:03,719 --> 00:41:06,959 expected inflation initially looked like 948 00:41:05,519 --> 00:41:09,318 what's going to decline and and now it's 949 00:41:06,960 --> 00:41:11,880 beginning to pick up again so you have a 950 00:41:09,318 --> 00:41:13,920 situation here where the FED wants to be 951 00:41:11,880 --> 00:41:16,480 restrictive but the real interest is 952 00:41:13,920 --> 00:41:18,800 declining not going up that's a problem 953 00:41:16,480 --> 00:41:21,000 okay it's a problem that's that's what 954 00:41:18,800 --> 00:41:22,800 is happening at this very moment fed has 955 00:41:21,000 --> 00:41:24,639 a big problem because of that they're 956 00:41:22,800 --> 00:41:26,640 trying to tighten interest rate but 957 00:41:24,639 --> 00:41:28,039 Financial conditions are relaxing in a 958 00:41:26,639 --> 00:41:29,598 sense 959 00:41:28,039 --> 00:41:32,119 because of an increase in expected 960 00:41:29,599 --> 00:41:35,400 inflation and even credit spreads were 961 00:41:32,119 --> 00:41:36,880 declining like so here is what I just 962 00:41:35,400 --> 00:41:39,519 said in terms of 963 00:41:36,880 --> 00:41:42,280 inflation ER expected inflation and you 964 00:41:39,519 --> 00:41:44,280 see here the big collapse during covid 965 00:41:42,280 --> 00:41:47,000 early on in covid but then it recovered 966 00:41:44,280 --> 00:41:50,400 very strongly and went very 967 00:41:47,000 --> 00:41:51,960 high and and actually the middle of 2022 968 00:41:50,400 --> 00:41:53,800 it really went up a lot and that's when 969 00:41:51,960 --> 00:41:55,119 the FED really got a scar and that's 970 00:41:53,800 --> 00:41:58,560 when they began to increase interest 971 00:41:55,119 --> 00:42:00,960 rate by 75 basis points in in a hurry 972 00:41:58,559 --> 00:42:03,000 okay and this is what you see recently I 973 00:42:00,960 --> 00:42:05,440 told you that we have a problem now 974 00:42:03,000 --> 00:42:08,280 because expected inflation they they 975 00:42:05,440 --> 00:42:12,119 were able there a famous conference 976 00:42:08,280 --> 00:42:15,880 Jackson happens in Jackson Hall ER and 977 00:42:12,119 --> 00:42:16,800 it's famous mostly because ER you know 978 00:42:15,880 --> 00:42:19,640 most 979 00:42:16,800 --> 00:42:21,280 Central chairs of presidents of central 980 00:42:19,639 --> 00:42:23,960 banks governors of central banks around 981 00:42:21,280 --> 00:42:25,880 the world sort of meet for a few days 982 00:42:23,960 --> 00:42:28,400 there but there is one speech that 983 00:42:25,880 --> 00:42:33,240 everyone looks at which is a speech of 984 00:42:28,400 --> 00:42:36,240 the of the um chair of the US Central 985 00:42:33,239 --> 00:42:38,039 Bank the FED okay and they were very 986 00:42:36,239 --> 00:42:40,479 worried that that conference happened 987 00:42:38,039 --> 00:42:42,119 around here and they were very worried 988 00:42:40,480 --> 00:42:44,760 because suspected inflation was just 989 00:42:42,119 --> 00:42:47,160 exploding I mean 6% or so that's those 990 00:42:44,760 --> 00:42:47,839 are unheard of numbers for the us since 991 00:42:47,159 --> 00:42:50,639 the 992 00:42:47,838 --> 00:42:53,960 80s and and so they came up with a very 993 00:42:50,639 --> 00:42:55,879 tough speech very Hwy speech saying look 994 00:42:53,960 --> 00:42:57,679 this is unacceptable we're going to do 995 00:42:55,880 --> 00:42:58,920 whatever it takes to bring this stuff 996 00:42:57,679 --> 00:43:01,318 down and and and they were very 997 00:42:58,920 --> 00:43:03,000 successful persuading people in fact 998 00:43:01,318 --> 00:43:05,159 expected inflation began to decline a 999 00:43:03,000 --> 00:43:08,599 lot very quickly which is one of the 1000 00:43:05,159 --> 00:43:10,838 reasons you see real rates Rising very 1001 00:43:08,599 --> 00:43:13,000 fast in fact faster than than the 1002 00:43:10,838 --> 00:43:15,279 nominal rates because nominal rates were 1003 00:43:13,000 --> 00:43:17,280 rising and on top of that expected 1004 00:43:15,280 --> 00:43:19,040 inflation began to plummet and that led 1005 00:43:17,280 --> 00:43:20,440 to a very sharp rise in real interest 1006 00:43:19,039 --> 00:43:24,318 rate and the collapse in the stock 1007 00:43:20,440 --> 00:43:24,318 market as a result 1008 00:43:24,480 --> 00:43:30,000 okay what about credit spreads in in 1009 00:43:27,800 --> 00:43:33,680 this 1010 00:43:30,000 --> 00:43:37,280 episode ER well here you 1011 00:43:33,679 --> 00:43:39,719 see we had during the covid shock again 1012 00:43:37,280 --> 00:43:41,440 we got a Bigg Spike here it was not as 1013 00:43:39,719 --> 00:43:43,959 large as in in the other one which was a 1014 00:43:41,440 --> 00:43:46,800 financial crisis per se but it was a 1015 00:43:43,960 --> 00:43:49,280 very large Spike and then eventually 1016 00:43:46,800 --> 00:43:50,720 sort of came down and it came down a lot 1017 00:43:49,280 --> 00:43:52,480 that's again when you're seeing rallying 1018 00:43:50,719 --> 00:43:55,959 and all the markets and so 1019 00:43:52,480 --> 00:43:57,719 on H but then began to go up and and 1020 00:43:55,960 --> 00:43:59,039 again here we began to a problem because 1021 00:43:57,719 --> 00:44:02,078 the fair wanted to tighten and this 1022 00:43:59,039 --> 00:44:04,039 credit spreads were coming down this got 1023 00:44:02,079 --> 00:44:04,880 this is I think I did this on Sunday or 1024 00:44:04,039 --> 00:44:07,960 something 1025 00:44:04,880 --> 00:44:11,519 so today's 27 yeah I did it yesterday 1026 00:44:07,960 --> 00:44:14,358 there it is okay so so this this pickup 1027 00:44:11,519 --> 00:44:16,920 here is very recent this last 1028 00:44:14,358 --> 00:44:19,920 week but great spreads were declining 1029 00:44:16,920 --> 00:44:22,440 and that again goes against to to what 1030 00:44:19,920 --> 00:44:27,318 the FED wants to do which is to tighten 1031 00:44:22,440 --> 00:44:30,079 Financial conditions for firms okay now 1032 00:44:27,318 --> 00:44:33,079 ER as I said before central banks 1033 00:44:30,079 --> 00:44:37,960 typically intervene only the monetary 1034 00:44:33,079 --> 00:44:40,519 policy they they involves very short 1035 00:44:37,960 --> 00:44:43,519 duration treasury bonds so their own 1036 00:44:40,519 --> 00:44:46,838 bonds okay the bonds of that government 1037 00:44:43,519 --> 00:44:49,880 in most places like that but this shock 1038 00:44:46,838 --> 00:44:52,679 was so disconcerting and so large and it 1039 00:44:49,880 --> 00:44:54,200 did affect corporations a lot no because 1040 00:44:52,679 --> 00:44:56,639 you get imagine you are in the irland 1041 00:44:54,199 --> 00:44:59,679 industry and then suddenly you get covid 1042 00:44:56,639 --> 00:45:01,519 so really was a a major shock to 1043 00:44:59,679 --> 00:45:05,239 corporate to 1044 00:45:01,519 --> 00:45:07,759 corporations and um so they went beyond 1045 00:45:05,239 --> 00:45:09,399 traditional conventional monetary policy 1046 00:45:07,760 --> 00:45:10,720 they certainly something that had done 1047 00:45:09,400 --> 00:45:12,079 already in the global financial crisis 1048 00:45:10,719 --> 00:45:15,358 they began to buy sort of very long 1049 00:45:12,079 --> 00:45:18,000 duration US Treasury bonds so 10 year 1050 00:45:15,358 --> 00:45:19,598 bonds and so on treasur but they went 1051 00:45:18,000 --> 00:45:22,719 beyond that and they created a facility 1052 00:45:19,599 --> 00:45:25,800 to buy corporate bonds okay that 1053 00:45:22,719 --> 00:45:28,639 facility was meant to deal with XS okay 1054 00:45:25,800 --> 00:45:30,480 you're getting a huge huge X shock and 1055 00:45:28,639 --> 00:45:33,239 they went directly to that to try to 1056 00:45:30,480 --> 00:45:34,838 bring that X shock down why do they want 1057 00:45:33,239 --> 00:45:39,318 to do that well because of the reasons 1058 00:45:34,838 --> 00:45:42,558 we have explained here H you 1059 00:45:39,318 --> 00:45:44,039 know that amounted the X shock which 1060 00:45:42,559 --> 00:45:46,760 came together with expected inflation 1061 00:45:44,039 --> 00:45:48,000 coming down amount of big shift there 1062 00:45:46,760 --> 00:45:49,800 they did all they could with 1063 00:45:48,000 --> 00:45:51,920 conventional monetary policy they 1064 00:45:49,800 --> 00:45:53,599 brought this down so you can think of 1065 00:45:51,920 --> 00:45:55,200 their policies of intervention it's 1066 00:45:53,599 --> 00:45:56,720 called they're called large scale asset 1067 00:45:55,199 --> 00:45:57,679 purchases that's a generic number of 1068 00:45:56,719 --> 00:45:59,279 that 1069 00:45:57,679 --> 00:46:01,039 well what they were trying to do really 1070 00:45:59,280 --> 00:46:02,880 is to act on those interest rates that 1071 00:46:01,039 --> 00:46:07,000 do not show up in the LM that show up in 1072 00:46:02,880 --> 00:46:10,920 here know x x is a parameter of here if 1073 00:46:07,000 --> 00:46:13,400 I go out there and I buy a a corporate 1074 00:46:10,920 --> 00:46:15,760 bonds then I'm reducing X which is a way 1075 00:46:13,400 --> 00:46:17,480 of Shifting the yes back okay 1076 00:46:15,760 --> 00:46:20,200 corporations can borrow more cheaply if 1077 00:46:17,480 --> 00:46:24,199 the government is buying their bonds 1078 00:46:20,199 --> 00:46:25,399 that's the whole idea in in in in Japan 1079 00:46:24,199 --> 00:46:28,078 they even bought 1080 00:46:25,400 --> 00:46:30,880 Equity okay the Equity interventions in 1081 00:46:28,079 --> 00:46:32,800 the equity market so happened in Hong 1082 00:46:30,880 --> 00:46:34,519 Kong in 1997 there was a massive 1083 00:46:32,800 --> 00:46:36,240 intervention in the equity Market 1084 00:46:34,519 --> 00:46:39,119 typically central banks don't do that 1085 00:46:36,239 --> 00:46:41,358 but when situations get desperate and 1086 00:46:39,119 --> 00:46:42,960 and you are against the zero lower bound 1087 00:46:41,358 --> 00:46:46,078 so you you lost your conventional 1088 00:46:42,960 --> 00:46:48,240 monetary tool ER they tend to be a 1089 00:46:46,079 --> 00:46:50,640 little more creative and and that's what 1090 00:46:48,239 --> 00:46:50,639 they've been 1091 00:46:52,119 --> 00:46:57,358 doing okay any questions that's it for 1092 00:46:56,400 --> 00:46:59,440 today 1093 00:46:57,358 --> 00:47:02,880 from the yeah you have a question could 1094 00:46:59,440 --> 00:47:04,318 you put X into like more tangible terms 1095 00:47:02,880 --> 00:47:07,960 I think I'm still sort of like trying to 1096 00:47:04,318 --> 00:47:12,639 figure out what a create spr for example 1097 00:47:07,960 --> 00:47:16,599 a uh if if boing I don't think Bo is a 1098 00:47:12,639 --> 00:47:19,318 high yield maybe maybe 1099 00:47:16,599 --> 00:47:20,880 ER well let's say boing it's okay if 1100 00:47:19,318 --> 00:47:23,519 boing borrows they're not going to be 1101 00:47:20,880 --> 00:47:25,920 able to borrow the say that the 10e rate 1102 00:47:23,519 --> 00:47:28,838 I'm showing it here in 10e rate spread 1103 00:47:25,920 --> 00:47:32,039 the 10e rate the us at this moment is 1104 00:47:28,838 --> 00:47:34,358 you know close to 4% if boing wants to 1105 00:47:32,039 --> 00:47:36,079 borrow 10 years he's not going to be 1106 00:47:34,358 --> 00:47:38,679 able to borrow at 4% they going to have 1107 00:47:36,079 --> 00:47:40,720 to borrow at 7% so there's a 3% 1108 00:47:38,679 --> 00:47:44,358 difference that's 1109 00:47:40,719 --> 00:47:46,199 X that's X that's great SP spread which 1110 00:47:44,358 --> 00:47:48,199 is linked to the perceived probability 1111 00:47:46,199 --> 00:47:50,239 of the fault I said it's more than it's 1112 00:47:48,199 --> 00:47:52,799 perceived when you say perceive is is 1113 00:47:50,239 --> 00:47:55,039 the say the actual probability of 1114 00:47:52,800 --> 00:47:56,559 theault who who knows who can measure 1115 00:47:55,039 --> 00:47:58,599 that there are again agencies that try 1116 00:47:56,559 --> 00:48:00,240 to meure measure them plus whatever 1117 00:47:58,599 --> 00:48:01,880 extra risk premium you want to put on 1118 00:48:00,239 --> 00:48:04,118 top of 1119 00:48:01,880 --> 00:48:08,519 that 1120 00:48:04,119 --> 00:48:11,318 Rel reliability of americ yeah how 1121 00:48:08,519 --> 00:48:13,039 unattractive it looks to lend to a 1122 00:48:11,318 --> 00:48:15,039 corporate versus lending to the US 1123 00:48:13,039 --> 00:48:16,719 government and when this LM is very high 1124 00:48:15,039 --> 00:48:17,960 it looks very unattractive to lend to 1125 00:48:16,719 --> 00:48:21,919 corporations and therefore you need to 1126 00:48:17,960 --> 00:48:21,920 be compensated a lot for 1127 00:48:22,000 --> 00:48:25,000 that 1128 00:48:25,760 --> 00:48:29,760 okay e