[00:18] okay let's uh let's start so by now uh
[00:22] you know the is Mo and if you don't
[00:26] fully control it please spend a lot of
[00:29] time on it um as I said two third of
[00:32] your quiz will be about that but uh
[00:35] we're going to start adding a few it's a
[00:37] very basic model but still H we can
[00:41] squeeze a lot of insight from it and uh
[00:45] and there are some very natural
[00:46] extensions that that I think we should
[00:48] also go over and and cover because uh
[00:53] again they have a high return in terms
[00:55] of investment to to knowledge you acquir
[00:58] from them and today I want to extend
[01:00] this islm model along two realistic
[01:05] Dimensions the first one ER is H is to
[01:11] make a distinction between nominal and
[01:13] real interest rate now
[01:16] nominal up to now since we assume in the
[01:18] mod since we assume that prices were
[01:20] completely fixed constant there's no
[01:23] inflation and then there is no
[01:25] distinction between nominal and real
[01:26] interest rates but needless to say we
[01:29] live in an environment with inflation is
[01:31] positive typically not always but
[01:32] typically and in fact nowadays we're
[01:35] having very high inflation and that's
[01:36] part of one of the big macroeconomic
[01:38] headaches that we have at this moment is
[01:40] the very high inflation rate we're
[01:42] experiencing now we're not going to talk
[01:44] about the determination of inflation
[01:46] until later in the course I'm going to
[01:48] start talking about that in the next
[01:50] lecture and it will not be part of your
[01:52] quiz though sorry not in the next next
[01:54] week but will not be part of your of of
[01:57] your quiz it will be very important part
[01:59] of quiz to but not of quiz one but I
[02:01] still can we can still say a few things
[02:04] about what happens to the framework we
[02:07] have conditional or taking as a
[02:10] parameter inflation we're not going to
[02:12] determine inflation the M but we say
[02:14] well what happens is inflation is not
[02:15] really zero more importantly what
[02:17] happens if people don't expect inflation
[02:19] to be really zero and and and we'll see
[02:22] how that modifies the
[02:24] analysis the second the second extension
[02:28] is is that
[02:30] that you know we simplify financial
[02:32] markets enormously and and and the and
[02:36] we targeted we customiz it to we could
[02:39] have simplified along many dimensions
[02:41] but the simplification that we had is we
[02:44] look at something that
[02:46] that that is closest to what central
[02:48] banks do in setting monetary policy and
[02:51] that's really the trade between cash
[02:54] deposit at the central bank and
[02:57] bonds US government bonds in the case of
[03:00] the US typically of very short maturity
[03:03] and that's what we had in mind H and
[03:06] that's that's the way we determine the
[03:08] interest rate now needless to say there
[03:10] are many many interest rates in the
[03:12] economy different duration you know one
[03:15] year rate twoe rate three 10 30 year
[03:18] rates some countries have 100 Year rates
[03:22] er er but there is also another
[03:25] dimension which is very important as the
[03:27] want to highlight there which is
[03:29] riskiness US Treasury bonds especially
[03:32] of short duration are riskless assets
[03:34] there no risk associated to it now we
[03:36] have a little event with the with the
[03:38] dead ceiling fight in in that may happen
[03:41] in August September but I mean nobody's
[03:44] really concerned that something major
[03:46] will happen except for a few disruptions
[03:48] for a few days let's hope that's true up
[03:52] to now if you look at all the risk
[03:53] markets there behaving as nothing will
[03:55] happen there um but but corporations
[03:58] don't typically borrow at those rates
[04:01] Corporation issue their own bonds or
[04:03] take loans from the banks and those
[04:05] bonds often have a risk premium that is
[04:08] they're equal to the safe interest rate
[04:10] the treasury rate if you want plus
[04:12] something else okay and and and so that
[04:16] you can anticipate that that will be
[04:17] important because interest rate enter
[04:21] into our islm analysis precisely through
[04:24] the borrowing cost of firms in the
[04:26] investment function so if there is a
[04:28] wtge there if there's a spread between
[04:31] what the rate we been talking about and
[04:35] the rate at which firms can actually
[04:36] borrow then that W will matter okay and
[04:41] uh and so that's that's what we're want
[04:43] to do so we're going to introduce this
[04:44] I'm want to explain what these things
[04:45] are and then I'm going to modify our
[04:48] islm model to take into consideration
[04:51] these extensions
[04:53] okay H so what is the nominal interest
[04:57] rate well we have been talking about the
[04:58] nominal interest rate we which we
[05:01] typically denote by little I is the
[05:04] interest rate in terms of dollars say if
[05:06] the interest rate is 10% no you buy a
[05:10] bond today that Bond will give you 10%
[05:12] of whatever amount of money you invest
[05:14] in the bond at the end of the year say
[05:16] it's a onee b okay that's a nominal
[05:19] interest
[05:20] rate um so if you buy 100 in bonds today
[05:25] and the interest rate is 10 the nominal
[05:27] interest rate 10% you receive $10 of
[05:31] interest payments one year from now $10
[05:34] of Interest payment okay a real interest
[05:38] rate is the interest rate in terms of a
[05:40] basket of
[05:42] goods
[05:44] okay so the CPI or something like that
[05:48] will will be important in that okay
[05:51] exante that is at the moment in which
[05:53] you decided were to invest in the real
[05:55] Bond or the nominal
[05:57] Bond the difference between the two the
[05:59] main difference there are other issues
[06:01] that have to do with Reem I'm not going
[06:03] to talk about but the main difference
[06:04] between these two is expected
[06:07] inflation okay in other words if you
[06:10] expect no inflation then the distinction
[06:12] between goods that is if you expect P to
[06:15] remain constant the distinction between
[06:17] an interest rate in dollars or in h
[06:21] Goods is inexistent they're the same but
[06:25] if you expect inflation then that's not
[06:27] the case because the goods are going to
[06:28] become more expensive over time and if
[06:30] the goods become more expensive over
[06:32] time that means something that pays you
[06:34] in dollars is paying you
[06:36] more per equal units so if the r little
[06:39] r which is the interest rate is equal to
[06:41] I and you expect inflation to be 10%
[06:45] really you're expecting the real
[06:46] instrument to pay you 10% more than the
[06:48] other that cannot happen in equilibrium
[06:51] but that's what it means no because one
[06:52] is paying you in dollars and the other
[06:54] one is paying you in Goods that will be
[06:55] 10% more expensive next year okay
[07:00] good so why do we care about this
[07:02] distinction between nominal and real
[07:04] interest rate well because the private
[07:07] sector ER important decisions of the
[07:09] private sector like the purchase of
[07:11] durable goods for consumers we're not
[07:12] modeling that in this course but
[07:15] investment in the case of phisical
[07:17] investment not Financial investment
[07:18] phisical investment depends on real
[07:20] rates not nominal rates okay so what
[07:24] what what determines whether H the
[07:27] opportunity cost of a real investment is
[07:29] high or low is the real interest rate
[07:30] not the nominal interest
[07:35] rate why do you think that's the
[07:47] case why do you think it's the real not
[07:50] the nominal interest rate that
[07:58] matters not really I mean most of the
[08:00] borrowing in the US is done in nominal
[08:05] rates so it has to come from something
[08:08] else why why do you
[08:11] invest you invest to produce more Goods
[08:13] in the
[08:14] future so if those goods are going to be
[08:17] more expensive in the future because of
[08:20] inflation then what matters to you is
[08:22] the difference between the cost of
[08:23] borrowing and what you'll get for those
[08:25] goods and the goods are going to be 10%
[08:27] more expensive so what really matter is
[08:29] the net for you you know if then if in
[08:32] other words if the real interest remains
[08:33] constant and now you give me interest
[08:35] rates are 10% higher but you also tell
[08:37] me that the goods I'm going to be
[08:38] selling are going to be 10% more
[08:39] expensive I I don't change my decision
[08:42] if it was a good project with zero
[08:44] inflation it's also a good project with
[08:46] 10 10% inflation that hasn't changed I
[08:49] tell you 30% the same thing no because
[08:54] I'm going to be investing now in order
[08:55] to get things are going to be 30% more
[08:57] expensive a year from now so the de
[08:59] ision that doesn't depend on that so
[09:02] that's the reason the real interest rate
[09:04] is what you really care about in the
[09:06] case of real investment and remember
[09:08] we're talking about real investment at
[09:10] the aggregate level obious can make a
[09:11] difference at the level of individual
[09:13] Goods because you know when inflation
[09:15] goes up not every Goods price go up by
[09:17] the same amount some some goods go up by
[09:20] more some some Goods prices go up by
[09:23] less but on average it's what I just
[09:27] said so let's let's try to look at this
[09:30] equivalence more formally how to derive
[09:32] the real interest
[09:33] rate
[09:35] well in I said not in the US but in many
[09:38] places you do re borrow in real terms
[09:41] for example in in Chile we have a a unit
[09:43] of account because we had very high
[09:45] inflation many years back which is
[09:47] called unid fomento and that in that
[09:50] unit of account is indexed to inflation
[09:53] okay so you borrow you know uh $10
[09:57] 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