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