WEBVTT

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okay let's uh let's start so by now uh

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you know the is Mo and if you don't

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fully control it please spend a lot of

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time on it um as I said two third of

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your quiz will be about that but uh

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we're going to start adding a few it's a

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very basic model but still H we can

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squeeze a lot of insight from it and uh

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and there are some very natural

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extensions that that I think we should

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also go over and and cover because uh

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again they have a high return in terms

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of investment to to knowledge you acquir

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from them and today I want to extend

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this islm model along two realistic

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Dimensions the first one ER is H is to

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make a distinction between nominal and

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real interest rate now

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nominal up to now since we assume in the

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mod since we assume that prices were

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completely fixed constant there's no

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inflation and then there is no

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distinction between nominal and real

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interest rates but needless to say we

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live in an environment with inflation is

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positive typically not always but

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typically and in fact nowadays we're

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having very high inflation and that's

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part of one of the big macroeconomic

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headaches that we have at this moment is

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the very high inflation rate we're

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experiencing now we're not going to talk

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about the determination of inflation

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until later in the course I'm going to

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start talking about that in the next

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lecture and it will not be part of your

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quiz though sorry not in the next next

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week but will not be part of your of of

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your quiz it will be very important part

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of quiz to but not of quiz one but I

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still can we can still say a few things

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about what happens to the framework we

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have conditional or taking as a

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parameter inflation we're not going to

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determine inflation the M but we say

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well what happens is inflation is not

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really zero more importantly what

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happens if people don't expect inflation

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to be really zero and and and we'll see

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how that modifies the

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analysis the second the second extension

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is is that

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that you know we simplify financial

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markets enormously and and and the and

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we targeted we customiz it to we could

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have simplified along many dimensions

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but the simplification that we had is we

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look at something that

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that that is closest to what central

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banks do in setting monetary policy and

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that's really the trade between cash

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deposit at the central bank and

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bonds US government bonds in the case of

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the US typically of very short maturity

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and that's what we had in mind H and

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that's that's the way we determine the

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interest rate now needless to say there

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are many many interest rates in the

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economy different duration you know one

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year rate twoe rate three 10 30 year

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rates some countries have 100 Year rates

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er er but there is also another

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dimension which is very important as the

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want to highlight there which is

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riskiness US Treasury bonds especially

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of short duration are riskless assets

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there no risk associated to it now we

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have a little event with the with the

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dead ceiling fight in in that may happen

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in August September but I mean nobody's

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really concerned that something major

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will happen except for a few disruptions

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for a few days let's hope that's true up

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to now if you look at all the risk

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markets there behaving as nothing will

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happen there um but but corporations

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don't typically borrow at those rates

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Corporation issue their own bonds or

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take loans from the banks and those

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bonds often have a risk premium that is

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they're equal to the safe interest rate

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the treasury rate if you want plus

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something else okay and and and so that

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you can anticipate that that will be

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important because interest rate enter

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into our islm analysis precisely through

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the borrowing cost of firms in the

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investment function so if there is a

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wtge there if there's a spread between

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what the rate we been talking about and

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the rate at which firms can actually

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borrow then that W will matter okay and

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uh and so that's that's what we're want

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to do so we're going to introduce this

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I'm want to explain what these things

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are and then I'm going to modify our

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islm model to take into consideration

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these extensions

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okay H so what is the nominal interest

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rate well we have been talking about the

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nominal interest rate we which we

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typically denote by little I is the

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interest rate in terms of dollars say if

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the interest rate is 10% no you buy a

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bond today that Bond will give you 10%

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of whatever amount of money you invest

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in the bond at the end of the year say

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it's a onee b okay that's a nominal

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interest

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rate um so if you buy 100 in bonds today

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and the interest rate is 10 the nominal

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interest rate 10% you receive $10 of

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interest payments one year from now $10

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of Interest payment okay a real interest

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rate is the interest rate in terms of a

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basket of

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goods

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okay so the CPI or something like that

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will will be important in that okay

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exante that is at the moment in which

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you decided were to invest in the real

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Bond or the nominal

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Bond the difference between the two the

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main difference there are other issues

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that have to do with Reem I'm not going

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to talk about but the main difference

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between these two is expected

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inflation okay in other words if you

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expect no inflation then the distinction

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between goods that is if you expect P to

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remain constant the distinction between

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an interest rate in dollars or in h

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Goods is inexistent they're the same but

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if you expect inflation then that's not

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the case because the goods are going to

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become more expensive over time and if

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the goods become more expensive over

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time that means something that pays you

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in dollars is paying you

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more per equal units so if the r little

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r which is the interest rate is equal to

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I and you expect inflation to be 10%

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really you're expecting the real

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instrument to pay you 10% more than the

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other that cannot happen in equilibrium

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but that's what it means no because one

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is paying you in dollars and the other

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one is paying you in Goods that will be

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10% more expensive next year okay

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good so why do we care about this

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distinction between nominal and real

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interest rate well because the private

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sector ER important decisions of the

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private sector like the purchase of

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durable goods for consumers we're not

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modeling that in this course but

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investment in the case of phisical

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investment not Financial investment

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phisical investment depends on real

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rates not nominal rates okay so what

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what what determines whether H the

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opportunity cost of a real investment is

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high or low is the real interest rate

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not the nominal interest

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rate why do you think that's the

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case why do you think it's the real not

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the nominal interest rate that

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matters not really I mean most of the

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borrowing in the US is done in nominal

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rates so it has to come from something

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else why why do you

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invest you invest to produce more Goods

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in the

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future so if those goods are going to be

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more expensive in the future because of

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inflation then what matters to you is

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the difference between the cost of

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borrowing and what you'll get for those

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goods and the goods are going to be 10%

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more expensive so what really matter is

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the net for you you know if then if in

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other words if the real interest remains

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constant and now you give me interest

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rates are 10% higher but you also tell

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me that the goods I'm going to be

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selling are going to be 10% more

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expensive I I don't change my decision

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if it was a good project with zero

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inflation it's also a good project with

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10 10% inflation that hasn't changed I

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tell you 30% the same thing no because

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I'm going to be investing now in order

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to get things are going to be 30% more

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expensive a year from now so the de

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ision that doesn't depend on that so

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that's the reason the real interest rate

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is what you really care about in the

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case of real investment and remember

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we're talking about real investment at

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the aggregate level obious can make a

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difference at the level of individual

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Goods because you know when inflation

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goes up not every Goods price go up by

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the same amount some some goods go up by

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more some some Goods prices go up by

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less but on average it's what I just

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said so let's let's try to look at this

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equivalence more formally how to derive

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the real interest

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rate

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well in I said not in the US but in many

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places you do re borrow in real terms

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for example in in Chile we have a a unit

00:09:43.679 --> 00:09:47.319
of account because we had very high

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inflation many years back which is

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called unid fomento and that in that

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unit of account is indexed to inflation

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okay so you borrow you know uh $10

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million equivalent in a formento and

00:10:00.799 --> 00:10:05.199
those 10 million pesos equivalent

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formento that means the interest rate is

00:10:05.200 --> 00:10:10.240
is indexed to that but in the US that

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happens very rarely the US government

00:10:10.240 --> 00:10:15.720
does do

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that it's called tips so so you have

00:10:15.720 --> 00:10:19.519
nominal bonds the great majority of the

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US Treasury bonds are nominal bonds but

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there are also some real bonds and those

00:10:21.519 --> 00:10:27.480
are indexed to inflation but but but

00:10:24.679 --> 00:10:31.599
firms very rarely can issue Bonds in the

00:10:27.480 --> 00:10:35.480
US that are in real terms okay that's so

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let's sometimes this is even a so but

00:10:35.480 --> 00:10:39.240
the point the reason I I made that

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clarification here is I'm going to

00:10:39.240 --> 00:10:43.839
derive the real interest rate but that

00:10:41.440 --> 00:10:46.240
doesn't mean that the instrument exists

00:10:43.839 --> 00:10:47.959
you know I'm saying given a nominal rate

00:10:46.240 --> 00:10:51.000
that I see out

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there how do I construct a real interest

00:10:51.000 --> 00:10:54.919
rate from that nominal interest rate

00:10:52.839 --> 00:10:56.160
that's what I want to hear it doesn't

00:10:54.919 --> 00:10:59.120
mean that there's an instrument that is

00:10:56.159 --> 00:11:02.439
traded in in real terms but when I go to

00:10:59.120 --> 00:11:05.000
the the bank as a firm and I borrow a

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10% nominal I need to calculate well

00:11:05.000 --> 00:11:08.958
what does that imply in real

00:11:06.958 --> 00:11:11.879
terms and that's what I'm going to

00:11:08.958 --> 00:11:16.078
illustrate now okay

00:11:11.879 --> 00:11:18.278
so good so or maybe I shouldn't use the

00:11:16.078 --> 00:11:20.519
word good since we're going to do this

00:11:18.278 --> 00:11:24.320
so what we want to pin down this this

00:11:20.519 --> 00:11:26.039
this real interest rate R okay so the

00:11:24.320 --> 00:11:29.360
real interest rate in terms of goods

00:11:26.039 --> 00:11:32.919
means if I borrow say one unit or if I

00:11:29.360 --> 00:11:35.959
buy a a an instrument that if I spend

00:11:32.919 --> 00:11:39.919
one unit of the good the aggregate good

00:11:35.958 --> 00:11:43.559
in a bond then I I receive one plus RT

00:11:39.919 --> 00:11:45.838
units of goods H one year from now then

00:11:43.559 --> 00:11:48.239
RT is the real interest rate no it's an

00:11:45.839 --> 00:11:51.760
interest rate in terms of

00:11:48.240 --> 00:11:53.720
goods now suppose that that I go this

00:11:51.759 --> 00:11:57.559
route instead say okay that's what I

00:11:53.720 --> 00:11:59.079
want to get to but um let me do it

00:11:57.559 --> 00:12:00.838
through the only instrument I have say

00:11:59.078 --> 00:12:05.679
the nominal interest rate the nominal

00:12:00.839 --> 00:12:09.079
bonds so if I buy one unit of goods

00:12:05.679 --> 00:12:13.278
today that means I'm really buying

00:12:09.078 --> 00:12:16.519
PT dollars in that Bond okay PT is the

00:12:13.278 --> 00:12:19.720
deflator we have we have PT

00:12:16.519 --> 00:12:23.000
dollars well PT dollars invested in a

00:12:19.720 --> 00:12:25.600
nominal Bond will give me 1 plus it the

00:12:23.000 --> 00:12:29.000
nominal interest rate times those PT

00:12:25.600 --> 00:12:32.879
dollars okay so say the price index here

00:12:29.000 --> 00:12:35.320
is is two then uh and the interest rate

00:12:32.879 --> 00:12:39.958
is 10 the nominal interest rate 10% then

00:12:35.320 --> 00:12:42.680
next period I get a two * 1.1 okay

00:12:39.958 --> 00:12:43.879
that's the number of dollars I get now

00:12:42.679 --> 00:12:47.039
that's

00:12:43.879 --> 00:12:48.958
still I cannot compare this with the

00:12:47.039 --> 00:12:50.679
with this up here because at this point

00:12:48.958 --> 00:12:52.319
I have dollars and really I want to

00:12:50.679 --> 00:12:55.000
convert it into Goods I want to go from

00:12:52.320 --> 00:12:59.040
Goods to Goods so how do I convert

00:12:55.000 --> 00:12:59.039
dollars into Goods

00:13:01.278 --> 00:13:04.799
I divide by the price of the goods but

00:13:02.919 --> 00:13:06.639
not here by the price of the goods at t

00:13:04.799 --> 00:13:09.479
plus one because I'm going to get this

00:13:06.639 --> 00:13:11.799
amount of dollars at t+1 one year from

00:13:09.480 --> 00:13:14.320
now I have to divide by the price of

00:13:11.799 --> 00:13:16.958
goods at t+ one in order to get the

00:13:14.320 --> 00:13:18.920
number of goods I'm getting a t plus one

00:13:16.958 --> 00:13:21.958
so I have to divide by p+ one but the

00:13:18.919 --> 00:13:23.719
problem is that time T I don't know what

00:13:21.958 --> 00:13:27.439
pt+ one will

00:13:23.720 --> 00:13:29.800
be okay the best I can do and here's

00:13:27.440 --> 00:13:32.639
where I'm I'm simplifying things a lot

00:13:29.799 --> 00:13:34.719
is to is to have an expectation of what

00:13:32.639 --> 00:13:37.320
the price level will be one year from

00:13:34.720 --> 00:13:39.440
now so the best I can do when I want to

00:13:37.320 --> 00:13:43.560
compare things today whether I want to

00:13:39.440 --> 00:13:48.279
go this way or that way is to a er use

00:13:43.559 --> 00:13:49.799
suspected price here okay so these two

00:13:48.278 --> 00:13:52.000
things are equivalent in the sense that

00:13:49.799 --> 00:13:54.958
they require exactly the same investment

00:13:52.000 --> 00:13:56.720
I'm now I'm going this way and then in

00:13:54.958 --> 00:13:59.879
expectation at least these two things

00:13:56.720 --> 00:14:01.120
are also equivalent okay

00:13:59.879 --> 00:14:02.759
because this is what I'm going to get in

00:14:01.120 --> 00:14:04.799
terms of goods from having invested a

00:14:02.759 --> 00:14:06.320
good this what I expect to get in terms

00:14:04.799 --> 00:14:09.799
of goods but I'm ignoring all that

00:14:06.320 --> 00:14:12.199
uncertainty around that H and this is

00:14:09.799 --> 00:14:14.758
what I get if I go directly the route

00:14:12.198 --> 00:14:16.919
the the Goods Route and and this is two

00:14:14.759 --> 00:14:18.839
things are to be equal by indifference

00:14:16.919 --> 00:14:20.399
okay I if I two things give me the same

00:14:18.839 --> 00:14:22.680
they have to be priced equally they have

00:14:20.399 --> 00:14:24.559
to have the same price and so these two

00:14:22.679 --> 00:14:26.758
things have to be the same because here

00:14:24.559 --> 00:14:28.319
I'm going from Goods to Goods here I'm

00:14:26.759 --> 00:14:30.360
going through this channel but also from

00:14:28.320 --> 00:14:32.720
Goods to Goods these two things should

00:14:30.360 --> 00:14:34.720
give us more or less the same return

00:14:32.720 --> 00:14:37.440
okay and we're going to assume strictly

00:14:34.720 --> 00:14:41.360
that they give us the same expected

00:14:37.440 --> 00:14:44.639
return okay so this relationship

00:14:41.360 --> 00:14:47.159
holds is this di clear diagram

00:14:44.639 --> 00:14:48.519
clear okay good because what I'm going

00:14:47.159 --> 00:14:52.078
to do now is I'm going to take this

00:14:48.519 --> 00:14:52.078
expression here and play with it a

00:14:52.320 --> 00:14:57.240
little so we arve in the previous slide

00:14:55.198 --> 00:14:59.399
to the conclusion that 1 plus the real

00:14:57.240 --> 00:15:01.720
interest rate is equal to 1 plus plus

00:14:59.399 --> 00:15:06.639
the nominal interest rate time PT over

00:15:01.720 --> 00:15:09.199
PT + one expected I'm going to denote

00:15:06.639 --> 00:15:11.560
expected inflation the inflation we

00:15:09.198 --> 00:15:13.399
expect the change in the the the log

00:15:11.559 --> 00:15:15.638
change in the price level or the rate of

00:15:13.399 --> 00:15:20.519
change of the price level from year T to

00:15:15.639 --> 00:15:24.159
year t+1 as Pi e t+1 is equal to that

00:15:20.519 --> 00:15:26.039
okay so this is expected inflation at t+

00:15:24.159 --> 00:15:29.078
one see

00:15:26.039 --> 00:15:32.919
that well do a little algebra and I can

00:15:29.078 --> 00:15:35.519
rewrite this guy here as 1 plus expected

00:15:32.919 --> 00:15:39.599
inflation between t and t plus one okay

00:15:35.519 --> 00:15:44.318
I just I just replace this for one one

00:15:39.600 --> 00:15:47.440
over 1+ pi+ one okay just algebra I got

00:15:44.318 --> 00:15:49.159
that so now I have relationship and

00:15:47.440 --> 00:15:51.319
these things if they if this interest

00:15:49.159 --> 00:15:53.719
rate is not too high this in expected

00:15:51.318 --> 00:15:55.879
inflation is not too high not too large

00:15:53.720 --> 00:15:59.240
as it happens in most countries but a

00:15:55.879 --> 00:16:01.879
few around the world then this is

00:15:59.240 --> 00:16:03.799
approximate implies approximately that

00:16:01.879 --> 00:16:06.759
the real interest rate is approximately

00:16:03.799 --> 00:16:08.039
equal to the nominal interest rate minus

00:16:06.759 --> 00:16:10.199
expected

00:16:08.039 --> 00:16:13.039
inflation okay I'm just taking

00:16:10.198 --> 00:16:13.039
approximations

00:16:17.480 --> 00:16:22.399
here okay and that's is an intuitive

00:16:20.879 --> 00:16:26.439
expression the real interest rate is

00:16:22.399 --> 00:16:30.440
equal to the nominal rate minus expected

00:16:26.440 --> 00:16:30.440
inflation so

00:16:30.720 --> 00:16:36.319
if if the interest rate is is

00:16:33.120 --> 00:16:39.600
6% and expected inflation is 3% well the

00:16:36.318 --> 00:16:41.240
real interest rate is only 3% okay in

00:16:39.600 --> 00:16:43.639
terms of good you're going to get 3%

00:16:41.240 --> 00:16:47.318
less because that's inflation

00:16:43.639 --> 00:16:48.959
rate good or if you're borrowing in

00:16:47.318 --> 00:16:51.879
terms of your borrowing cost well it's

00:16:48.958 --> 00:16:53.838
going to cost you 3% less effectively

00:16:51.879 --> 00:16:56.198
because the goods you're going to be in

00:16:53.839 --> 00:16:59.839
selling out of your investment are Al

00:16:56.198 --> 00:17:02.958
are going to be 3% more expensive

00:16:59.839 --> 00:17:04.759
good so look this is what happened I'm

00:17:02.958 --> 00:17:06.480
showing you what happened around the

00:17:04.759 --> 00:17:08.480
years of the Great Recession remember

00:17:06.480 --> 00:17:10.759
the Great Recession happened 20 end of

00:17:08.480 --> 00:17:13.360
2008 2009

00:17:10.759 --> 00:17:16.038
2010 several things you can see in this

00:17:13.359 --> 00:17:18.759
picture ER the white line here is the

00:17:16.038 --> 00:17:22.078
nominal interest rate and the yellow is

00:17:18.759 --> 00:17:25.558
the real interest rate in the US okay

00:17:22.078 --> 00:17:27.599
and and this is a since in the US you

00:17:25.558 --> 00:17:30.279
can actually trade real and nominal

00:17:27.599 --> 00:17:34.399
bonds the difference between these two

00:17:30.279 --> 00:17:35.960
is expected inflation okay as as priced

00:17:34.400 --> 00:17:38.120
by financial

00:17:35.960 --> 00:17:40.558
markets they're called in the US they're

00:17:38.119 --> 00:17:42.558
called inflation break evens these are

00:17:40.558 --> 00:17:45.240
swaps inflation swaps okay inflation

00:17:42.558 --> 00:17:46.480
break evens but anyways so several

00:17:45.240 --> 00:17:50.120
things you can see in this picture the

00:17:46.480 --> 00:17:53.480
first one is that typically typically

00:17:50.119 --> 00:17:56.879
the unless you're in Japan probably the

00:17:53.480 --> 00:18:00.079
the the the white line that is a nominal

00:17:56.880 --> 00:18:03.120
rate is above the orange line which is

00:18:00.079 --> 00:18:04.599
or the yellow line which is the real

00:18:03.119 --> 00:18:07.279
interest rate why do you think that's

00:18:04.599 --> 00:18:12.279
the case or what does it tell

00:18:07.279 --> 00:18:14.798
you the fact that on average sort of

00:18:12.279 --> 00:18:17.240
er the nominal interest rate is above

00:18:14.798 --> 00:18:20.200
the real interest

00:18:17.240 --> 00:18:22.480
rate yeah on average in most advanced

00:18:20.200 --> 00:18:24.640
economies and even more so in Emerging

00:18:22.480 --> 00:18:26.759
Markets inflation is positive and

00:18:24.640 --> 00:18:29.240
therefore people expect inflation to be

00:18:26.759 --> 00:18:30.879
positive okay yeah in Japan went through

00:18:29.240 --> 00:18:33.839
these long periods of deflation but

00:18:30.880 --> 00:18:36.039
that's a rarity that was an anomaly what

00:18:33.839 --> 00:18:39.199
was going on in Japan but you see

00:18:36.038 --> 00:18:41.558
something else here there's an episode

00:18:39.200 --> 00:18:43.679
very clearly when the opposite was

00:18:41.558 --> 00:18:45.038
holding no when the real interet went

00:18:43.679 --> 00:18:47.480
much higher than the nominal interest

00:18:45.038 --> 00:18:49.038
rate and this is despite the fact that

00:18:47.480 --> 00:18:51.480
you see even they cross in opposite

00:18:49.038 --> 00:18:54.158
direction here there was a sharp decline

00:18:51.480 --> 00:18:56.599
in the nominal interest rate and a sharp

00:18:54.159 --> 00:19:00.640
rise in the real interest rate what

00:18:56.599 --> 00:19:00.639
happened what was happening there

00:19:07.440 --> 00:19:13.279
first of all forget about the picture

00:19:09.519 --> 00:19:17.000
what was happening around 2008

00:19:13.279 --> 00:19:19.480
2009 the Great Recession okay so that's

00:19:17.000 --> 00:19:21.359
one observation typically especially

00:19:19.480 --> 00:19:24.279
modern recession certainly recessions

00:19:21.359 --> 00:19:29.839
caused by financial crisis as this one

00:19:24.279 --> 00:19:32.119
was a a um real interest

00:19:29.839 --> 00:19:34.519
go above nominal interest rate can go

00:19:32.119 --> 00:19:35.839
above nominal interest rates what does

00:19:34.519 --> 00:19:38.480
it

00:19:35.839 --> 00:19:40.959
mean in terms of

00:19:38.480 --> 00:19:43.798
inflation I mean remember what the FED

00:19:40.960 --> 00:19:45.480
is setting is this is this one more or

00:19:43.798 --> 00:19:46.960
less this I think is a one-ear rate so

00:19:45.480 --> 00:19:50.360
it's not exactly what the FED said but

00:19:46.960 --> 00:19:53.600
more or less okay so why do you think

00:19:50.359 --> 00:19:55.639
the FED cut interest rate there very

00:19:53.599 --> 00:19:57.359
aggressively yeah we were in the middle

00:19:55.640 --> 00:19:59.759
of a big financial crisis so we wanted

00:19:57.359 --> 00:20:02.319
to boost the economy no so interest rate

00:19:59.759 --> 00:20:04.038
and this is when you map it into into

00:20:02.319 --> 00:20:05.399
the very short rate this is effectively

00:20:04.038 --> 00:20:07.119
they hit the zero lower bound they

00:20:05.400 --> 00:20:10.480
couldn't lower it more they lower it as

00:20:07.119 --> 00:20:13.000
much as they could and that was it so

00:20:10.480 --> 00:20:16.759
what must have happened for this real

00:20:13.000 --> 00:20:16.759
interest rate to go up like

00:20:17.759 --> 00:20:22.400
crazy how can it be there the FED

00:20:20.839 --> 00:20:26.079
Bringing Down the nominal interest rate

00:20:22.400 --> 00:20:29.360
and the real rate boom jumps

00:20:26.079 --> 00:20:31.599
up expected inflation went down and L so

00:20:29.359 --> 00:20:34.558
what I was saying is in expected

00:20:31.599 --> 00:20:36.719
inflation is typically positive in in in

00:20:34.558 --> 00:20:38.678
sort of developed economies around 2%

00:20:36.720 --> 00:20:41.839
two and a half perc that's the type of

00:20:38.679 --> 00:20:44.400
numbers but in deep recessions it can go

00:20:41.839 --> 00:20:46.519
even negative okay and that's what

00:20:44.400 --> 00:20:49.120
happen there is the expected inflation

00:20:46.519 --> 00:20:51.679
as extracted from inflation break evens

00:20:49.119 --> 00:20:54.479
from these swaps and you see you know

00:20:51.679 --> 00:20:56.519
typically it's around 2% and so on

00:20:54.480 --> 00:20:59.159
because that's more or less the the the

00:20:56.519 --> 00:21:02.200
FED inflation Target in the US

00:20:59.159 --> 00:21:05.559
okay but during this episode here we

00:21:02.200 --> 00:21:07.720
enter into a very deflationary

00:21:05.558 --> 00:21:10.599
episode expected inflation close to

00:21:07.720 --> 00:21:12.720
minus 4% that was very deflationary was

00:21:10.599 --> 00:21:15.839
very scary deflations can be very

00:21:12.720 --> 00:21:19.720
complicated objects to deal with ER

00:21:15.839 --> 00:21:22.798
we'll say more about that later okay but

00:21:19.720 --> 00:21:25.839
that's that's what happened

00:21:22.798 --> 00:21:27.319
there good so that's that's nominal

00:21:25.839 --> 00:21:29.199
versus real interest rate now let me

00:21:27.319 --> 00:21:32.918
talk about credit spread and then we're

00:21:29.200 --> 00:21:36.240
going to put everything together

00:21:32.919 --> 00:21:38.520
so most bonds issued by corporations are

00:21:36.240 --> 00:21:40.359
risky they are not us Treasures are as

00:21:38.519 --> 00:21:44.240
safe as it gets that's consider the

00:21:40.359 --> 00:21:48.038
safest Assets in the world together with

00:21:44.240 --> 00:21:50.120
German bond market bonds you know

00:21:48.038 --> 00:21:52.759
government bonds and SS and there are a

00:21:50.119 --> 00:21:55.199
few but but the US in terms of liquidity

00:21:52.759 --> 00:21:58.240
everything is the Premier safe asset in

00:21:55.200 --> 00:21:59.919
the world okay but most corporations

00:21:58.240 --> 00:22:01.519
don't issue at those rates they have to

00:21:59.919 --> 00:22:05.480
pay a premium because they're not as

00:22:01.519 --> 00:22:08.558
safe as as those as the treasury

00:22:05.480 --> 00:22:12.960
instrument so let me call that the real

00:22:08.558 --> 00:22:15.678
interest rate paid by this uh bonds by

00:22:12.960 --> 00:22:17.360
issues by firms on average be equal to

00:22:15.679 --> 00:22:18.559
the safe real interest rate plus a

00:22:17.359 --> 00:22:20.639
premium

00:22:18.558 --> 00:22:22.200
XT

00:22:20.640 --> 00:22:25.520
okay

00:22:22.200 --> 00:22:27.319
now the point and is important is that

00:22:25.519 --> 00:22:29.519
this risk premium moves a lot over the

00:22:27.319 --> 00:22:31.960
business cycle especially when you have

00:22:29.519 --> 00:22:34.240
a financial crisis you know people

00:22:31.960 --> 00:22:35.919
really want to run away from

00:22:34.240 --> 00:22:38.880
risk

00:22:35.919 --> 00:22:40.799
now and and and so it tends to be higher

00:22:38.880 --> 00:22:42.360
during recessions especially when

00:22:40.798 --> 00:22:45.639
recessions are caused by financial

00:22:42.359 --> 00:22:47.599
crisis and things of that kind now why

00:22:45.640 --> 00:22:49.840
do we care about the risk premium again

00:22:47.599 --> 00:22:51.798
because important private sector

00:22:49.839 --> 00:22:54.319
decisions depend on that real interest

00:22:51.798 --> 00:22:58.639
rate on the on on the on the risk

00:22:54.319 --> 00:23:01.158
adjusted interest rate okay if a firm

00:22:58.640 --> 00:23:02.759
has lots of credibility problems and is

00:23:01.159 --> 00:23:04.200
considered very risky the cost of

00:23:02.759 --> 00:23:05.480
borrowing is going to be very high and

00:23:04.200 --> 00:23:07.440
therefore it's going to have to have a

00:23:05.480 --> 00:23:09.798
higher threshold for any physical

00:23:07.440 --> 00:23:11.360
investment no it's more costly for that

00:23:09.798 --> 00:23:14.400
firm to

00:23:11.359 --> 00:23:16.918
borrow so that's a reason to worry so

00:23:14.400 --> 00:23:19.200
the risk premium is that X there is

00:23:16.919 --> 00:23:21.278
determined by two things essentially in

00:23:19.200 --> 00:23:22.840
in the case of bonds there's also risk

00:23:21.278 --> 00:23:24.919
premiums in equity but in the case of

00:23:22.839 --> 00:23:27.079
bonds one thing is the priority of

00:23:24.919 --> 00:23:29.559
theault I mean it may be that the firm

00:23:27.079 --> 00:23:32.079
doesn't honor those BS and defaults on

00:23:29.558 --> 00:23:34.359
them okay so one thing is a primary

00:23:32.079 --> 00:23:36.519
default the other one is the degree of

00:23:34.359 --> 00:23:38.158
risk aversion of bone bone holders there

00:23:36.519 --> 00:23:40.000
are sometime times in which you say look

00:23:38.159 --> 00:23:41.240
I don't want to hold any risk here or

00:23:40.000 --> 00:23:43.278
very little risk because you know

00:23:41.240 --> 00:23:45.640
everything looks very complicated to me

00:23:43.278 --> 00:23:47.400
I rather go safe I go to treasury bonds

00:23:45.640 --> 00:23:50.640
I don't want this stuff so those two

00:23:47.400 --> 00:23:53.159
reasons make that spread grow the second

00:23:50.640 --> 00:23:55.480
reason on average to me is the most

00:23:53.159 --> 00:23:57.559
important reason but it's easier to

00:23:55.480 --> 00:23:59.038
model all this stuff as a priority of

00:23:57.558 --> 00:24:00.399
the fault so that's what I'm going to

00:23:59.038 --> 00:24:02.519
assuming what I'm going to do here is

00:24:00.400 --> 00:24:04.720
I'm going to ignore this the degree of

00:24:02.519 --> 00:24:05.918
risk aversion of bond holders and I'm

00:24:04.720 --> 00:24:08.558
going to just concentrate on the

00:24:05.919 --> 00:24:11.600
probability of theault of a bond but in

00:24:08.558 --> 00:24:14.000
a sense you can model both as the same

00:24:11.599 --> 00:24:15.839
because you can think of risk aversion

00:24:14.000 --> 00:24:18.640
as somebody exaggerating the probability

00:24:15.839 --> 00:24:20.519
of the fault of a bond if I if I get

00:24:18.640 --> 00:24:22.799
very nervous about investing in Risky

00:24:20.519 --> 00:24:24.400
stuff there is some true probability of

00:24:22.798 --> 00:24:26.480
the fault that some agenci is

00:24:24.400 --> 00:24:28.679
calculating out there but if I'm very

00:24:26.480 --> 00:24:31.000
nervous about that I may as well put a

00:24:28.679 --> 00:24:33.480
markup say well you know these guys have

00:24:31.000 --> 00:24:34.839
messed up in the past they may think

00:24:33.480 --> 00:24:38.319
that the probility def fall of this bond

00:24:34.839 --> 00:24:41.519
is 5% during the next year I'm going to

00:24:38.319 --> 00:24:44.398
treat it as 10% okay because I want to

00:24:41.519 --> 00:24:46.599
penalize for the risk I'm incurring so

00:24:44.398 --> 00:24:49.519
so think of this P here as a probity of

00:24:46.599 --> 00:24:51.319
theault but as perceived by in you don't

00:24:49.519 --> 00:24:55.639
know the what is the true probity of

00:24:51.319 --> 00:24:57.960
theault that's a abstract concept

00:24:55.640 --> 00:25:00.000
no but it's whatever you use in your

00:24:57.960 --> 00:25:02.960
investment decisions that I'm modeling

00:25:00.000 --> 00:25:05.038
here so by the same principle we had

00:25:02.960 --> 00:25:07.640
before between nominal and real bonds

00:25:05.038 --> 00:25:09.599
what we need to have is is I need to be

00:25:07.640 --> 00:25:13.520
different in equilibrium I need to be

00:25:09.599 --> 00:25:16.359
different between H investing in in in

00:25:13.519 --> 00:25:19.119
treasury bonds the safe bonds that pay

00:25:16.359 --> 00:25:21.759
an interest RT and investing in Risky

00:25:19.119 --> 00:25:25.519
bonds that are paying an interest rate

00:25:21.759 --> 00:25:27.200
RF which is greater than a RT no so I

00:25:25.519 --> 00:25:29.240
have to be indiffer between these two

00:25:27.200 --> 00:25:31.679
things and the and the the spread here

00:25:29.240 --> 00:25:33.640
will have to adjust so I'm indifferent

00:25:31.679 --> 00:25:35.480
between these two things indeed it's

00:25:33.640 --> 00:25:38.240
obvious if the probability of default is

00:25:35.480 --> 00:25:39.759
greater than zero that this RF is going

00:25:38.240 --> 00:25:41.278
to have to be greater than R because

00:25:39.759 --> 00:25:42.720
otherwise I don't you know I don't want

00:25:41.278 --> 00:25:45.679
to invest in a bond that pays me the

00:25:42.720 --> 00:25:48.038
same as that and on top of that I I I

00:25:45.679 --> 00:25:50.720
can experience a default occasion don't

00:25:48.038 --> 00:25:53.398
get my money back okay so what we have

00:25:50.720 --> 00:25:55.640
here this indifference condition means

00:25:53.398 --> 00:25:58.599
okay during the next

00:25:55.640 --> 00:26:01.399
year there's a probability to the fall p

00:25:58.599 --> 00:26:03.119
that means with probability one minus P

00:26:01.398 --> 00:26:05.278
I'm going to get this High interest rate

00:26:03.119 --> 00:26:07.278
I'm going to get my money back I invest

00:26:05.278 --> 00:26:08.599
one in a bond I get my money back plus

00:26:07.278 --> 00:26:10.880
an interest rate Which is higher than

00:26:08.599 --> 00:26:13.798
the safe interest rate is our F okay

00:26:10.880 --> 00:26:15.278
that's a good thing against that is

00:26:13.798 --> 00:26:17.000
there's a probability that the bone

00:26:15.278 --> 00:26:19.000
there's a default and I'm going to

00:26:17.000 --> 00:26:20.798
assume always in practice there is some

00:26:19.000 --> 00:26:21.919
recovery of a bone which is much less

00:26:20.798 --> 00:26:26.278
than the principal I'm going to assume

00:26:21.919 --> 00:26:27.799
it's zero okay so if p is positive as I

00:26:26.278 --> 00:26:30.038
said before then it better be the case

00:26:27.798 --> 00:26:32.119
that this f is greater than R otherwise

00:26:30.038 --> 00:26:33.000
I'm not going to invest anything in the

00:26:32.119 --> 00:26:35.359
risky

00:26:33.000 --> 00:26:39.200
Bond so I'm going to replace just this

00:26:35.359 --> 00:26:41.119
RF by RT plus X just to calculate XT and

00:26:39.200 --> 00:26:45.399
you can solve this out here and you get

00:26:41.119 --> 00:26:48.278
that this risk premium is XT is an

00:26:45.398 --> 00:26:50.879
increasing function of P okay naturally

00:26:48.278 --> 00:26:53.359
if this if I perceive bonds to be more

00:26:50.880 --> 00:26:56.080
likely to default and when I require a

00:26:53.359 --> 00:26:59.240
higher compensation if the bond doesn't

00:26:56.079 --> 00:27:02.278
default okay and that's what we we have

00:26:59.240 --> 00:27:03.599
here now during what happens is that

00:27:02.278 --> 00:27:06.240
during severe

00:27:03.599 --> 00:27:07.918
recessions actual defaults go up so the

00:27:06.240 --> 00:27:10.278
probability of theault objectively goes

00:27:07.919 --> 00:27:12.320
up and people get a lot more scared also

00:27:10.278 --> 00:27:15.200
that this will happen and so P tends to

00:27:12.319 --> 00:27:18.079
go up a lot okay so during SE severe

00:27:15.200 --> 00:27:19.798
recessions but is is always almost in

00:27:18.079 --> 00:27:24.079
recession but especially in severe

00:27:19.798 --> 00:27:27.480
recessions P can rise a lot okay it can

00:27:24.079 --> 00:27:30.319
rise a lot R may fall or not we shall

00:27:27.480 --> 00:27:34.120
see but but this stuff dominates

00:27:30.319 --> 00:27:37.359
actually okay so this credit this x can

00:27:34.119 --> 00:27:40.038
move up a lot during recessions and in

00:27:37.359 --> 00:27:41.359
fact if I show you what happened during

00:27:40.038 --> 00:27:44.440
the gr

00:27:41.359 --> 00:27:47.759
recession same episode as before there

00:27:44.440 --> 00:27:52.159
you have it this is our X really okay

00:27:47.759 --> 00:27:54.480
look how it jump during 2008 okay so uh

00:27:52.159 --> 00:27:56.960
the average and this is for I think it's

00:27:54.480 --> 00:27:59.798
high yield I think but it's not junk

00:27:56.960 --> 00:28:02.278
it's high yield though

00:27:59.798 --> 00:28:04.599
ER I think it's a it's a it's a weighted

00:28:02.278 --> 00:28:07.599
average of things

00:28:04.599 --> 00:28:11.519
but think of this as the median bond out

00:28:07.599 --> 00:28:15.278
there corporate bond ER it had to pay

00:28:11.519 --> 00:28:16.960
20% more than a treasury bond okay so

00:28:15.278 --> 00:28:19.159
big difference if you are in the private

00:28:16.960 --> 00:28:20.558
sector and wanted to borrow than if the

00:28:19.159 --> 00:28:25.000
government wanted to

00:28:20.558 --> 00:28:29.038
borrow big thing this was a big

00:28:25.000 --> 00:28:32.119
issue good now it's all almost always oh

00:28:29.038 --> 00:28:35.000
but that level this is high yield H so

00:28:32.119 --> 00:28:37.239
you see typically because this high

00:28:35.000 --> 00:28:40.038
yield these are not the the primest

00:28:37.240 --> 00:28:41.399
companies H they have a vary of default

00:28:40.038 --> 00:28:45.240
there's a risk out there they typically

00:28:41.398 --> 00:28:48.398
have to pay a spread 3% 4% things like

00:28:45.240 --> 00:28:50.839
that but during severe events that can

00:28:48.398 --> 00:28:52.839
go very very high so if you're a

00:28:50.839 --> 00:28:54.240
corporation and you're trying to borrow

00:28:52.839 --> 00:28:57.720
here it's going to be pretty difficult

00:28:54.240 --> 00:29:01.000
to borrow that's the point okay not a

00:28:57.720 --> 00:29:03.519
good time to invest in that sense it's

00:29:01.000 --> 00:29:03.519
going to be pretty

00:29:03.679 --> 00:29:09.399
expensive so that takes me to the slm

00:29:06.119 --> 00:29:11.158
mod I want to sort of now bring in these

00:29:09.398 --> 00:29:15.839
two

00:29:11.159 --> 00:29:19.240
ingredients so the two modifications I

00:29:15.839 --> 00:29:20.759
introduce are relevant for the is the LM

00:29:19.240 --> 00:29:23.120
doesn't change the Central Bank keeps

00:29:20.759 --> 00:29:25.440
setting the nominal interest rate and

00:29:23.119 --> 00:29:26.759
that's what it does okay so that's not

00:29:25.440 --> 00:29:29.360
changing and that's the target of the

00:29:26.759 --> 00:29:31.480
Central Bank

00:29:29.359 --> 00:29:32.959
the the Central Bank may decide to react

00:29:31.480 --> 00:29:36.079
to things that happen in expected

00:29:32.960 --> 00:29:38.798
inflation and cre spread but the LM is

00:29:36.079 --> 00:29:41.158
is the same as it used to be in the book

00:29:38.798 --> 00:29:42.759
at some point make the book makes a

00:29:41.159 --> 00:29:44.120
simplification and it starts setting the

00:29:42.759 --> 00:29:45.519
interest rate in terms of the real

00:29:44.119 --> 00:29:47.839
interest rate I think that's a bad idea

00:29:45.519 --> 00:29:50.960
so I'm not going to do that okay I'm

00:29:47.839 --> 00:29:54.439
going to keep our is our LM as it was

00:29:50.960 --> 00:29:56.840
but now with this extensions we have to

00:29:54.440 --> 00:29:59.159
modify well the only place where

00:29:56.839 --> 00:30:01.319
interest rate enters for us

00:29:59.159 --> 00:30:02.960
which is in the investment function and

00:30:01.319 --> 00:30:04.079
so the investment function now is not a

00:30:02.960 --> 00:30:05.480
function of the nominal interest rate

00:30:04.079 --> 00:30:07.678
it's a function of the real interest

00:30:05.480 --> 00:30:11.360
rate adjusted by credit risk because

00:30:07.679 --> 00:30:12.880
that's the relevant opportunity cost of

00:30:11.359 --> 00:30:17.558
that's a real cost of borrowing if you

00:30:12.880 --> 00:30:20.840
will of firms when they want to invest

00:30:17.558 --> 00:30:23.398
okay so that's a modification now for

00:30:20.839 --> 00:30:25.439
this part of the course as I said I'm

00:30:23.398 --> 00:30:27.439
going to take this as two new

00:30:25.440 --> 00:30:29.919
parameters we're not going to look at

00:30:27.440 --> 00:30:32.480
equilibrium determination of that when

00:30:29.919 --> 00:30:34.399
we get into the next part of the course

00:30:32.480 --> 00:30:36.278
then we're never going to do much about

00:30:34.398 --> 00:30:38.398
that but yes about this but for now

00:30:36.278 --> 00:30:41.599
these are just two new parameters so in

00:30:38.398 --> 00:30:43.239
our equilibrium in lecture three in the

00:30:41.599 --> 00:30:45.278
goods market equilibrium now we have two

00:30:43.240 --> 00:30:48.399
more parameters expected

00:30:45.278 --> 00:30:51.398
inflation and in the remember the ZZ

00:30:48.398 --> 00:30:52.798
curve where we have GT interest rate all

00:30:51.398 --> 00:30:55.038
those things has constant well now we

00:30:52.798 --> 00:30:58.798
have two new parameters expected

00:30:55.038 --> 00:31:02.798
inflation and the credited spread

00:30:58.798 --> 00:31:05.440
okay so that's it that's lecture three

00:31:02.798 --> 00:31:09.319
now so what I'm showing you here is what

00:31:05.440 --> 00:31:12.840
happened in lecture three if the credit

00:31:09.319 --> 00:31:15.119
spreads comes down or expected inflation

00:31:12.839 --> 00:31:19.678
Rises for any given nominal interest

00:31:15.119 --> 00:31:23.038
rate okay then that shift the ZZ curve

00:31:19.679 --> 00:31:23.038
up why is

00:31:24.440 --> 00:31:28.919
that and sorry and if aggregate demand

00:31:27.200 --> 00:31:30.600
goes up then the multiply it kicks in

00:31:28.919 --> 00:31:33.519
and we end up with an expansion in

00:31:30.599 --> 00:31:36.398
output so I'm saying for a given nominal

00:31:33.519 --> 00:31:41.278
interest rate if now expected inflation

00:31:36.398 --> 00:31:45.199
goes up or H the credit spreads spreads

00:31:41.278 --> 00:31:46.880
go down then we that's act acts almost

00:31:45.200 --> 00:31:49.038
like an expansionary monetary policy you

00:31:46.880 --> 00:31:53.000
see you get an expansion in aggregate

00:31:49.038 --> 00:31:53.000
demand yes

00:31:58.038 --> 00:32:04.158
for RIS deine they can they can borrow

00:32:02.319 --> 00:32:06.918
exactly that's it yes because of

00:32:04.159 --> 00:32:09.080
borrowing went up for down for firms

00:32:06.919 --> 00:32:11.278
okay so that's what I'm saying those two

00:32:09.079 --> 00:32:12.960
things operate almost as monetary policy

00:32:11.278 --> 00:32:14.599
that is not been done by the fed by the

00:32:12.960 --> 00:32:16.000
way by the central bank but they have

00:32:14.599 --> 00:32:18.398
the same effect because that's the way

00:32:16.000 --> 00:32:21.079
they enter they enter exactly the same

00:32:18.398 --> 00:32:22.959
as as an interest rate so saying that

00:32:21.079 --> 00:32:27.319
this guy is going up or this guy is

00:32:22.960 --> 00:32:31.399
going down leads to the same analysis as

00:32:27.319 --> 00:32:33.038
as as when we lower I because they're

00:32:31.398 --> 00:32:38.558
identical they enter exactly in the same

00:32:33.038 --> 00:32:40.200
place no so what I showed you here I had

00:32:38.558 --> 00:32:42.158
done diagrams like this before that's

00:32:40.200 --> 00:32:45.159
what you get when you lower the interest

00:32:42.159 --> 00:32:46.639
rate well the the two shocks I describ

00:32:45.159 --> 00:32:48.880
is effectively like lowering the

00:32:46.638 --> 00:32:54.359
interest rate that is the relevant

00:32:48.880 --> 00:32:56.559
interest rate for a a the firms because

00:32:54.359 --> 00:33:00.158
lower CR spreads higher expected

00:32:56.558 --> 00:33:04.038
inflation means lower re interest rate

00:33:00.159 --> 00:33:06.960
okay now the the episode I describe you

00:33:04.038 --> 00:33:10.679
in in in in during the global financial

00:33:06.960 --> 00:33:13.399
crisis was exact opposite of this no in

00:33:10.679 --> 00:33:15.360
the global financial crisis we had this

00:33:13.398 --> 00:33:17.839
x boom

00:33:15.359 --> 00:33:21.079
jumping and I had shown you

00:33:17.839 --> 00:33:22.038
before that expected inflation came down

00:33:21.079 --> 00:33:25.158
a

00:33:22.038 --> 00:33:28.398
lot okay remember expected inflation

00:33:25.159 --> 00:33:31.519
came down a lot when negative

00:33:28.398 --> 00:33:35.079
no from around 2% to minus four that's a

00:33:31.519 --> 00:33:35.798
big shock for the real cost of borrowing

00:33:35.079 --> 00:33:37.519
for

00:33:35.798 --> 00:33:41.000
firms

00:33:37.519 --> 00:33:44.278
and the X went up like

00:33:41.000 --> 00:33:46.119
crazy that's the reason in the global

00:33:44.278 --> 00:33:48.558
financial crisis what we got is exactly

00:33:46.119 --> 00:33:51.759
the opposite of this we got a massive

00:33:48.558 --> 00:33:54.759
shift down in the zzer for the reasons

00:33:51.759 --> 00:33:57.240
we just described

00:33:54.759 --> 00:34:00.158
okay because this again this is the case

00:33:57.240 --> 00:34:01.798
for x going down or Pi going up in the

00:34:00.159 --> 00:34:04.559
global financial crisis we' got exactly

00:34:01.798 --> 00:34:07.440
the opposite and in massive amounts no

00:34:04.558 --> 00:34:09.838
massive increase in X massive decline in

00:34:07.440 --> 00:34:12.159
expected inflation so it's exact

00:34:09.838 --> 00:34:14.559
opposite of this and in a much larger

00:34:12.159 --> 00:34:17.559
scale that was a massive

00:34:14.559 --> 00:34:17.559
shock

00:34:18.398 --> 00:34:21.878
good so that's the case I was just

00:34:20.679 --> 00:34:24.119
describing that's what happened in the

00:34:21.878 --> 00:34:27.199
global financial crisis so the first

00:34:24.119 --> 00:34:28.679
thing is so if x goes up as it did in

00:34:27.199 --> 00:34:31.118
the global financial crisis and the

00:34:28.679 --> 00:34:32.918
Great Recession I I by the way when I

00:34:31.119 --> 00:34:34.079
say the global financial crisis or the

00:34:32.918 --> 00:34:36.679
Great Recession those are the same

00:34:34.079 --> 00:34:38.599
episode end up being it started from a

00:34:36.679 --> 00:34:41.320
financial crisis and it turned out ended

00:34:38.599 --> 00:34:44.519
up being a recession everywhere and a

00:34:41.320 --> 00:34:47.679
financial crisis everywhere as well okay

00:34:44.519 --> 00:34:51.320
but uh anyway so what I just described

00:34:47.679 --> 00:34:54.240
is this is the in the islm space the is

00:34:51.320 --> 00:34:57.000
is shifting inwards a lot no for any

00:34:54.239 --> 00:34:59.078
given nominal interest rate if x goes up

00:34:57.000 --> 00:35:02.039
a lot that means there is less

00:34:59.079 --> 00:35:04.440
investment and that means that the LM

00:35:02.039 --> 00:35:07.320
shift to the sorry the is shift to the

00:35:04.440 --> 00:35:09.400
left okay and the same would happen if

00:35:07.320 --> 00:35:11.280
there's a fallen expected inflation so

00:35:09.400 --> 00:35:13.800
for the great session we had two reasons

00:35:11.280 --> 00:35:15.200
why this thing move inward a lot one

00:35:13.800 --> 00:35:17.480
expected inflation came down and the

00:35:15.199 --> 00:35:19.838
other one X went up a lot massive

00:35:17.480 --> 00:35:21.838
movement to the left now what do you

00:35:19.838 --> 00:35:24.039
think a central bank should do face with

00:35:21.838 --> 00:35:27.199
a situation like

00:35:24.039 --> 00:35:29.759
this drop interest rate no why you you

00:35:27.199 --> 00:35:31.799
do that because this shocks enter like

00:35:29.760 --> 00:35:33.760
negative interest rate like shocks to

00:35:31.800 --> 00:35:35.079
the interest rate effectively it's like

00:35:33.760 --> 00:35:37.359
you had increased the interest rate a

00:35:35.079 --> 00:35:39.839
lot and so the central bank will try to

00:35:37.358 --> 00:35:42.719
offset that by lowering the interest

00:35:39.838 --> 00:35:46.199
rate what problem May the Central Bank

00:35:42.719 --> 00:35:46.199
face in doing

00:35:47.440 --> 00:35:51.800
this yeah reaching the zero lower bound

00:35:50.039 --> 00:35:53.279
effective lower one liquidity trap

00:35:51.800 --> 00:35:54.800
exactly it's a limit of how much you can

00:35:53.280 --> 00:35:56.000
do and I show you that that's what

00:35:54.800 --> 00:35:59.920
happened really

00:35:56.000 --> 00:36:01.960
here you see if effectively this is like

00:35:59.920 --> 00:36:03.440
it's the reason looks so flat it doesn't

00:36:01.960 --> 00:36:05.000
move is because it's against a lower

00:36:03.440 --> 00:36:07.358
bound it cannot

00:36:05.000 --> 00:36:10.920
move let me tell you a little bit about

00:36:07.358 --> 00:36:12.598
what is happening now so this is now

00:36:10.920 --> 00:36:16.159
remember the other one was for the

00:36:12.599 --> 00:36:19.000
period from 2008 to 2013 I show you now

00:36:16.159 --> 00:36:24.239
I'm shifting everything by 10 years okay

00:36:19.000 --> 00:36:25.800
so still you see on average the the the

00:36:24.239 --> 00:36:29.959
the white line which is the nominal

00:36:25.800 --> 00:36:31.880
interest rate is above the um the Orange

00:36:29.960 --> 00:36:33.559
Line the Orange Line the yellow line

00:36:31.880 --> 00:36:38.240
which is the

00:36:33.559 --> 00:36:38.239
um the real interest rate why is

00:36:40.440 --> 00:36:46.400
that

00:36:42.800 --> 00:36:48.119
yeah yeah posi inflation posit INF

00:36:46.400 --> 00:36:50.400
expected inflation but they're

00:36:48.119 --> 00:36:52.039
correlated when inflation is on average

00:36:50.400 --> 00:36:53.838
positive then expected inflation is also

00:36:52.039 --> 00:36:56.559
an average

00:36:53.838 --> 00:37:00.000
positive there's an exception there why

00:36:56.559 --> 00:37:00.000
is that what when does it

00:37:02.159 --> 00:37:06.039
happen there's one point

00:37:06.119 --> 00:37:11.280
where the real interest rate went above

00:37:08.480 --> 00:37:11.280
the nominal interest

00:37:12.039 --> 00:37:16.480
rate

00:37:13.559 --> 00:37:19.000
sorry recession yeah exactly the covid

00:37:16.480 --> 00:37:21.240
recession so as I said before that was a

00:37:19.000 --> 00:37:22.880
massive shock a scary shock and initial

00:37:21.239 --> 00:37:24.879
reaction of expected inflation was to

00:37:22.880 --> 00:37:27.640
come down enormously and that's so

00:37:24.880 --> 00:37:30.240
that's what we saw and also see that

00:37:27.639 --> 00:37:32.239
this biggest step here in the in the

00:37:30.239 --> 00:37:35.159
nominal interest

00:37:32.239 --> 00:37:37.358
rate and then flat so what do you think

00:37:35.159 --> 00:37:41.318
happened

00:37:37.358 --> 00:37:43.759
there yep again they went all the way

00:37:41.318 --> 00:37:45.199
down at to at the maximum they could do

00:37:43.760 --> 00:37:47.800
they said the the shortterm interest

00:37:45.199 --> 00:37:50.639
rate to zero effectively effect it's not

00:37:47.800 --> 00:37:53.440
exactly zero but to zero and they stay

00:37:50.639 --> 00:37:55.639
there for a very long period of time now

00:37:53.440 --> 00:37:59.000
why do you think and this I think help a

00:37:55.639 --> 00:38:03.598
lot the recovery of the US economy and

00:37:59.000 --> 00:38:05.880
it also a a a big reason for the rally

00:38:03.599 --> 00:38:08.920
that you saw in the equity Market in

00:38:05.880 --> 00:38:11.280
2021 you can see in this picture which

00:38:08.920 --> 00:38:14.880
is this notice that the real interest

00:38:11.280 --> 00:38:14.880
rate went very very

00:38:15.480 --> 00:38:21.039
low you see that the real interest went

00:38:18.079 --> 00:38:22.560
very very low that's a reason Equity

00:38:21.039 --> 00:38:25.440
markets were flying I mean you have

00:38:22.559 --> 00:38:27.799
effectively very low real interest rates

00:38:25.440 --> 00:38:30.039
so what happened there how did that

00:38:27.800 --> 00:38:32.720
happened what must have happened in this

00:38:30.039 --> 00:38:34.920
episode yeah the central bank was

00:38:32.719 --> 00:38:37.679
putting injecting everything possible to

00:38:34.920 --> 00:38:40.400
it but even more than monetary policy

00:38:37.679 --> 00:38:43.919
conventional monetary but but what can

00:38:40.400 --> 00:38:46.880
prod what is the reason let me say this

00:38:43.920 --> 00:38:46.880
wedge reflects

00:38:53.039 --> 00:38:59.000
what what is the what is that W as a

00:38:56.719 --> 00:39:01.239
matter of accounting

00:38:59.000 --> 00:39:02.679
expected inflation yeah it's expected

00:39:01.239 --> 00:39:04.919
inflation so this tells you this

00:39:02.679 --> 00:39:07.480
interest was at zero the real interest

00:39:04.920 --> 00:39:10.480
was at at minus four here it means that

00:39:07.480 --> 00:39:13.719
expected inflation must have been

00:39:10.480 --> 00:39:15.240
4% okay that means so we had a

00:39:13.719 --> 00:39:17.480
combination in which the nominal

00:39:15.239 --> 00:39:19.479
interest remain at zero but inflation

00:39:17.480 --> 00:39:21.240
was high which is not the typical

00:39:19.480 --> 00:39:23.599
combination we get in recessions like

00:39:21.239 --> 00:39:25.719
the previous one demand recessions

00:39:23.599 --> 00:39:27.400
financial crisis where inflation is goes

00:39:25.719 --> 00:39:29.199
down when you are in a recession this

00:39:27.400 --> 00:39:31.838
was a different shock and after the

00:39:29.199 --> 00:39:33.960
initial shock we got lots of bottlenecks

00:39:31.838 --> 00:39:36.078
on the supply side of the economy which

00:39:33.960 --> 00:39:38.519
we don't have a good mod yet later we

00:39:36.079 --> 00:39:40.240
want to have to model here and when you

00:39:38.519 --> 00:39:42.599
have prod in the supply side you can get

00:39:40.239 --> 00:39:44.358
a situation which it feels recessionary

00:39:42.599 --> 00:39:47.000
because there's low activity and so on

00:39:44.358 --> 00:39:50.799
but inflation is high and that's exactly

00:39:47.000 --> 00:39:53.318
what we had here okay the inflation was

00:39:50.800 --> 00:39:56.599
high now at some

00:39:53.318 --> 00:39:58.639
point H you know for a while we

00:39:56.599 --> 00:40:00.000
tolerated this inflation thinking that

00:39:58.639 --> 00:40:01.960
this was going to be a transitory

00:40:00.000 --> 00:40:04.838
phenomenon and so on but then it began

00:40:01.960 --> 00:40:08.159
to last for too long okay and when it

00:40:04.838 --> 00:40:10.719
began to last for too long then the the

00:40:08.159 --> 00:40:13.960
FED reacted and that's when you see they

00:40:10.719 --> 00:40:16.039
began to hike interest rate okay and

00:40:13.960 --> 00:40:20.199
they began to hike interest rate and

00:40:16.039 --> 00:40:21.759
that initially didn't do much er er to

00:40:20.199 --> 00:40:23.318
the real rates because expected

00:40:21.760 --> 00:40:25.720
inflation kept

00:40:23.318 --> 00:40:27.519
rising and then eventually they

00:40:25.719 --> 00:40:29.480
convinced everyone that they were

00:40:27.519 --> 00:40:33.920
serious about this and so real interest

00:40:29.480 --> 00:40:35.838
rate began to H rise a lot here and

00:40:33.920 --> 00:40:37.119
that's when the equity Market Collapse

00:40:35.838 --> 00:40:38.480
by the way you don't know that yet but

00:40:37.119 --> 00:40:40.720
I'm going to talk about Equity Market

00:40:38.480 --> 00:40:43.599
later on but but I believe me that's

00:40:40.719 --> 00:40:46.639
what essentially brought down the NASDAQ

00:40:43.599 --> 00:40:48.838
for sure primarily and all these M

00:40:46.639 --> 00:40:51.358
stocks and all that well that's that's

00:40:48.838 --> 00:40:56.000
that

00:40:51.358 --> 00:40:57.679
okay um what about today well Houston we

00:40:56.000 --> 00:40:59.318
have a problem because because you see

00:40:57.679 --> 00:41:01.000
the FED keeps Rising interest rate and

00:40:59.318 --> 00:41:03.719
inflation is not coming

00:41:01.000 --> 00:41:05.519
down as much as we expected in fact

00:41:03.719 --> 00:41:06.959
expected inflation initially looked like

00:41:05.519 --> 00:41:09.318
what's going to decline and and now it's

00:41:06.960 --> 00:41:11.880
beginning to pick up again so you have a

00:41:09.318 --> 00:41:13.920
situation here where the FED wants to be

00:41:11.880 --> 00:41:16.480
restrictive but the real interest is

00:41:13.920 --> 00:41:18.800
declining not going up that's a problem

00:41:16.480 --> 00:41:21.000
okay it's a problem that's that's what

00:41:18.800 --> 00:41:22.800
is happening at this very moment fed has

00:41:21.000 --> 00:41:24.639
a big problem because of that they're

00:41:22.800 --> 00:41:26.640
trying to tighten interest rate but

00:41:24.639 --> 00:41:28.039
Financial conditions are relaxing in a

00:41:26.639 --> 00:41:29.598
sense

00:41:28.039 --> 00:41:32.119
because of an increase in expected

00:41:29.599 --> 00:41:35.400
inflation and even credit spreads were

00:41:32.119 --> 00:41:36.880
declining like so here is what I just

00:41:35.400 --> 00:41:39.519
said in terms of

00:41:36.880 --> 00:41:42.280
inflation ER expected inflation and you

00:41:39.519 --> 00:41:44.280
see here the big collapse during covid

00:41:42.280 --> 00:41:47.000
early on in covid but then it recovered

00:41:44.280 --> 00:41:50.400
very strongly and went very

00:41:47.000 --> 00:41:51.960
high and and actually the middle of 2022

00:41:50.400 --> 00:41:53.800
it really went up a lot and that's when

00:41:51.960 --> 00:41:55.119
the FED really got a scar and that's

00:41:53.800 --> 00:41:58.560
when they began to increase interest

00:41:55.119 --> 00:42:00.960
rate by 75 basis points in in a hurry

00:41:58.559 --> 00:42:03.000
okay and this is what you see recently I

00:42:00.960 --> 00:42:05.440
told you that we have a problem now

00:42:03.000 --> 00:42:08.280
because expected inflation they they

00:42:05.440 --> 00:42:12.119
were able there a famous conference

00:42:08.280 --> 00:42:15.880
Jackson happens in Jackson Hall ER and

00:42:12.119 --> 00:42:16.800
it's famous mostly because ER you know

00:42:15.880 --> 00:42:19.640
most

00:42:16.800 --> 00:42:21.280
Central chairs of presidents of central

00:42:19.639 --> 00:42:23.960
banks governors of central banks around

00:42:21.280 --> 00:42:25.880
the world sort of meet for a few days

00:42:23.960 --> 00:42:28.400
there but there is one speech that

00:42:25.880 --> 00:42:33.240
everyone looks at which is a speech of

00:42:28.400 --> 00:42:36.240
the of the um chair of the US Central

00:42:33.239 --> 00:42:38.039
Bank the FED okay and they were very

00:42:36.239 --> 00:42:40.479
worried that that conference happened

00:42:38.039 --> 00:42:42.119
around here and they were very worried

00:42:40.480 --> 00:42:44.760
because suspected inflation was just

00:42:42.119 --> 00:42:47.160
exploding I mean 6% or so that's those

00:42:44.760 --> 00:42:47.839
are unheard of numbers for the us since

00:42:47.159 --> 00:42:50.639
the

00:42:47.838 --> 00:42:53.960
80s and and so they came up with a very

00:42:50.639 --> 00:42:55.879
tough speech very Hwy speech saying look

00:42:53.960 --> 00:42:57.679
this is unacceptable we're going to do

00:42:55.880 --> 00:42:58.920
whatever it takes to bring this stuff

00:42:57.679 --> 00:43:01.318
down and and and they were very

00:42:58.920 --> 00:43:03.000
successful persuading people in fact

00:43:01.318 --> 00:43:05.159
expected inflation began to decline a

00:43:03.000 --> 00:43:08.599
lot very quickly which is one of the

00:43:05.159 --> 00:43:10.838
reasons you see real rates Rising very

00:43:08.599 --> 00:43:13.000
fast in fact faster than than the

00:43:10.838 --> 00:43:15.279
nominal rates because nominal rates were

00:43:13.000 --> 00:43:17.280
rising and on top of that expected

00:43:15.280 --> 00:43:19.040
inflation began to plummet and that led

00:43:17.280 --> 00:43:20.440
to a very sharp rise in real interest

00:43:19.039 --> 00:43:24.318
rate and the collapse in the stock

00:43:20.440 --> 00:43:24.318
market as a result

00:43:24.480 --> 00:43:30.000
okay what about credit spreads in in

00:43:27.800 --> 00:43:33.680
this

00:43:30.000 --> 00:43:37.280
episode ER well here you

00:43:33.679 --> 00:43:39.719
see we had during the covid shock again

00:43:37.280 --> 00:43:41.440
we got a Bigg Spike here it was not as

00:43:39.719 --> 00:43:43.959
large as in in the other one which was a

00:43:41.440 --> 00:43:46.800
financial crisis per se but it was a

00:43:43.960 --> 00:43:49.280
very large Spike and then eventually

00:43:46.800 --> 00:43:50.720
sort of came down and it came down a lot

00:43:49.280 --> 00:43:52.480
that's again when you're seeing rallying

00:43:50.719 --> 00:43:55.959
and all the markets and so

00:43:52.480 --> 00:43:57.719
on H but then began to go up and and

00:43:55.960 --> 00:43:59.039
again here we began to a problem because

00:43:57.719 --> 00:44:02.078
the fair wanted to tighten and this

00:43:59.039 --> 00:44:04.039
credit spreads were coming down this got

00:44:02.079 --> 00:44:04.880
this is I think I did this on Sunday or

00:44:04.039 --> 00:44:07.960
something

00:44:04.880 --> 00:44:11.519
so today's 27 yeah I did it yesterday

00:44:07.960 --> 00:44:14.358
there it is okay so so this this pickup

00:44:11.519 --> 00:44:16.920
here is very recent this last

00:44:14.358 --> 00:44:19.920
week but great spreads were declining

00:44:16.920 --> 00:44:22.440
and that again goes against to to what

00:44:19.920 --> 00:44:27.318
the FED wants to do which is to tighten

00:44:22.440 --> 00:44:30.079
Financial conditions for firms okay now

00:44:27.318 --> 00:44:33.079
ER as I said before central banks

00:44:30.079 --> 00:44:37.960
typically intervene only the monetary

00:44:33.079 --> 00:44:40.519
policy they they involves very short

00:44:37.960 --> 00:44:43.519
duration treasury bonds so their own

00:44:40.519 --> 00:44:46.838
bonds okay the bonds of that government

00:44:43.519 --> 00:44:49.880
in most places like that but this shock

00:44:46.838 --> 00:44:52.679
was so disconcerting and so large and it

00:44:49.880 --> 00:44:54.200
did affect corporations a lot no because

00:44:52.679 --> 00:44:56.639
you get imagine you are in the irland

00:44:54.199 --> 00:44:59.679
industry and then suddenly you get covid

00:44:56.639 --> 00:45:01.519
so really was a a major shock to

00:44:59.679 --> 00:45:05.239
corporate to

00:45:01.519 --> 00:45:07.759
corporations and um so they went beyond

00:45:05.239 --> 00:45:09.399
traditional conventional monetary policy

00:45:07.760 --> 00:45:10.720
they certainly something that had done

00:45:09.400 --> 00:45:12.079
already in the global financial crisis

00:45:10.719 --> 00:45:15.358
they began to buy sort of very long

00:45:12.079 --> 00:45:18.000
duration US Treasury bonds so 10 year

00:45:15.358 --> 00:45:19.598
bonds and so on treasur but they went

00:45:18.000 --> 00:45:22.719
beyond that and they created a facility

00:45:19.599 --> 00:45:25.800
to buy corporate bonds okay that

00:45:22.719 --> 00:45:28.639
facility was meant to deal with XS okay

00:45:25.800 --> 00:45:30.480
you're getting a huge huge X shock and

00:45:28.639 --> 00:45:33.239
they went directly to that to try to

00:45:30.480 --> 00:45:34.838
bring that X shock down why do they want

00:45:33.239 --> 00:45:39.318
to do that well because of the reasons

00:45:34.838 --> 00:45:42.558
we have explained here H you

00:45:39.318 --> 00:45:44.039
know that amounted the X shock which

00:45:42.559 --> 00:45:46.760
came together with expected inflation

00:45:44.039 --> 00:45:48.000
coming down amount of big shift there

00:45:46.760 --> 00:45:49.800
they did all they could with

00:45:48.000 --> 00:45:51.920
conventional monetary policy they

00:45:49.800 --> 00:45:53.599
brought this down so you can think of

00:45:51.920 --> 00:45:55.200
their policies of intervention it's

00:45:53.599 --> 00:45:56.720
called they're called large scale asset

00:45:55.199 --> 00:45:57.679
purchases that's a generic number of

00:45:56.719 --> 00:45:59.279
that

00:45:57.679 --> 00:46:01.039
well what they were trying to do really

00:45:59.280 --> 00:46:02.880
is to act on those interest rates that

00:46:01.039 --> 00:46:07.000
do not show up in the LM that show up in

00:46:02.880 --> 00:46:10.920
here know x x is a parameter of here if

00:46:07.000 --> 00:46:13.400
I go out there and I buy a a corporate

00:46:10.920 --> 00:46:15.760
bonds then I'm reducing X which is a way

00:46:13.400 --> 00:46:17.480
of Shifting the yes back okay

00:46:15.760 --> 00:46:20.200
corporations can borrow more cheaply if

00:46:17.480 --> 00:46:24.199
the government is buying their bonds

00:46:20.199 --> 00:46:25.399
that's the whole idea in in in in Japan

00:46:24.199 --> 00:46:28.078
they even bought

00:46:25.400 --> 00:46:30.880
Equity okay the Equity interventions in

00:46:28.079 --> 00:46:32.800
the equity market so happened in Hong

00:46:30.880 --> 00:46:34.519
Kong in 1997 there was a massive

00:46:32.800 --> 00:46:36.240
intervention in the equity Market

00:46:34.519 --> 00:46:39.119
typically central banks don't do that

00:46:36.239 --> 00:46:41.358
but when situations get desperate and

00:46:39.119 --> 00:46:42.960
and you are against the zero lower bound

00:46:41.358 --> 00:46:46.078
so you you lost your conventional

00:46:42.960 --> 00:46:48.240
monetary tool ER they tend to be a

00:46:46.079 --> 00:46:50.640
little more creative and and that's what

00:46:48.239 --> 00:46:50.639
they've been

00:46:52.119 --> 00:46:57.358
doing okay any questions that's it for

00:46:56.400 --> 00:46:59.440
today

00:46:57.358 --> 00:47:02.880
from the yeah you have a question could

00:46:59.440 --> 00:47:04.318
you put X into like more tangible terms

00:47:02.880 --> 00:47:07.960
I think I'm still sort of like trying to

00:47:04.318 --> 00:47:12.639
figure out what a create spr for example

00:47:07.960 --> 00:47:16.599
a uh if if boing I don't think Bo is a

00:47:12.639 --> 00:47:19.318
high yield maybe maybe

00:47:16.599 --> 00:47:20.880
ER well let's say boing it's okay if

00:47:19.318 --> 00:47:23.519
boing borrows they're not going to be

00:47:20.880 --> 00:47:25.920
able to borrow the say that the 10e rate

00:47:23.519 --> 00:47:28.838
I'm showing it here in 10e rate spread

00:47:25.920 --> 00:47:32.039
the 10e rate the us at this moment is

00:47:28.838 --> 00:47:34.358
you know close to 4% if boing wants to

00:47:32.039 --> 00:47:36.079
borrow 10 years he's not going to be

00:47:34.358 --> 00:47:38.679
able to borrow at 4% they going to have

00:47:36.079 --> 00:47:40.720
to borrow at 7% so there's a 3%

00:47:38.679 --> 00:47:44.358
difference that's

00:47:40.719 --> 00:47:46.199
X that's X that's great SP spread which

00:47:44.358 --> 00:47:48.199
is linked to the perceived probability

00:47:46.199 --> 00:47:50.239
of the fault I said it's more than it's

00:47:48.199 --> 00:47:52.799
perceived when you say perceive is is

00:47:50.239 --> 00:47:55.039
the say the actual probability of

00:47:52.800 --> 00:47:56.559
theault who who knows who can measure

00:47:55.039 --> 00:47:58.599
that there are again agencies that try

00:47:56.559 --> 00:48:00.240
to meure measure them plus whatever

00:47:58.599 --> 00:48:01.880
extra risk premium you want to put on

00:48:00.239 --> 00:48:04.118
top of

00:48:01.880 --> 00:48:08.519
that

00:48:04.119 --> 00:48:11.318
Rel reliability of americ yeah how

00:48:08.519 --> 00:48:13.039
unattractive it looks to lend to a

00:48:11.318 --> 00:48:15.039
corporate versus lending to the US

00:48:13.039 --> 00:48:16.719
government and when this LM is very high

00:48:15.039 --> 00:48:17.960
it looks very unattractive to lend to

00:48:16.719 --> 00:48:21.919
corporations and therefore you need to

00:48:17.960 --> 00:48:21.920
be compensated a lot for

00:48:22.000 --> 00:48:25.000
that

00:48:25.760 --> 00:48:29.760
okay e