[00:16] the main topic in this part is really
[00:19] open economy and uh so we extended the
[00:22] eslm mo uh we did not bring in we we
[00:27] again shut down price changes so we said
[00:29] uh pric is completely fixed no Philips
[00:32] curve here so we expanded the eslm model
[00:36] to add this open E economy Dimension and
[00:40] so we start from the same aggregate
[00:42] demand function that we had in close
[00:44] economy consumption plus investment plus
[00:47] government expenditure but now we have
[00:48] to draw a distinction between Demand by
[00:51] domestic households companies and the
[00:54] government and the demand for
[00:56] domestically produced goods and so Z is
[00:59] the demand domestically produced Goods
[01:01] which is equal to demand plus the demand
[01:03] that foreigners have for the goods
[01:05] produces at home minus the Imports that
[01:09] part of that expenditure that is going
[01:10] to Imports that means Goods produced by
[01:12] other
[01:14] countries um so the new behavioral
[01:16] functions here where the export function
[01:18] and the import function uh export is
[01:22] increasing in foreign output more income
[01:24] abroad will lead to more Imports by them
[01:27] which means more export for home home
[01:30] and the it's decreasing on with respect
[01:33] to the exchange rate real exchange rate
[01:35] and nominal exchange rate will be the
[01:36] same here since we have fully sticky
[01:38] prices but
[01:40] H if if the real exchange it appreciat
[01:43] that means domestic goods are more
[01:45] expensive it means exports are less
[01:47] foreigners are going to buy less of our
[01:49] Goods conversely for imports is like the
[01:52] exports of the other country means that
[01:54] if domestic output goes up then then
[01:57] there will be more purchases of foreign
[01:59] foreign er er goods and if the exchange
[02:03] is appreciate means also that foreign
[02:04] goods are cheaper for us and therefore
[02:06] we import more okay so positive so those
[02:10] were those were the two new behavioral
[02:12] functions in the in the Goods Market
[02:14] expanded to include an open economy and
[02:16] that had implications for the diagram
[02:18] that we had in lecture three or so to
[02:22] determine equilibrium output ER you know
[02:24] we started from the same demand we had
[02:27] in close economy then we had to subtract
[02:29] in
[02:30] in import and uh and that is shift
[02:34] things down because we are now as part
[02:36] of the domestic demand that is going to
[02:38] foreign Goods not to domestic Goods but
[02:42] ER it's also rotates a curve because the
[02:45] higher is domestic income the more are
[02:47] the Imports uh that we do from the rest
[02:50] of the world now to that we have to add
[02:53] the export which are not a function of
[02:55] domestic output that's that's a parallel
[02:56] shift with respect to this curve no we
[02:59] go up up and and that gives us the ZZ
[03:03] curve which is what we call the demand
[03:06] for domestic Le domestically produced
[03:09] Goods now notice that the distance
[03:11] between the demand for domestically
[03:13] produced goods and the domestic demand
[03:16] for goods is what is the net export so
[03:19] the distance between z z and the D is
[03:21] the net export so in this point here for
[03:26] example ZZ is higher than DD which means
[03:29] that our exports are greater than our
[03:31] Imports and that's the reason you have a
[03:33] trade surplus at this point they're the
[03:35] same and that's the reason the trade
[03:37] account is balance and but over here
[03:40] Imports exceed exports and that's the
[03:42] reason we have a trade deficit
[03:45] okay I'm going to go very quickly so you
[03:47] you're in charge of stopping me I'm not
[03:49] going to ask you question just stop me
[03:50] if there's something that you need
[03:52] clarifications okay for so that's what
[03:54] the demand for domestically produced
[03:56] Goods now we're going to determine
[03:58] equilibrium output in this open e e omic
[04:00] context and that means you know
[04:01] aggregate demand has to be equal
[04:03] aggregate demand for domestically
[04:05] produced good has to be equal to output
[04:08] and that's what we do with the 45 degree
[04:10] line here and so where the 45 degree
[04:13] line intersect with this ZZ curve that's
[04:14] our equilibrium output now it happens
[04:18] that in this example that leads to a
[04:19] trade deficit but there's nothing here
[04:22] so we still determine equili output up
[04:24] here and then we read in this curve
[04:27] bottom curve what is implication for the
[04:29] traes deficit or Surplus
[04:32] okay H but the equilibrium condition
[04:34] important is that output domestically
[04:37] produc output has to be equal to the
[04:39] demand for domestically produced Goods
[04:42] not for total demand it's Dem demand for
[04:44] domestically produced Goods okay because
[04:46] this is a can model in which output is
[04:49] aggregate demand determined but it has
[04:50] to be aggregate demand for the things
[04:52] you're producing not AG demand for all
[04:55] Goods around the world okay good so then
[04:59] we did some experiments we said well
[05:02] suppose what happens in this open
[05:03] economy context if we increase
[05:05] government expenditure well the curent
[05:08] will shift up in exactly the same way as
[05:12] as in the close economy the difference
[05:14] will be in the multiplier though because
[05:17] as output goes up as a result of the
[05:19] expansionary aggregate demand that also
[05:21] means that domestic income will go up
[05:24] and and that means that Imports will go
[05:26] up and that's demand that will go for
[05:27] foreign goods and that's the reason the
[05:29] z z curve has a lower multiplier it's
[05:32] flatter than the DD curve okay still if
[05:36] we start for example with a trade
[05:38] balance since Imports are going to
[05:39] increase as a result of this
[05:41] expansionary fiscal policy we going end
[05:43] up with a trade deficit and that's the
[05:46] reason the response of output is less
[05:48] than close economies because part of
[05:50] that goes to foreign Goods conversely if
[05:53] this other country that is doing a
[05:55] expansion in fiscal policy or something
[05:56] that leads to higher output abroad wi
[05:58] star that's also expansionary for home
[06:01] because exports the export function goes
[06:03] up no and that leads to an increase in
[06:06] output ER still with lower multiplier
[06:09] because part of that increase in
[06:10] domestic output will go will go to
[06:13] Imports but the in this case unlike the
[06:16] other ones actually the current the the
[06:18] trade balance improves because it's been
[06:20] pulled by exports and so we at at impact
[06:23] we get a big increase in export which is
[06:26] the driver of increasable demand for
[06:28] domestically produced Goods and then as
[06:30] income goes up we undo some of that but
[06:32] you end up with sort of higher high
[06:34] higher better trade deficit better trade
[06:37] surpluses than than in the case in which
[06:40] you induce the the expansion in agre
[06:45] demand uh then the last step there was H
[06:48] to look at the role of the exchange rate
[06:51] and uh where we said is we're going to
[06:53] make some assumptions that I promise you
[06:55] and and I now read the quiz so I I I I
[06:59] guarantee you I honor This Promise H
[07:02] nothing weird will happen meaning if if
[07:04] our Goods gets more expensive that means
[07:07] that net exports will be worse and and
[07:11] if if H for two reasons for at least for
[07:14] at least one reason but it could be too
[07:16] if if if the exchange rate goes up then
[07:19] there's going to be less exports at any
[07:20] given level of foreign income that will
[07:23] worsen the net export and then we were
[07:27] going to tend to import more now that
[07:28] will be parti should upset for the fact
[07:30] that you can buy more with the same
[07:31] amount of dollars H but we said we're
[07:34] going to impose conditions such that the
[07:36] positive the negative effect of an
[07:38] appreciation on that export always
[07:40] dominates and again in your quiz you're
[07:42] going to have a situation like that and
[07:44] that will be the
[07:47] case so don't think that that we're
[07:50] trying to trick you anything this will
[07:52] hold okay the the point of this being
[07:56] that you know that that uh
[08:00] depreciating your
[08:02] currency you know making your goods less
[08:06] expensive ER is equivalent to will
[08:09] produce an a response equivalent to what
[08:11] you get here out of an increasing y star
[08:14] no because that's export will go
[08:18] up and you're going to get all the shift
[08:22] net export function will go up that will
[08:24] increase aggregate demand and so on so
[08:26] that's kind things that countries want
[08:28] to typically when they're in a recession
[08:30] and so on then that was an introduction
[08:35] to the most important lecture in this
[08:38] part of
[08:39] the course which is the Mandel flaming
[08:42] model and I I I promise you that you
[08:47] would get 70% at least in the quiz and I
[08:50] already read the quiz so I tell you
[08:52] there is at least 70% of your points
[08:54] have to do with this model so you better
[08:57] understand it very well you do every
[08:58] single comparative Statics that you can
[09:00] imagine with this Mo and then you'll get
[09:02] 70% at least I think you get 73 actually
[09:05] but but but that's
[09:08] the so what's this well the Mandel
[09:12] flaming model is simply what I just
[09:14] showed you is the good market
[09:15] equilibrium no that's the but with an
[09:20] endogenous exchange rate and uh so we we
[09:25] rewrote to say since we're assuming
[09:26] compettive sticky prices we can replace
[09:28] the real Exchange by the nominal
[09:29] exchange rate H but now we're going to
[09:33] endogenize the exchange rate and and and
[09:36] for that we're going to use the uncover
[09:38] in parity condition this a condition you
[09:40] should understand very well as well okay
[09:43] so that tells you essentially that the
[09:46] expected Return of the two bonds the
[09:49] bonds issuing foreign currency and
[09:51] domestic currency have to be the same
[09:53] the Spector return have to be the same
[09:55] okay and this condition ensures that
[09:58] because if a country for example example
[10:00] if the domestic interest rate is higher
[10:02] than the international interest rate you
[10:04] need to expect a depreciation of the
[10:06] current currency otherwise the expected
[10:09] return would not be the same okay and
[10:12] that's the reason when we add the
[10:14] assumption that the Spector exchanges is
[10:17] fixed at least temporarily H then an
[10:21] increase in the interest rate leads to
[10:22] an appreciation of the exchange rate why
[10:24] because that if the exchange rate
[10:26] appreciate but the expected exchange
[10:28] rate stays put that that means the
[10:29] expected appreciation will have to be
[10:31] undone and that means that leads to
[10:33] unexpected depreciation okay so that's
[10:36] very important okay so here you have
[10:38] therefore you need to understand this
[10:40] know that forgiv expectation of the
[10:43] exchange rate and increasing domestic
[10:45] interest rate appreciates the domestic
[10:47] currency and and increasing the foreign
[10:49] interest rate without us matching it
[10:52] will lead to a depreciation of the
[10:54] current of of the domestic currency okay
[10:57] so that's what you have there that's
[10:59] important
[11:01] important now notice that if the
[11:03] expected exchange rate goes
[11:06] up and the interest rates do not change
[11:09] then the current exchanger has to go up
[11:12] because if it didn't then you would have
[11:14] an expected capital gain out of the
[11:16] currency and expected appreciation and
[11:18] that would add to the expected return of
[11:21] own owning a domestic bones okay
[11:26] good so we characterize that interest
[11:29] parity condition as follows we said well
[11:31] look this this here we're plotting the
[11:34] domestic interest rate here we're
[11:36] putting the current exchange rate and
[11:38] what we're marking in this picture this
[11:40] is the curve that traces the uip the and
[11:43] cover by the condition and naturally
[11:45] when the domestic interest rate is equal
[11:47] to International interest rate then it
[11:49] has to be the case that the exchange
[11:51] rate is at the same level as the
[11:52] expected exchange no if that is equal to
[11:55] that so if we're here then we know that
[11:58] a point in that curve is that in which
[12:00] the exchange rate is equal to the
[12:02] expected exchange rate okay that's what
[12:05] we have
[12:08] yeah good so you should understand this
[12:11] curve and and know what moves it here
[12:13] it's very clear what moves it no if
[12:15] there are two things that can move this
[12:16] this curve here one is a change in I
[12:19] star the other one is a change in
[12:20] expected exchange rate if what happens
[12:24] if the is star goes
[12:27] up well you know that the new new the
[12:29] uip will shift but you do know that the
[12:34] next the The Point equivalent to that
[12:36] that is one in which exchange rate is
[12:38] equal to expected exchange rate we have
[12:40] to have a higher interest rate domestic
[12:41] interest rate no because if I'm bringing
[12:44] this up and I want to still look at the
[12:46] point in which e is equal to expected
[12:48] exchange rate then I have to move I up
[12:51] by the same amount and so I know that
[12:53] this curve when when is Star goes up
[12:55] this curve moves up or to the left you
[12:57] pick which way you analyze
[13:00] okay now what about the expected
[13:02] exchange rate well if the expected
[13:04] exchange rate goes
[13:06] up if the spected exchange goes up and
[13:09] the international interest hasn't gone
[13:11] up H so if this moves to to the spected
[13:15] exchanger moves to the right then and
[13:17] the and the and the domestic interest
[13:21] doesn't go up then that means that the
[13:24] current exchanger will have to also go
[13:27] up okay so that means H if this goes up
[13:32] then at an interest rate equal to the
[13:34] the international interest rate so let's
[13:36] tra look in this direction then we have
[13:38] a point around here okay if if that
[13:43] wasn't the cas case then you would
[13:45] respecting an appreciation and then
[13:46] again would be inconsistent with
[13:50] h the uip then we put things together so
[13:54] what we did is we replace we use the uip
[13:57] to replace exchange rate there and now
[13:59] we get this expression in the net export
[14:02] function now we the LM is exactly the
[14:04] same as before we we have
[14:07] a the Central Bank sets the interest
[14:10] rate here I'm writing it in terms of the
[14:12] nominal interest rate I think in the
[14:14] quiz we wrote it in terms of the real
[14:16] interest rate but it's the same because
[14:17] prices is equal to are fixed so real and
[14:20] nominal interest rate are exactly the
[14:21] same
[14:23] yeah is the xais the expected exchange
[14:27] rate no is the actual exchange rate the
[14:30] spected exchange rate is in this curve
[14:32] here that is a parameter okay this
[14:36] happens to be a value of the current
[14:37] exchange equal to the spected exchange
[14:39] rate which is convenient to plot because
[14:41] that's also when the domestic interest
[14:42] rate which is what I'm putting here is
[14:44] equal to International interest rate
[14:46] that's all that I'm saying and then if
[14:47] you shift this to the
[14:51] right exchange rate up the expect exate
[14:55] up then I know that a new point in this
[14:57] curve has to have a higher current
[15:00] exchange rate so that I know I know that
[15:02] the equivalent to this point a is going
[15:04] to be to the right if you lower the
[15:05] foreign interest rate then what I know
[15:08] is that exactly that that the point at
[15:13] which exchange it is equal to expected
[15:14] exchange rate has to have a lower
[15:17] domestic interest rate so that means
[15:19] that I know that that that this point a
[15:22] will be around here which is like a
[15:24] shift to the right okay
[15:31] anyway so so as I said I was saying ER
[15:35] nominal real interest are the same I
[15:37] think in the in the quiz we wrote are
[15:39] there but it's the same same
[15:42] more so now you see that interest rate
[15:44] have two effects no h one is the
[15:47] traditional effect affects investment
[15:49] but it also affects exchange R so H an
[15:52] increas in the domestic interest rate
[15:54] now will will be doubly contractional in
[15:56] the sense that we lower domestic
[15:58] investment that reduces aggregate demand
[16:00] but at the same time it will also
[16:03] appreciate the exchange rate and
[16:04] therefore it will reduce net exports
[16:06] okay we're going to import more and
[16:08] Export less and that's also going to
[16:10] reduce aggregate demand so that's that's
[16:13] the those are the two effects so that's
[16:15] the contribution of the all this
[16:17] exchange rate block to our islm
[16:20] framework Mandel flaming is simply islm
[16:23] plus a a you know a uip condition and a
[16:26] net export function that's it
[16:30] so we put out now the two things
[16:32] together sort of a standard is islm now
[16:35] with different slope and so on because
[16:37] we have this net export function and we
[16:38] have more parameter we have y star is
[16:42] star and things like that and then we
[16:43] have the uip there and then then we did
[16:46] a few experiments no said suppose that
[16:49] now you have an expansionary monetary
[16:51] policy okay so an expansion in monetary
[16:56] policy as before with a slightly
[16:58] different slopes and so on because of
[17:00] the net export function will lower
[17:02] equilibrium output and it will lower it
[17:04] for two reasons as I said before will
[17:05] lower it because investment will decline
[17:08] but also because higher interest rate
[17:10] means an appreciation of the exchange
[17:12] rate
[17:13] today because you have to expect a
[17:15] depreciation now in the next period and
[17:17] and that that means also less net
[17:20] exports okay so interest rate is
[17:22] contractionary for for two different
[17:24] reasons here is that clear
[17:29] yeah raise interest
[17:33] rate raise interest rate will lower
[17:35] aggregate demand for the standard reason
[17:37] but on top of that we're going to get an
[17:39] appreciation of the exchange rate which
[17:41] also reduces net exports
[17:45] okay what about an increase in go
[17:47] expenditure well H it's the same as
[17:50] before and nothing changes relative to
[17:52] before except for the fact that we have
[17:54] a lower multiplier but it's still the
[17:56] case that is expansionary but it doesn't
[17:58] affect the interest rate it doesn't
[17:59] affect the exchange rate or anything
[18:01] like that again it's less expansionary
[18:04] than in closed economy because part of
[18:05] that energy will go to
[18:08] inputs then I went to this diagram and
[18:11] and I play with this uh diagram here I
[18:15] said well suppose that the expected
[18:17] exchanger goes up then what which curves
[18:21] change and the first one that changes is
[18:24] this one no this one moves to the right
[18:26] so you get an appreciation today and
[18:28] that also means that this curve here the
[18:30] yes will shift to the left okay if the
[18:33] spected exchanger goes up and you don't
[18:36] change monetary policy that means
[18:37] interest rate will go
[18:39] up sorry and you don't change monetary
[18:41] policy that means the current exchanger
[18:43] will appreciate that will reduce net
[18:45] export and and that's a shift in this
[18:47] space as a shift in the yes to the left
[18:50] okay this is a parameter these two
[18:53] things are parameters now in the ls
[18:55] diagram okay what about for an output uh
[18:58] going down well that doesn't affect the
[19:00] uip condition but it does affect net
[19:03] export so that moves I to the left okay
[19:07] and the last thing we did was an
[19:10] increase in in in isar and an increase
[19:13] in isar what does is know is that at the
[19:16] same interest rate then you know that
[19:18] you need a depreciation of the currency
[19:19] today because that will lead to an
[19:21] apprec expected appreciation so that
[19:23] means that this uip PE curve moves to
[19:25] the left and the is curve
[19:29] moves to the right that's an increase in
[19:32] the interest rate taken as given for an
[19:34] output okay if for an output also
[19:36] changes then you have to look at the
[19:38] combination of the two things okay but
[19:41] um but taking for an output as given
[19:44] then this Curve will shift to the left
[19:46] and that will move the to the right
[19:48] because the exchanger will
[19:52] depreciate you said sometimes countries
[19:54] choose to fix exchange rates and when
[19:56] you fix an exchange rate well and if
[19:58] it's credible exchange rate then the
[20:00] spected exchange rate equal to the
[20:02] actual exchange rate equal to some
[20:03] constant then that implies immediately
[20:06] that the domestic interest rate has to
[20:07] be equal to International interest rate
[20:10] okay so that if you fix your exchange
[20:12] rate to someone else then you give up
[20:13] your monetary policy the monetary policy
[20:15] is run by a different country
[20:19] okay okay good okay so that's a very
[20:22] important lecture play with it please
[20:25] well we then we look more carefully at
[20:28] at at
[20:30] uh at different exchanger
[20:32] regimes ER and and the effectiveness of
[20:36] policy within each of this regime the
[20:39] flexible exchange rate system which is
[20:40] the one we were discussing before H you
[20:43] get sort of you know if a country is in
[20:46] a recession you can use fiscal policy I
[20:48] showed you that before it works well ER
[20:50] and you can also use expansionary
[20:52] monetary policy which will be very
[20:54] successful for two reasons one the
[20:56] traditional one but the second reason is
[20:58] that it will depreciate your currency
[21:01] okay good now then we say suppose that
[21:04] you have a country that that is also in
[21:06] a recession but you have a a fixed
[21:08] exchange rate well then you still can
[21:10] use fiscal policy there's nothing
[21:12] against that but but you cannot use the
[21:14] expansion in monetary policy okay so
[21:17] that's a limitation of fixed exchang
[21:18] that you lose an important
[21:22] tool another problem that can arise with
[21:25] fix fixable exch fixed exchange rates is
[21:28] is speculative attacks on the currency
[21:30] sometimes the peg is not credible and
[21:33] when the peg is not credible you can
[21:35] imagine that you know that suppose that
[21:37] people expect your currency to
[21:41] depreciate depreciate so expected
[21:43] exchanger goes down and and suppose that
[21:46] you do want to keep your peg today
[21:49] that's what typically happens somebody
[21:50] speculates against your P But Central
[21:52] Bank resist that for a while but the
[21:55] only way it can resist that short of
[21:57] closing the capital account and doing
[21:59] all sort of things there but you haven't
[22:03] learned about those so don't worry H the
[22:05] only tool you have here to defend a
[22:07] speculative attack on your currency that
[22:09] is for the exchange not to depreciate
[22:10] today is by raising interest rate so the
[22:13] defense of an exchange rate causes a
[22:14] recession at
[22:16] home that's another problem that
[22:18] flexible exchange rate
[22:20] have and and there are sort of the deal
[22:22] seems pretty obvious that you don't want
[22:24] to have a fixed exchange rate and I said
[22:26] well be careful because flexible
[22:28] exchange rate are also not a panasa you
[22:30] may get lots of volatility in the
[22:31] exchange rate because the role of
[22:33] expectations is sort of is is very
[22:37] important um anyways this looks
[22:40] complicated but it's essentially what we
[22:42] did later on when we price equity and
[22:43] things like that we use sort of the same
[22:45] sort of iterated substitutions of things
[22:48] this was just meant to say that in a
[22:50] flexible exchange rate really and if
[22:53] once you endogenize Spector exchange you
[22:55] don't take it as a constant it gets to
[22:56] be very complicated because effectively
[22:58] The Exchange is spin down by the
[23:00] expectations of infinite Horizon of
[23:03] interest rate at home and abroad so so
[23:05] there's lots of space for creativity and
[23:07] moving things around and that's the
[23:09] reason exchanges can be very
[23:14] volatile okay good so anyway so all that
[23:17] that was it for ER Mandel flaming plus
[23:21] okay any question about that because now
[23:23] I'm going to move to the next part okay
[23:26] so then then uh The Next Step uh was to
[23:28] look at the asset prices really and or
[23:31] valuations of Assets in general that
[23:34] that have cash flows in the future or or
[23:38] or and exchange it's a little bit like
[23:40] that by the way but we talk a lot about
[23:43] current
[23:44] events but the key thing was this no we
[23:48] said okay you know many
[23:51] things ER many Financial or real assets
[23:55] actually or even your human wealth we
[23:57] discuss later on
[23:59] you know you you you you you you are
[24:01] receiving some income today but you're
[24:02] also expecting to receive income in the
[24:04] future and this part was about how do we
[24:07] value those things that we receive in
[24:08] the future those cash flows that come in
[24:10] the future and so we developed this
[24:12] concept
[24:13] of expected present discounted value and
[24:16] we said well very natural way of
[24:18] bringing dollars receiving the future to
[24:20] the present is to discount them by the
[24:23] interest rate between now and then okay
[24:26] and and the reason the logic behind that
[24:28] is because if you give me a dollar today
[24:30] I can do a lot more than if you give me
[24:32] a dollar five years from now because I
[24:34] can invest the dollar today and earn the
[24:36] interest rate return up to five years
[24:38] from now so a dollar today is worth a
[24:40] lot more than five years a dollar five
[24:42] years from now therefore a dollar five
[24:45] years from now is worth a lot less than
[24:46] a dollar today how much less one over
[24:49] one plus the interest rate over that
[24:50] period which is
[24:53] okay so that's what we did then I show
[24:55] you sort of a general a general cash
[24:58] flow this is an asset that gives a cash
[25:00] flow ZT at the beginning of this period
[25:03] ZT plus one at the beginning of the next
[25:04] one or at the end of this one something
[25:07] like that well this one you don't need
[25:09] to Discount that one you do need to
[25:10] Discount because you're not receiving it
[25:12] now you're receiving it a year from now
[25:14] this when you need it's two years from
[25:15] now you need to discount it more because
[25:17] you know it's two years that you could
[25:19] be earning interest rate and so on so
[25:21] forth okay this formula you need to
[25:27] understand uh and I said well that's if
[25:29] you know the future if you don't know
[25:31] the future then you just replace the
[25:33] things you don't know for the respected
[25:35] value that's what and that's the
[25:36] approximation in real I mean if you were
[25:38] to do this formally it's a little more
[25:41] complicated but for this course that's
[25:43] all that you do
[25:46] okay and then I look at some particular
[25:48] cases this this is a case the same case
[25:52] but in one in which the interest rate is
[25:53] constant suppose that you expect the
[25:55] interest rate to be constant then is a
[25:57] little simpler expression because rather
[25:58] than getting these products of one plus
[26:01] one the interest rates at different
[26:03] times H you get just powers of one plus
[26:06] I then another one that is simpler
[26:08] obviously is one in which all these
[26:10] expected payments are constant and so on
[26:13] and then even simpler if you spec if the
[26:16] con if the interest rate is constant and
[26:18] the payment is constant H you get some
[26:21] simple formulas like that simpler
[26:23] formulas and then cases in which asset
[26:26] lives forever of that kind then that's
[26:28] value if you don't pay for if you don't
[26:31] receive the the First Cash Flow now but
[26:32] you receive it at the beginning of next
[26:34] year or at the end of this one then it
[26:35] gets even simpler like that and I you're
[26:38] going to get a question of this kind
[26:40] okay and which you're going to be asked
[26:42] to compare two different assets that
[26:45] have a different profiles of cash flows
[26:49] and you're going to have to compare
[26:50] between those two okay then we talk
[26:53] about bonds and bond yields and
[26:56] essentially we use expected present
[26:57] discounted value formula just for bonds
[27:00] and bonds bonds have a very particular
[27:02] form profile of payment typically some
[27:04] coupons and some final payment which is
[27:07] we call it the face value of the bond or
[27:09] something like that and we said a very
[27:12] important Concept in bonds is
[27:14] maturity maturity is the date or the
[27:17] number of years till the last payment on
[27:20] that Bond okay doesn't matter whether
[27:22] you receive lots of little coupons along
[27:24] the way and one final payment whether
[27:26] you receive no payment what whatever
[27:28] until the last date that doesn't matter
[27:31] the maturity of a bond is the date the
[27:34] number of years till the last time you
[27:36] your last payment
[27:38] okay so we give some examples there a
[27:41] bond that pays nothing now but pays 101
[27:43] year from now ER has a has a price is a
[27:47] pres is discounted value of 100 no one
[27:50] year divided by one plus the one year
[27:52] interest rate at time
[27:54] T um a bond that pays nothing up to two
[27:57] years and then in the second at the end
[28:00] then after two years pays $100 then
[28:03] that's a value the price of that bond
[28:05] which is 100 discounted by that
[28:09] okay H then we look at Arbitrage which
[28:11] is says suppose that you you hold a bond
[28:15] that that you're considering
[28:17] investing your money for one year but
[28:20] you have two options one is to buy a
[28:21] one-year Bond the alternative is to buy
[28:24] a two-year Bond now and sell it at the
[28:25] end of the year those two strategies
[28:27] should would give you more or less the
[28:29] same return H well you know if you if
[28:32] you buy a one-year Bond you're going to
[28:34] get 1 plus i1t at the end of the year if
[28:37] you go through the two-year Bond
[28:40] strategy then H you're going to pay this
[28:43] today but you're going to you're going
[28:45] to H ER rece expect you expect to
[28:48] receive the price of a oneyear bond one
[28:51] year from now and we said these two
[28:53] things have to be equal more or less
[28:56] equal I mean again we're not adding risk
[28:59] to these things H if there's no risk
[29:01] consideration of agents at risk neutral
[29:03] then these two things have to be equal H
[29:06] that allows you to solve for the price
[29:08] of a two-year Bond as expected price of
[29:10] a oneyear bond one year from now divided
[29:12] by one plus the interest rate but the
[29:14] expected price of one year bond one year
[29:17] from now is going to be like a oneyear
[29:19] bond but one year from now so it's 100
[29:22] divided 1 + i1 t + 1 expected value I
[29:26] can stick that in there and I get EX the
[29:28] same expression okay so these are two
[29:30] different ways of pricing a
[29:33] bond or any other asset by
[29:38] actually and then we Define the yield to
[29:40] maturity so that's an important
[29:43] concept yield to
[29:46] maturity is is is is a is a rate that is
[29:51] a constant
[29:53] rate that gives you Thea exactly the
[29:57] same
[29:58] that gives you the current price of the
[30:00] bond okay so we already determined the
[30:03] the price of a two-year bond is that
[30:07] okay and now I'm saying well suppose
[30:10] that let me look for a rate that is the
[30:12] same in both
[30:14] periods that gives me the same price and
[30:17] that's that's the reason I have a
[30:18] subscript two here at time T so what is
[30:21] the rate that if I put a constant rate
[30:25] so I have 1 + I2 T * 1 +
[30:29] i2t gives me exactly the same price as
[30:33] the one we already determined okay and
[30:36] that's what we call the yield to
[30:37] maturity or the yield or or the end in
[30:40] this case would be a two-year rate if
[30:41] you hear what is a two-year rate is that
[30:45] okay H so so we know what this price is
[30:49] which is equal to that that's this
[30:51] expression there so the whole trick here
[30:53] is to find the 2-year rate at time T
[30:57] that that gives exactly the same value
[30:59] that means obviously since 100 is equal
[31:01] to 100 it means to find the i2t that
[31:03] gives you this equal to that which would
[31:07] say is approximate implies that
[31:08] approximately the twoyear rate is like
[31:10] an average of the two rate of the two
[31:12] onee rates okay but this concept you
[31:16] should know what it
[31:18] is I said there are two forms of risk in
[31:21] a bond there one one type of risk is the
[31:23] fall risk what if the issuer of the bond
[31:26] doesn't pay you now there's a huge issue
[31:27] with the US you know Deb ceiling because
[31:30] if they somehow they don't fix that
[31:32] there will be a default on some treasury
[31:34] bonds let's hope that it doesn't happen
[31:36] but but but that's theault risk is that
[31:39] whoever issued the debt at the time in
[31:42] which he should be paying you a coupon
[31:43] or or the principal the face value it
[31:47] doesn't pay you that's the fall risk
[31:49] okay and and and typically US Treasury
[31:52] bonds don't have the risk so nobody
[31:55] worries about that at this moment
[31:58] the default risk price in US bonds for
[32:01] one month bonds is higher than that of
[32:03] Mexico the bonds in Mexico or Brazil
[32:07] that tells you that the kind of things
[32:09] we have but in any EV so so this is a
[32:13] temporary default risk I mean nobody
[32:16] expects in the US that this will not be
[32:17] eventually repaid but you can cause a
[32:20] big
[32:20] mess by just ER delaying a a coupon
[32:24] payment I mean when when when these
[32:26] coupons are huge no
[32:28] and so so that's what's leading to all
[32:31] this concern but but in any
[32:33] EV that's one type of risk but we didn't
[32:36] look at that type of risk a lot the
[32:37] corporate bonds have a lot of that risk
[32:39] but we didn't look at that kind of risk
[32:41] we look at the another kind of risk
[32:42] which is price risk no if you have a one
[32:45] you invest in your oneyear bond there no
[32:47] price risk you're going to get your
[32:49] coupon your face value of 100 at the end
[32:51] of the year that's it if you go through
[32:52] a two-year strategy there's a risk there
[32:54] because you don't know exactly what the
[32:56] price of the two oneyear Bond will will
[32:58] be one year from now and there's a risk
[33:00] there we are not looking at what risk
[33:03] Avers cons investors do and so on but in
[33:06] reality there is such a risk okay and
[33:09] just the way we mold that is we said
[33:11] well then if I'm going to go through two
[33:13] years through a two-year bone route for
[33:16] a one-year investment then I don't have
[33:19] to H set this equal to the return I get
[33:23] in the sh Bond the oneyear bond I have
[33:25] to add an extra risk premium and then
[33:27] where right to this formula using the
[33:29] same steps we said well the one the the
[33:32] the two-year rate is really the average
[33:34] of the one expected onee rates plus a a
[33:37] premium and we call that actually the
[33:39] term
[33:40] premium you're more likely to face a
[33:42] question about the top of this slide and
[33:44] the bottom of the slide but I don't
[33:45] remember
[33:48] fully
[33:50] ER stock prices and Present Value well
[33:53] it's the same sort of idea know the only
[33:55] difference is
[33:56] that that that uh equities do not have
[34:02] maturity stocks do not have maturity in
[34:04] principle a company would last forever
[34:07] and and and so there's no there's no
[34:10] maturity and there is also the
[34:12] commitment of the coupons are a lot
[34:15] shakier in the sense that you know yeah
[34:17] compan is likely to give dividends they
[34:19] may announce a dividend policy but it's
[34:20] not a
[34:21] commitment if you know Regional Banks
[34:24] now are not giving any dividend because
[34:26] they want to preserve the capital okay
[34:28] they could but they're not because they
[34:30] want to build Capital just to be more
[34:32] resilient
[34:34] to any fly bad news okay but anyway so
[34:38] Equity that that means that you always
[34:40] have this future price floating around
[34:42] and you can keep substituting this
[34:44] multiple times and essentially you get
[34:46] to an expression that says look the the
[34:49] price of equity is really this the
[34:51] spected present discounted value of the
[34:54] dividends H and that includes lots of
[34:57] uncertainty because because you don't
[34:57] know exactly where the interest rate
[34:59] will be in that period and so on and
[35:01] there's always a a a remaining term out
[35:03] there which also causes a lot of trouble
[35:06] in practice
[35:08] assets equities move a lot more than
[35:12] than what you can justify with the
[35:13] Spector present value of
[35:16] dividends there's a lot of
[35:18] volatility ER there are bubbles and all
[35:20] sort of things I told you the story of
[35:25] Newton and and so on so so this formula
[35:28] for the bonds those formulas are great
[35:31] for Equity you're going to be pretty far
[35:33] off actual prices if you use this type
[35:35] of formulas still people call this the
[35:37] fundamental value of equity and then the
[35:40] rest is sort of more speculative but the
[35:43] point is that the speculative component
[35:44] moves at all is is responsible for a
[35:47] very large share of the volatility in
[35:49] asset in equity price in any event I'm
[35:51] not going to ask you about this kind of
[35:54] yeah for that final equation on the SL
[35:56] uh there's no
[35:58] like expression for Q it's here keep
[36:02] going forever it doesn't stop yeah it
[36:06] just discounted more and more and more
[36:08] so you would expect it to be less and
[36:09] less important but if the thing is
[36:11] blowing up then you know it maybe it may
[36:15] dominate the the the the heavier and
[36:18] heavier discounting because it's further
[36:19] further out in the future and that's the
[36:22] way you create theories of bubbles you
[36:23] can even come up with rational bubbles
[36:25] into the way but again that's what of
[36:29] course uh what else ah then we look at
[36:32] what is the effect of an expansionary
[36:34] monetary policy on asset prices and we
[36:36] said well obviously it's going to if
[36:38] lower interest rate that's going to
[36:39] increase the value of any asset that
[36:41] pays in the future returns and so it
[36:44] typically is typically the case that
[36:45] that expansion in Monet monetary policy
[36:48] will lead to an appreciation of all
[36:50] assets uh most assets but certainly
[36:53] bonds will go up directly because that's
[36:56] where the interest rate has the maximum
[36:58] the clearest effect but it's also the
[37:00] case that it tends to be bullish for
[37:01] Equity as well no it's that got interest
[37:04] rate and that a lot of the response of
[37:07] equity to news has to do with expected
[37:11] behavior of the FED in the future do you
[37:13] think that this will lead them to
[37:14] increase interest rate or to lower
[37:16] interest rate and things of that kind
[37:18] and again I think that's a little too
[37:20] complicated for you for
[37:22] now it said what is the effect of an
[37:24] increase in consumer spending on asset
[37:26] prices well that depends I mean it's
[37:29] clear that that if consumers become more
[37:32] bullish that's going to tend to lead to
[37:33] more cash flows for the firms so Equity
[37:36] at least will go up bonds no because
[37:38] they don't the coupon is set fixed
[37:40] doesn't depend on whether the econom is
[37:42] doing better or worse I'm assuming
[37:44] there's no default risk ER but it
[37:47] depends a lot of what you expect the FED
[37:48] to do if the FED if you think that this
[37:51] is going to trigger a Fed hike then it's
[37:53] bad news for bonds you know because the
[37:55] F the bonds do not benefit from the
[37:58] economic activity and and they get hurt
[38:00] by higher interest rate so it depends a
[38:03] lot on what you anticipate the FED to do
[38:04] or not but again I think this is a bit
[38:07] more complicated than what you need to
[38:08] know okay the last step was
[38:13] to H bring expectations into the aslm
[38:16] model I said the model we discussed
[38:17] through the course on the aslm except
[38:20] for the part where we put the exchange
[38:22] rate where we you know we we have to
[38:25] think about the future exchange rates
[38:26] and things like that it was really
[38:28] overweight the present in reality
[38:31] expectations matter a lot for consu
[38:33] consumers decisions for firm's decisions
[38:35] and so on probably matters even more
[38:37] than the future than the present okay
[38:40] ER and so so what we did is we expanded
[38:46] H the islm to include expectation we see
[38:49] well consumers not only worry about
[38:51] disposable income this part will show up
[38:54] in your test so so you should understand
[38:57] what what the eslm model is and do the
[38:59] comparative Statics that correspond to
[39:02] this model so what we did here is as
[39:04] well consumers not only worry about the
[39:06] current disposable income H they also
[39:09] worry about the income they receive in
[39:11] the future through financial asset
[39:13] Financial wealth or through their future
[39:15] labor income that's what we call human
[39:17] wealth but the point is that
[39:19] expectations about the future matter for
[39:21] consumption in the first part of the
[39:24] course we we summarize all that in that
[39:27] little parameters c0 which said
[39:28] consumers can be bullish or not but a
[39:31] lot of what happens here is what shifts
[39:32] c0 in the first part of the of the
[39:35] course and and this also highlight an
[39:37] important concept which is typically if
[39:40] you expect something to have only a
[39:42] temporary transitory consequence it will
[39:45] move consumption little relative to when
[39:47] you expect that change to be permanent
[39:49] so you expect current income to be up
[39:52] but but future income to go back to a
[39:53] lower level that's not going to change
[39:55] current consumption a lot however if you
[39:57] think there's a change that will
[39:58] increase in consumers income permanently
[40:01] up well that will increase not only this
[40:03] but also wealth human wealth and that
[40:05] will lead to a much larger response of
[40:07] consumption
[40:08] okay we did more or less for the same
[40:11] for investment obviously what matters
[40:13] for investment is the is future cash
[40:15] flows and and there we talk about the
[40:17] concept of depreciation but really was
[40:20] this was expected present discounted
[40:21] value of the cash flow generated by by
[40:24] an extra unit of capital so expected per
[40:28] Val discounted value
[40:30] formula so we said you know we we in the
[40:34] first part of the course we just look at
[40:36] an investment function that has output
[40:38] here and then we have an interest rate
[40:39] here where now we have something that's
[40:40] more complicated has future output which
[40:43] has appr proxim for future cash flows
[40:45] but also current and future interest
[40:47] rates because those affect the value of
[40:50] those future cash flows H in terms of
[40:52] today's
[40:53] dollars and we put all of this together
[40:56] and we ended up with an expanded
[40:59] aggregate demand in which ER you know in
[41:03] which we had the same parameters that we
[41:05] had ER when we did the static
[41:09] model without expectations but now we
[41:12] get sort of the same things repeated
[41:15] here one year ahead because it it
[41:18] matters not only for aggregate demand
[41:20] not only the income the consumers are
[41:22] receiving today or the sales that firms
[41:24] are making today but also what they
[41:26] expect to have next year here it matters
[41:29] what the taxes they're paying today but
[41:31] also what they expect to pay in the
[41:32] future the interest rate matters not
[41:35] only today but also what they expect the
[41:37] interest rate to be in the future and so
[41:38] on okay so the bottom line is that we if
[41:42] we now look at the slm model I said now
[41:45] we have lots of more parameters all
[41:47] these things that happen in the future
[41:48] are new
[41:50] parameters H I said notice notice that
[41:54] also this curve now is a lot steeper
[41:57] why is that well because if you change
[41:59] the interest rate today without without
[42:01] changing the interest rate in the future
[42:03] then that has a small effect okay and so
[42:07] I said now this is becomes very steep
[42:10] but the equivalent to what we did the
[42:12] static model is a is a situation where
[42:14] you cut the interest rate today say the
[42:16] Central Bank cuts the interest rate
[42:18] today but it also convinces the public
[42:20] that they will also keep the interest
[42:22] rate low in the next period that is not
[42:25] only you move along the SAS but you also
[42:27] persuade the public that the interest
[42:30] rate will be lower in the future that
[42:32] will shift yes to the right and then
[42:34] therefore therefore you're going to get
[42:35] a much larger kick out of monetary
[42:37] policy and pol monetary policy is a lot
[42:40] about forward guidance is that you know
[42:42] you cut interest rate today but you're
[42:44] also telling there's always a speech
[42:46] after they they take the policy action
[42:48] which they talk about how they see
[42:50] interest rates going in the future and
[42:52] all of that that's because you want to
[42:54] have maximum power okay if you if if you
[42:57] just tell the market I'm going to change
[42:59] the interest rate for now and then
[43:00] nothing else that's going to have a very
[43:02] limited impact to have a large impact
[43:04] out of monetary policy you have to
[43:06] convince them that you will also affect
[43:08] the interest R path in the
[43:11] future same sort of situation here the
[43:13] other parameters is what happens if for
[43:16] example you expect future output to go
[43:18] up H well that's going to shift a yes to
[43:21] the right that's yet another reason why
[43:23] convincing people that you're going to
[43:25] cut interest rate in the future as well
[43:27] they going to keep them low in the
[43:29] future shift yes even more because if
[43:31] you're going to keep the interest rate
[43:33] low in the future that means probably
[43:34] the future output will be higher and
[43:36] since future output is higher that
[43:38] increases human wealth and that means
[43:40] consumption will tend to go up okay but
[43:43] do play with this and and again the the
[43:46] it's important to have this distinction
[43:49] between the impact of temporary things
[43:51] which is much smaller and and the the
[43:54] impact of permanent things which is
[43:56] bigger because it affect
[43:57] wealth
[44:01] okay oh that's an example okay so
[44:04] monetary policy again ER that's just if
[44:08] if you don't persuade the public that
[44:10] you're going to change the interest rate
[44:11] in the future then it just a movement
[44:12] along but if you also convince them that
[44:16] you will remain sort of H lose monetary
[44:19] conditions in next year then that that
[44:22] effectively shift the yes to the right
[44:24] for for a variety of Reon for two
[44:25] reasons at least that's much more
[44:29] expansionary the last thing we did is
[44:32] fiscal policy I said well fiscal policy
[44:34] fiscal policy today is contraction and
[44:36] there's no doubt of that but it can have
[44:39] but there are episodes and I show you
[44:40] the Irish episode in which actually may
[44:43] end up going the other way around in
[44:45] which you cut expenditure today which is
[44:47] contractionary but you end up actually
[44:49] having an expansion but for that the
[44:51] only way that can happen is that if
[44:54] somehow you affect expectations in a
[44:55] very significant way so that's what I
[44:58] said if if you ever get sort of a a a
[45:01] strange correl response to to a policy
[45:04] announcement is probably because there
[45:06] has been a big effect on expectations so
[45:09] I show you the case of Ireland because
[45:10] there a case that was famous in which
[45:12] all the people talk about there was a
[45:14] fiscal deficit as the big drug in the
[45:16] economy that there was going to be a big
[45:18] Day of Reckoning and that you and so on
[45:21] so forth so once they dealt with it sort
[45:23] of expectations they realize they could
[45:25] cut interest rates then they could
[45:27] realiz that that that also that that
[45:30] this Malay and the economy was going to
[45:31] go away so people became optimistic
[45:33] about the future and so on and they end
[45:35] up with an expansion okay that shows you
[45:38] how important expectations are so
[45:41] economic policy in general you the the
[45:44] direct immediate effect is what we have
[45:46] been discussing throughout the course
[45:48] but a lot of its power and even the sort
[45:51] of perverse or or or or good synergies
[45:53] that you get out of them has to do with
[45:55] what you do to with expect patience okay
[45:58] good