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