WEBVTT 00:00:16.920 --> 00:00:22.439 the main topic in this part is really 00:00:19.079 --> 00:00:27.079 open economy and uh so we extended the 00:00:22.439 --> 00:00:29.719 eslm mo uh we did not bring in we we 00:00:27.079 --> 00:00:32.399 again shut down price changes so we said 00:00:29.719 --> 00:00:36.238 uh pric is completely fixed no Philips 00:00:32.399 --> 00:00:40.480 curve here so we expanded the eslm model 00:00:36.238 --> 00:00:42.759 to add this open E economy Dimension and 00:00:40.479 --> 00:00:44.558 so we start from the same aggregate 00:00:42.759 --> 00:00:47.039 demand function that we had in close 00:00:44.558 --> 00:00:48.959 economy consumption plus investment plus 00:00:47.039 --> 00:00:51.800 government expenditure but now we have 00:00:48.960 --> 00:00:54.679 to draw a distinction between Demand by 00:00:51.799 --> 00:00:56.399 domestic households companies and the 00:00:54.679 --> 00:00:59.320 government and the demand for 00:00:56.399 --> 00:01:01.439 domestically produced goods and so Z is 00:00:59.320 --> 00:01:03.920 the demand domestically produced Goods 00:01:01.439 --> 00:01:05.719 which is equal to demand plus the demand 00:01:03.920 --> 00:01:09.118 that foreigners have for the goods 00:01:05.719 --> 00:01:10.759 produces at home minus the Imports that 00:01:09.118 --> 00:01:12.920 part of that expenditure that is going 00:01:10.759 --> 00:01:14.519 to Imports that means Goods produced by 00:01:12.920 --> 00:01:16.840 other 00:01:14.519 --> 00:01:18.759 countries um so the new behavioral 00:01:16.840 --> 00:01:22.159 functions here where the export function 00:01:18.759 --> 00:01:24.959 and the import function uh export is 00:01:22.159 --> 00:01:27.799 increasing in foreign output more income 00:01:24.959 --> 00:01:30.879 abroad will lead to more Imports by them 00:01:27.799 --> 00:01:33.560 which means more export for home home 00:01:30.879 --> 00:01:35.599 and the it's decreasing on with respect 00:01:33.560 --> 00:01:36.960 to the exchange rate real exchange rate 00:01:35.599 --> 00:01:38.599 and nominal exchange rate will be the 00:01:36.959 --> 00:01:40.719 same here since we have fully sticky 00:01:38.599 --> 00:01:43.640 prices but 00:01:40.719 --> 00:01:45.280 H if if the real exchange it appreciat 00:01:43.640 --> 00:01:47.399 that means domestic goods are more 00:01:45.280 --> 00:01:49.040 expensive it means exports are less 00:01:47.399 --> 00:01:52.879 foreigners are going to buy less of our 00:01:49.040 --> 00:01:54.759 Goods conversely for imports is like the 00:01:52.879 --> 00:01:57.399 exports of the other country means that 00:01:54.759 --> 00:01:59.359 if domestic output goes up then then 00:01:57.399 --> 00:02:03.200 there will be more purchases of foreign 00:01:59.359 --> 00:02:04.959 foreign er er goods and if the exchange 00:02:03.200 --> 00:02:06.920 is appreciate means also that foreign 00:02:04.959 --> 00:02:10.280 goods are cheaper for us and therefore 00:02:06.920 --> 00:02:12.080 we import more okay so positive so those 00:02:10.280 --> 00:02:14.039 were those were the two new behavioral 00:02:12.080 --> 00:02:16.920 functions in the in the Goods Market 00:02:14.039 --> 00:02:18.799 expanded to include an open economy and 00:02:16.919 --> 00:02:22.000 that had implications for the diagram 00:02:18.800 --> 00:02:24.879 that we had in lecture three or so to 00:02:22.000 --> 00:02:27.120 determine equilibrium output ER you know 00:02:24.878 --> 00:02:29.598 we started from the same demand we had 00:02:27.120 --> 00:02:30.400 in close economy then we had to subtract 00:02:29.598 --> 00:02:34.318 in 00:02:30.400 --> 00:02:36.760 in import and uh and that is shift 00:02:34.318 --> 00:02:38.958 things down because we are now as part 00:02:36.759 --> 00:02:42.479 of the domestic demand that is going to 00:02:38.959 --> 00:02:45.680 foreign Goods not to domestic Goods but 00:02:42.479 --> 00:02:47.518 ER it's also rotates a curve because the 00:02:45.680 --> 00:02:50.000 higher is domestic income the more are 00:02:47.519 --> 00:02:53.000 the Imports uh that we do from the rest 00:02:50.000 --> 00:02:55.039 of the world now to that we have to add 00:02:53.000 --> 00:02:56.878 the export which are not a function of 00:02:55.039 --> 00:02:59.519 domestic output that's that's a parallel 00:02:56.878 --> 00:03:03.759 shift with respect to this curve no we 00:02:59.519 --> 00:03:06.080 go up up and and that gives us the ZZ 00:03:03.759 --> 00:03:09.199 curve which is what we call the demand 00:03:06.080 --> 00:03:11.599 for domestic Le domestically produced 00:03:09.199 --> 00:03:13.119 Goods now notice that the distance 00:03:11.598 --> 00:03:16.119 between the demand for domestically 00:03:13.120 --> 00:03:19.480 produced goods and the domestic demand 00:03:16.120 --> 00:03:21.439 for goods is what is the net export so 00:03:19.479 --> 00:03:26.439 the distance between z z and the D is 00:03:21.439 --> 00:03:26.439 the net export so in this point here for 00:03:26.680 --> 00:03:31.879 example ZZ is higher than DD which means 00:03:29.959 --> 00:03:33.560 that our exports are greater than our 00:03:31.878 --> 00:03:35.798 Imports and that's the reason you have a 00:03:33.560 --> 00:03:37.239 trade surplus at this point they're the 00:03:35.799 --> 00:03:40.400 same and that's the reason the trade 00:03:37.239 --> 00:03:42.120 account is balance and but over here 00:03:40.400 --> 00:03:45.000 Imports exceed exports and that's the 00:03:42.120 --> 00:03:47.599 reason we have a trade deficit 00:03:45.000 --> 00:03:49.199 okay I'm going to go very quickly so you 00:03:47.598 --> 00:03:50.560 you're in charge of stopping me I'm not 00:03:49.199 --> 00:03:52.518 going to ask you question just stop me 00:03:50.560 --> 00:03:54.598 if there's something that you need 00:03:52.519 --> 00:03:56.039 clarifications okay for so that's what 00:03:54.598 --> 00:03:58.238 the demand for domestically produced 00:03:56.039 --> 00:04:00.120 Goods now we're going to determine 00:03:58.239 --> 00:04:01.959 equilibrium output in this open e e omic 00:04:00.120 --> 00:04:03.920 context and that means you know 00:04:01.959 --> 00:04:05.360 aggregate demand has to be equal 00:04:03.919 --> 00:04:08.878 aggregate demand for domestically 00:04:05.360 --> 00:04:10.599 produced good has to be equal to output 00:04:08.878 --> 00:04:13.039 and that's what we do with the 45 degree 00:04:10.598 --> 00:04:14.919 line here and so where the 45 degree 00:04:13.039 --> 00:04:18.238 line intersect with this ZZ curve that's 00:04:14.919 --> 00:04:19.839 our equilibrium output now it happens 00:04:18.238 --> 00:04:22.239 that in this example that leads to a 00:04:19.839 --> 00:04:24.638 trade deficit but there's nothing here 00:04:22.240 --> 00:04:27.160 so we still determine equili output up 00:04:24.639 --> 00:04:29.759 here and then we read in this curve 00:04:27.160 --> 00:04:32.199 bottom curve what is implication for the 00:04:29.759 --> 00:04:34.759 traes deficit or Surplus 00:04:32.199 --> 00:04:37.160 okay H but the equilibrium condition 00:04:34.759 --> 00:04:39.439 important is that output domestically 00:04:37.160 --> 00:04:42.360 produc output has to be equal to the 00:04:39.439 --> 00:04:44.639 demand for domestically produced Goods 00:04:42.360 --> 00:04:46.800 not for total demand it's Dem demand for 00:04:44.639 --> 00:04:49.280 domestically produced Goods okay because 00:04:46.800 --> 00:04:50.918 this is a can model in which output is 00:04:49.279 --> 00:04:52.638 aggregate demand determined but it has 00:04:50.918 --> 00:04:55.240 to be aggregate demand for the things 00:04:52.639 --> 00:04:59.720 you're producing not AG demand for all 00:04:55.240 --> 00:05:02.038 Goods around the world okay good so then 00:04:59.720 --> 00:05:03.479 we did some experiments we said well 00:05:02.038 --> 00:05:05.240 suppose what happens in this open 00:05:03.478 --> 00:05:08.159 economy context if we increase 00:05:05.240 --> 00:05:12.120 government expenditure well the curent 00:05:08.160 --> 00:05:14.199 will shift up in exactly the same way as 00:05:12.120 --> 00:05:17.360 as in the close economy the difference 00:05:14.199 --> 00:05:19.120 will be in the multiplier though because 00:05:17.360 --> 00:05:21.479 as output goes up as a result of the 00:05:19.120 --> 00:05:24.600 expansionary aggregate demand that also 00:05:21.478 --> 00:05:26.360 means that domestic income will go up 00:05:24.600 --> 00:05:27.879 and and that means that Imports will go 00:05:26.360 --> 00:05:29.840 up and that's demand that will go for 00:05:27.879 --> 00:05:32.240 foreign goods and that's the reason the 00:05:29.839 --> 00:05:36.679 z z curve has a lower multiplier it's 00:05:32.240 --> 00:05:38.160 flatter than the DD curve okay still if 00:05:36.680 --> 00:05:39.800 we start for example with a trade 00:05:38.160 --> 00:05:41.000 balance since Imports are going to 00:05:39.800 --> 00:05:43.879 increase as a result of this 00:05:41.000 --> 00:05:46.160 expansionary fiscal policy we going end 00:05:43.879 --> 00:05:48.399 up with a trade deficit and that's the 00:05:46.160 --> 00:05:50.160 reason the response of output is less 00:05:48.399 --> 00:05:53.000 than close economies because part of 00:05:50.160 --> 00:05:55.000 that goes to foreign Goods conversely if 00:05:53.000 --> 00:05:56.759 this other country that is doing a 00:05:55.000 --> 00:05:58.879 expansion in fiscal policy or something 00:05:56.759 --> 00:06:01.680 that leads to higher output abroad wi 00:05:58.879 --> 00:06:03.759 star that's also expansionary for home 00:06:01.680 --> 00:06:06.079 because exports the export function goes 00:06:03.759 --> 00:06:09.639 up no and that leads to an increase in 00:06:06.079 --> 00:06:10.839 output ER still with lower multiplier 00:06:09.639 --> 00:06:13.079 because part of that increase in 00:06:10.839 --> 00:06:16.719 domestic output will go will go to 00:06:13.079 --> 00:06:18.359 Imports but the in this case unlike the 00:06:16.720 --> 00:06:20.680 other ones actually the current the the 00:06:18.360 --> 00:06:23.759 trade balance improves because it's been 00:06:20.680 --> 00:06:26.199 pulled by exports and so we at at impact 00:06:23.759 --> 00:06:28.160 we get a big increase in export which is 00:06:26.199 --> 00:06:30.120 the driver of increasable demand for 00:06:28.160 --> 00:06:32.280 domestically produced Goods and then as 00:06:30.120 --> 00:06:34.199 income goes up we undo some of that but 00:06:32.279 --> 00:06:37.679 you end up with sort of higher high 00:06:34.199 --> 00:06:40.280 higher better trade deficit better trade 00:06:37.680 --> 00:06:44.759 surpluses than than in the case in which 00:06:40.279 --> 00:06:44.758 you induce the the expansion in agre 00:06:45.120 --> 00:06:51.240 demand uh then the last step there was H 00:06:48.800 --> 00:06:53.280 to look at the role of the exchange rate 00:06:51.240 --> 00:06:55.960 and uh where we said is we're going to 00:06:53.279 --> 00:06:59.598 make some assumptions that I promise you 00:06:55.959 --> 00:07:02.359 and and I now read the quiz so I I I I 00:06:59.598 --> 00:07:04.680 guarantee you I honor This Promise H 00:07:02.360 --> 00:07:07.879 nothing weird will happen meaning if if 00:07:04.680 --> 00:07:11.038 our Goods gets more expensive that means 00:07:07.879 --> 00:07:14.560 that net exports will be worse and and 00:07:11.038 --> 00:07:16.680 if if H for two reasons for at least for 00:07:14.560 --> 00:07:19.160 at least one reason but it could be too 00:07:16.680 --> 00:07:20.800 if if if the exchange rate goes up then 00:07:19.160 --> 00:07:23.599 there's going to be less exports at any 00:07:20.800 --> 00:07:27.160 given level of foreign income that will 00:07:23.598 --> 00:07:28.959 worsen the net export and then we were 00:07:27.160 --> 00:07:30.560 going to tend to import more now that 00:07:28.959 --> 00:07:31.878 will be parti should upset for the fact 00:07:30.560 --> 00:07:34.240 that you can buy more with the same 00:07:31.879 --> 00:07:36.800 amount of dollars H but we said we're 00:07:34.240 --> 00:07:38.519 going to impose conditions such that the 00:07:36.800 --> 00:07:40.598 positive the negative effect of an 00:07:38.519 --> 00:07:42.758 appreciation on that export always 00:07:40.598 --> 00:07:44.680 dominates and again in your quiz you're 00:07:42.759 --> 00:07:47.120 going to have a situation like that and 00:07:44.680 --> 00:07:50.280 that will be the 00:07:47.120 --> 00:07:52.240 case so don't think that that we're 00:07:50.279 --> 00:07:56.119 trying to trick you anything this will 00:07:52.240 --> 00:08:00.840 hold okay the the point of this being 00:07:56.120 --> 00:08:02.319 that you know that that uh 00:08:00.839 --> 00:08:06.279 depreciating your 00:08:02.319 --> 00:08:09.199 currency you know making your goods less 00:08:06.279 --> 00:08:11.158 expensive ER is equivalent to will 00:08:09.199 --> 00:08:14.199 produce an a response equivalent to what 00:08:11.158 --> 00:08:18.839 you get here out of an increasing y star 00:08:14.199 --> 00:08:22.360 no because that's export will go 00:08:18.839 --> 00:08:24.918 up and you're going to get all the shift 00:08:22.360 --> 00:08:26.879 net export function will go up that will 00:08:24.918 --> 00:08:28.639 increase aggregate demand and so on so 00:08:26.879 --> 00:08:30.840 that's kind things that countries want 00:08:28.639 --> 00:08:35.560 to typically when they're in a recession 00:08:30.839 --> 00:08:38.199 and so on then that was an introduction 00:08:35.559 --> 00:08:39.639 to the most important lecture in this 00:08:38.200 --> 00:08:42.959 part of 00:08:39.639 --> 00:08:47.120 the course which is the Mandel flaming 00:08:42.958 --> 00:08:50.439 model and I I I promise you that you 00:08:47.120 --> 00:08:52.200 would get 70% at least in the quiz and I 00:08:50.440 --> 00:08:54.600 already read the quiz so I tell you 00:08:52.200 --> 00:08:57.160 there is at least 70% of your points 00:08:54.600 --> 00:08:58.480 have to do with this model so you better 00:08:57.159 --> 00:09:00.159 understand it very well you do every 00:08:58.480 --> 00:09:02.278 single comparative Statics that you can 00:09:00.159 --> 00:09:05.838 imagine with this Mo and then you'll get 00:09:02.278 --> 00:09:08.519 70% at least I think you get 73 actually 00:09:05.839 --> 00:09:12.240 but but but that's 00:09:08.519 --> 00:09:14.399 the so what's this well the Mandel 00:09:12.240 --> 00:09:15.959 flaming model is simply what I just 00:09:14.399 --> 00:09:20.078 showed you is the good market 00:09:15.958 --> 00:09:25.359 equilibrium no that's the but with an 00:09:20.078 --> 00:09:26.919 endogenous exchange rate and uh so we we 00:09:25.360 --> 00:09:28.600 rewrote to say since we're assuming 00:09:26.919 --> 00:09:29.958 compettive sticky prices we can replace 00:09:28.600 --> 00:09:33.200 the real Exchange by the nominal 00:09:29.958 --> 00:09:36.000 exchange rate H but now we're going to 00:09:33.200 --> 00:09:38.839 endogenize the exchange rate and and and 00:09:36.000 --> 00:09:40.839 for that we're going to use the uncover 00:09:38.839 --> 00:09:43.600 in parity condition this a condition you 00:09:40.839 --> 00:09:46.160 should understand very well as well okay 00:09:43.600 --> 00:09:49.159 so that tells you essentially that the 00:09:46.159 --> 00:09:51.360 expected Return of the two bonds the 00:09:49.159 --> 00:09:53.639 bonds issuing foreign currency and 00:09:51.360 --> 00:09:55.759 domestic currency have to be the same 00:09:53.639 --> 00:09:58.078 the Spector return have to be the same 00:09:55.759 --> 00:10:00.278 okay and this condition ensures that 00:09:58.078 --> 00:10:02.399 because if a country for example example 00:10:00.278 --> 00:10:04.879 if the domestic interest rate is higher 00:10:02.399 --> 00:10:06.879 than the international interest rate you 00:10:04.879 --> 00:10:09.439 need to expect a depreciation of the 00:10:06.879 --> 00:10:12.159 current currency otherwise the expected 00:10:09.440 --> 00:10:14.720 return would not be the same okay and 00:10:12.159 --> 00:10:17.000 that's the reason when we add the 00:10:14.720 --> 00:10:21.040 assumption that the Spector exchanges is 00:10:17.000 --> 00:10:22.480 fixed at least temporarily H then an 00:10:21.039 --> 00:10:24.399 increase in the interest rate leads to 00:10:22.480 --> 00:10:26.600 an appreciation of the exchange rate why 00:10:24.399 --> 00:10:28.078 because that if the exchange rate 00:10:26.600 --> 00:10:29.879 appreciate but the expected exchange 00:10:28.078 --> 00:10:31.439 rate stays put that that means the 00:10:29.879 --> 00:10:33.838 expected appreciation will have to be 00:10:31.440 --> 00:10:36.120 undone and that means that leads to 00:10:33.839 --> 00:10:38.200 unexpected depreciation okay so that's 00:10:36.120 --> 00:10:40.519 very important okay so here you have 00:10:38.200 --> 00:10:43.240 therefore you need to understand this 00:10:40.519 --> 00:10:45.159 know that forgiv expectation of the 00:10:43.240 --> 00:10:47.399 exchange rate and increasing domestic 00:10:45.159 --> 00:10:49.838 interest rate appreciates the domestic 00:10:47.399 --> 00:10:52.120 currency and and increasing the foreign 00:10:49.839 --> 00:10:54.279 interest rate without us matching it 00:10:52.120 --> 00:10:57.639 will lead to a depreciation of the 00:10:54.278 --> 00:10:59.000 current of of the domestic currency okay 00:10:57.639 --> 00:11:01.240 so that's what you have there that's 00:10:59.000 --> 00:11:01.240 important 00:11:01.679 --> 00:11:06.078 important now notice that if the 00:11:03.919 --> 00:11:09.240 expected exchange rate goes 00:11:06.078 --> 00:11:12.679 up and the interest rates do not change 00:11:09.240 --> 00:11:14.879 then the current exchanger has to go up 00:11:12.679 --> 00:11:16.799 because if it didn't then you would have 00:11:14.879 --> 00:11:18.879 an expected capital gain out of the 00:11:16.799 --> 00:11:21.559 currency and expected appreciation and 00:11:18.879 --> 00:11:26.519 that would add to the expected return of 00:11:21.559 --> 00:11:29.599 own owning a domestic bones okay 00:11:26.519 --> 00:11:31.919 good so we characterize that interest 00:11:29.600 --> 00:11:34.440 parity condition as follows we said well 00:11:31.919 --> 00:11:36.078 look this this here we're plotting the 00:11:34.440 --> 00:11:38.399 domestic interest rate here we're 00:11:36.078 --> 00:11:40.120 putting the current exchange rate and 00:11:38.399 --> 00:11:43.078 what we're marking in this picture this 00:11:40.120 --> 00:11:45.600 is the curve that traces the uip the and 00:11:43.078 --> 00:11:47.519 cover by the condition and naturally 00:11:45.600 --> 00:11:49.680 when the domestic interest rate is equal 00:11:47.519 --> 00:11:51.120 to International interest rate then it 00:11:49.679 --> 00:11:52.599 has to be the case that the exchange 00:11:51.120 --> 00:11:55.278 rate is at the same level as the 00:11:52.600 --> 00:11:58.079 expected exchange no if that is equal to 00:11:55.278 --> 00:12:00.600 that so if we're here then we know that 00:11:58.078 --> 00:12:02.719 a point in that curve is that in which 00:12:00.600 --> 00:12:05.639 the exchange rate is equal to the 00:12:02.720 --> 00:12:08.278 expected exchange rate okay that's what 00:12:05.639 --> 00:12:11.200 we have 00:12:08.278 --> 00:12:13.439 yeah good so you should understand this 00:12:11.200 --> 00:12:15.480 curve and and know what moves it here 00:12:13.440 --> 00:12:16.839 it's very clear what moves it no if 00:12:15.480 --> 00:12:19.519 there are two things that can move this 00:12:16.839 --> 00:12:20.760 this curve here one is a change in I 00:12:19.519 --> 00:12:24.440 star the other one is a change in 00:12:20.759 --> 00:12:27.000 expected exchange rate if what happens 00:12:24.440 --> 00:12:29.880 if the is star goes 00:12:27.000 --> 00:12:34.360 up well you know that the new new the 00:12:29.879 --> 00:12:36.958 uip will shift but you do know that the 00:12:34.360 --> 00:12:38.440 next the The Point equivalent to that 00:12:36.958 --> 00:12:40.078 that is one in which exchange rate is 00:12:38.440 --> 00:12:41.800 equal to expected exchange rate we have 00:12:40.078 --> 00:12:44.439 to have a higher interest rate domestic 00:12:41.799 --> 00:12:46.599 interest rate no because if I'm bringing 00:12:44.440 --> 00:12:48.240 this up and I want to still look at the 00:12:46.600 --> 00:12:51.199 point in which e is equal to expected 00:12:48.240 --> 00:12:53.000 exchange rate then I have to move I up 00:12:51.198 --> 00:12:55.319 by the same amount and so I know that 00:12:53.000 --> 00:12:57.958 this curve when when is Star goes up 00:12:55.320 --> 00:13:00.160 this curve moves up or to the left you 00:12:57.958 --> 00:13:02.399 pick which way you analyze 00:13:00.159 --> 00:13:04.519 okay now what about the expected 00:13:02.399 --> 00:13:06.839 exchange rate well if the expected 00:13:04.519 --> 00:13:09.560 exchange rate goes 00:13:06.839 --> 00:13:11.720 up if the spected exchange goes up and 00:13:09.559 --> 00:13:15.039 the international interest hasn't gone 00:13:11.720 --> 00:13:17.879 up H so if this moves to to the spected 00:13:15.039 --> 00:13:21.240 exchanger moves to the right then and 00:13:17.879 --> 00:13:24.759 the and the and the domestic interest 00:13:21.240 --> 00:13:27.360 doesn't go up then that means that the 00:13:24.759 --> 00:13:32.559 current exchanger will have to also go 00:13:27.360 --> 00:13:34.800 up okay so that means H if this goes up 00:13:32.559 --> 00:13:36.479 then at an interest rate equal to the 00:13:34.799 --> 00:13:38.719 the international interest rate so let's 00:13:36.480 --> 00:13:43.320 tra look in this direction then we have 00:13:38.720 --> 00:13:45.199 a point around here okay if if that 00:13:43.320 --> 00:13:46.680 wasn't the cas case then you would 00:13:45.198 --> 00:13:50.439 respecting an appreciation and then 00:13:46.679 --> 00:13:54.120 again would be inconsistent with 00:13:50.440 --> 00:13:57.240 h the uip then we put things together so 00:13:54.120 --> 00:13:59.799 what we did is we replace we use the uip 00:13:57.240 --> 00:14:02.240 to replace exchange rate there and now 00:13:59.799 --> 00:14:04.758 we get this expression in the net export 00:14:02.240 --> 00:14:07.560 function now we the LM is exactly the 00:14:04.759 --> 00:14:10.560 same as before we we have 00:14:07.559 --> 00:14:12.679 a the Central Bank sets the interest 00:14:10.559 --> 00:14:14.958 rate here I'm writing it in terms of the 00:14:12.679 --> 00:14:16.359 nominal interest rate I think in the 00:14:14.958 --> 00:14:17.758 quiz we wrote it in terms of the real 00:14:16.360 --> 00:14:20.360 interest rate but it's the same because 00:14:17.759 --> 00:14:21.759 prices is equal to are fixed so real and 00:14:20.360 --> 00:14:23.399 nominal interest rate are exactly the 00:14:21.759 --> 00:14:27.720 same 00:14:23.399 --> 00:14:30.559 yeah is the xais the expected exchange 00:14:27.720 --> 00:14:32.519 rate no is the actual exchange rate the 00:14:30.559 --> 00:14:36.078 spected exchange rate is in this curve 00:14:32.519 --> 00:14:37.679 here that is a parameter okay this 00:14:36.078 --> 00:14:39.159 happens to be a value of the current 00:14:37.679 --> 00:14:41.198 exchange equal to the spected exchange 00:14:39.159 --> 00:14:42.919 rate which is convenient to plot because 00:14:41.198 --> 00:14:44.758 that's also when the domestic interest 00:14:42.919 --> 00:14:46.198 rate which is what I'm putting here is 00:14:44.759 --> 00:14:47.919 equal to International interest rate 00:14:46.198 --> 00:14:51.240 that's all that I'm saying and then if 00:14:47.919 --> 00:14:55.078 you shift this to the 00:14:51.240 --> 00:14:57.639 right exchange rate up the expect exate 00:14:55.078 --> 00:15:00.239 up then I know that a new point in this 00:14:57.639 --> 00:15:02.600 curve has to have a higher current 00:15:00.240 --> 00:15:04.079 exchange rate so that I know I know that 00:15:02.600 --> 00:15:05.800 the equivalent to this point a is going 00:15:04.078 --> 00:15:08.879 to be to the right if you lower the 00:15:05.799 --> 00:15:13.159 foreign interest rate then what I know 00:15:08.879 --> 00:15:14.838 is that exactly that that the point at 00:15:13.159 --> 00:15:17.039 which exchange it is equal to expected 00:15:14.839 --> 00:15:19.199 exchange rate has to have a lower 00:15:17.039 --> 00:15:22.639 domestic interest rate so that means 00:15:19.198 --> 00:15:24.758 that I know that that that this point a 00:15:22.639 --> 00:15:29.120 will be around here which is like a 00:15:24.759 --> 00:15:29.120 shift to the right okay 00:15:31.039 --> 00:15:37.159 anyway so so as I said I was saying ER 00:15:35.360 --> 00:15:39.278 nominal real interest are the same I 00:15:37.159 --> 00:15:42.039 think in the in the quiz we wrote are 00:15:39.278 --> 00:15:44.600 there but it's the same same 00:15:42.039 --> 00:15:47.360 more so now you see that interest rate 00:15:44.600 --> 00:15:49.759 have two effects no h one is the 00:15:47.360 --> 00:15:52.560 traditional effect affects investment 00:15:49.759 --> 00:15:54.240 but it also affects exchange R so H an 00:15:52.559 --> 00:15:56.679 increas in the domestic interest rate 00:15:54.240 --> 00:15:58.198 now will will be doubly contractional in 00:15:56.679 --> 00:16:00.599 the sense that we lower domestic 00:15:58.198 --> 00:16:03.599 investment that reduces aggregate demand 00:16:00.600 --> 00:16:04.879 but at the same time it will also 00:16:03.600 --> 00:16:06.560 appreciate the exchange rate and 00:16:04.879 --> 00:16:08.078 therefore it will reduce net exports 00:16:06.559 --> 00:16:10.638 okay we're going to import more and 00:16:08.078 --> 00:16:13.239 Export less and that's also going to 00:16:10.639 --> 00:16:15.919 reduce aggregate demand so that's that's 00:16:13.240 --> 00:16:17.639 the those are the two effects so that's 00:16:15.919 --> 00:16:20.639 the contribution of the all this 00:16:17.639 --> 00:16:23.318 exchange rate block to our islm 00:16:20.639 --> 00:16:26.759 framework Mandel flaming is simply islm 00:16:23.318 --> 00:16:30.679 plus a a you know a uip condition and a 00:16:26.759 --> 00:16:32.680 net export function that's it 00:16:30.679 --> 00:16:35.599 so we put out now the two things 00:16:32.679 --> 00:16:37.198 together sort of a standard is islm now 00:16:35.600 --> 00:16:38.839 with different slope and so on because 00:16:37.198 --> 00:16:42.039 we have this net export function and we 00:16:38.839 --> 00:16:43.959 have more parameter we have y star is 00:16:42.039 --> 00:16:46.399 star and things like that and then we 00:16:43.958 --> 00:16:49.318 have the uip there and then then we did 00:16:46.399 --> 00:16:51.720 a few experiments no said suppose that 00:16:49.318 --> 00:16:56.078 now you have an expansionary monetary 00:16:51.720 --> 00:16:58.519 policy okay so an expansion in monetary 00:16:56.078 --> 00:17:00.039 policy as before with a slightly 00:16:58.519 --> 00:17:02.240 different slopes and so on because of 00:17:00.039 --> 00:17:04.480 the net export function will lower 00:17:02.240 --> 00:17:05.798 equilibrium output and it will lower it 00:17:04.480 --> 00:17:08.318 for two reasons as I said before will 00:17:05.798 --> 00:17:10.759 lower it because investment will decline 00:17:08.318 --> 00:17:12.279 but also because higher interest rate 00:17:10.759 --> 00:17:13.359 means an appreciation of the exchange 00:17:12.279 --> 00:17:15.318 rate 00:17:13.359 --> 00:17:17.879 today because you have to expect a 00:17:15.318 --> 00:17:20.480 depreciation now in the next period and 00:17:17.880 --> 00:17:22.959 and that that means also less net 00:17:20.480 --> 00:17:24.679 exports okay so interest rate is 00:17:22.959 --> 00:17:29.440 contractionary for for two different 00:17:24.679 --> 00:17:33.160 reasons here is that clear 00:17:29.440 --> 00:17:33.160 yeah raise interest 00:17:33.319 --> 00:17:37.558 rate raise interest rate will lower 00:17:35.720 --> 00:17:39.160 aggregate demand for the standard reason 00:17:37.558 --> 00:17:41.240 but on top of that we're going to get an 00:17:39.160 --> 00:17:45.120 appreciation of the exchange rate which 00:17:41.240 --> 00:17:47.480 also reduces net exports 00:17:45.119 --> 00:17:50.918 okay what about an increase in go 00:17:47.480 --> 00:17:52.880 expenditure well H it's the same as 00:17:50.919 --> 00:17:54.600 before and nothing changes relative to 00:17:52.880 --> 00:17:56.520 before except for the fact that we have 00:17:54.599 --> 00:17:58.599 a lower multiplier but it's still the 00:17:56.519 --> 00:17:59.918 case that is expansionary but it doesn't 00:17:58.599 --> 00:18:01.119 affect the interest rate it doesn't 00:17:59.919 --> 00:18:04.080 affect the exchange rate or anything 00:18:01.119 --> 00:18:05.678 like that again it's less expansionary 00:18:04.079 --> 00:18:08.639 than in closed economy because part of 00:18:05.679 --> 00:18:08.640 that energy will go to 00:18:08.720 --> 00:18:15.200 inputs then I went to this diagram and 00:18:11.319 --> 00:18:17.678 and I play with this uh diagram here I 00:18:15.200 --> 00:18:21.840 said well suppose that the expected 00:18:17.679 --> 00:18:24.519 exchanger goes up then what which curves 00:18:21.839 --> 00:18:26.519 change and the first one that changes is 00:18:24.519 --> 00:18:28.558 this one no this one moves to the right 00:18:26.519 --> 00:18:30.679 so you get an appreciation today and 00:18:28.558 --> 00:18:33.319 that also means that this curve here the 00:18:30.679 --> 00:18:36.000 yes will shift to the left okay if the 00:18:33.319 --> 00:18:37.678 spected exchanger goes up and you don't 00:18:36.000 --> 00:18:39.599 change monetary policy that means 00:18:37.679 --> 00:18:41.720 interest rate will go 00:18:39.599 --> 00:18:43.119 up sorry and you don't change monetary 00:18:41.720 --> 00:18:45.038 policy that means the current exchanger 00:18:43.119 --> 00:18:47.798 will appreciate that will reduce net 00:18:45.038 --> 00:18:50.720 export and and that's a shift in this 00:18:47.798 --> 00:18:53.240 space as a shift in the yes to the left 00:18:50.720 --> 00:18:55.480 okay this is a parameter these two 00:18:53.240 --> 00:18:58.839 things are parameters now in the ls 00:18:55.480 --> 00:19:00.720 diagram okay what about for an output uh 00:18:58.839 --> 00:19:03.759 going down well that doesn't affect the 00:19:00.720 --> 00:19:07.720 uip condition but it does affect net 00:19:03.759 --> 00:19:10.079 export so that moves I to the left okay 00:19:07.720 --> 00:19:13.200 and the last thing we did was an 00:19:10.079 --> 00:19:16.319 increase in in in isar and an increase 00:19:13.200 --> 00:19:18.279 in isar what does is know is that at the 00:19:16.319 --> 00:19:19.960 same interest rate then you know that 00:19:18.279 --> 00:19:21.480 you need a depreciation of the currency 00:19:19.960 --> 00:19:23.519 today because that will lead to an 00:19:21.480 --> 00:19:25.360 apprec expected appreciation so that 00:19:23.519 --> 00:19:29.519 means that this uip PE curve moves to 00:19:25.359 --> 00:19:32.199 the left and the is curve 00:19:29.519 --> 00:19:34.000 moves to the right that's an increase in 00:19:32.200 --> 00:19:36.759 the interest rate taken as given for an 00:19:34.000 --> 00:19:38.000 output okay if for an output also 00:19:36.759 --> 00:19:41.200 changes then you have to look at the 00:19:38.000 --> 00:19:44.880 combination of the two things okay but 00:19:41.200 --> 00:19:46.919 um but taking for an output as given 00:19:44.880 --> 00:19:48.520 then this Curve will shift to the left 00:19:46.919 --> 00:19:51.440 and that will move the to the right 00:19:48.519 --> 00:19:51.440 because the exchanger will 00:19:52.599 --> 00:19:56.678 depreciate you said sometimes countries 00:19:54.839 --> 00:19:58.399 choose to fix exchange rates and when 00:19:56.679 --> 00:20:00.640 you fix an exchange rate well and if 00:19:58.400 --> 00:20:02.480 it's credible exchange rate then the 00:20:00.640 --> 00:20:03.919 spected exchange rate equal to the 00:20:02.480 --> 00:20:06.159 actual exchange rate equal to some 00:20:03.919 --> 00:20:07.880 constant then that implies immediately 00:20:06.159 --> 00:20:10.120 that the domestic interest rate has to 00:20:07.880 --> 00:20:12.159 be equal to International interest rate 00:20:10.119 --> 00:20:13.879 okay so that if you fix your exchange 00:20:12.159 --> 00:20:15.520 rate to someone else then you give up 00:20:13.880 --> 00:20:19.200 your monetary policy the monetary policy 00:20:15.519 --> 00:20:19.200 is run by a different country 00:20:19.319 --> 00:20:25.759 okay okay good okay so that's a very 00:20:22.880 --> 00:20:28.760 important lecture play with it please 00:20:25.759 --> 00:20:30.279 well we then we look more carefully at 00:20:28.759 --> 00:20:32.879 at at 00:20:30.279 --> 00:20:36.000 uh at different exchanger 00:20:32.880 --> 00:20:39.200 regimes ER and and the effectiveness of 00:20:36.000 --> 00:20:40.960 policy within each of this regime the 00:20:39.200 --> 00:20:43.919 flexible exchange rate system which is 00:20:40.960 --> 00:20:46.000 the one we were discussing before H you 00:20:43.919 --> 00:20:48.038 get sort of you know if a country is in 00:20:46.000 --> 00:20:50.759 a recession you can use fiscal policy I 00:20:48.038 --> 00:20:52.400 showed you that before it works well ER 00:20:50.759 --> 00:20:54.200 and you can also use expansionary 00:20:52.400 --> 00:20:56.440 monetary policy which will be very 00:20:54.200 --> 00:20:58.960 successful for two reasons one the 00:20:56.440 --> 00:21:01.360 traditional one but the second reason is 00:20:58.960 --> 00:21:04.640 that it will depreciate your currency 00:21:01.359 --> 00:21:06.199 okay good now then we say suppose that 00:21:04.640 --> 00:21:08.200 you have a country that that is also in 00:21:06.200 --> 00:21:10.240 a recession but you have a a fixed 00:21:08.200 --> 00:21:12.240 exchange rate well then you still can 00:21:10.240 --> 00:21:14.919 use fiscal policy there's nothing 00:21:12.240 --> 00:21:17.240 against that but but you cannot use the 00:21:14.919 --> 00:21:18.759 expansion in monetary policy okay so 00:21:17.240 --> 00:21:21.759 that's a limitation of fixed exchang 00:21:18.759 --> 00:21:21.759 that you lose an important 00:21:22.038 --> 00:21:28.359 tool another problem that can arise with 00:21:25.359 --> 00:21:30.678 fix fixable exch fixed exchange rates is 00:21:28.359 --> 00:21:33.199 is speculative attacks on the currency 00:21:30.679 --> 00:21:35.440 sometimes the peg is not credible and 00:21:33.200 --> 00:21:37.919 when the peg is not credible you can 00:21:35.440 --> 00:21:41.400 imagine that you know that suppose that 00:21:37.919 --> 00:21:41.400 people expect your currency to 00:21:41.440 --> 00:21:46.679 depreciate depreciate so expected 00:21:43.720 --> 00:21:49.558 exchanger goes down and and suppose that 00:21:46.679 --> 00:21:50.880 you do want to keep your peg today 00:21:49.558 --> 00:21:52.918 that's what typically happens somebody 00:21:50.880 --> 00:21:55.200 speculates against your P But Central 00:21:52.919 --> 00:21:57.640 Bank resist that for a while but the 00:21:55.200 --> 00:21:59.798 only way it can resist that short of 00:21:57.640 --> 00:22:03.000 closing the capital account and doing 00:21:59.798 --> 00:22:05.440 all sort of things there but you haven't 00:22:03.000 --> 00:22:07.359 learned about those so don't worry H the 00:22:05.440 --> 00:22:09.038 only tool you have here to defend a 00:22:07.359 --> 00:22:10.759 speculative attack on your currency that 00:22:09.038 --> 00:22:13.240 is for the exchange not to depreciate 00:22:10.759 --> 00:22:14.879 today is by raising interest rate so the 00:22:13.240 --> 00:22:16.079 defense of an exchange rate causes a 00:22:14.880 --> 00:22:18.559 recession at 00:22:16.079 --> 00:22:20.240 home that's another problem that 00:22:18.558 --> 00:22:22.720 flexible exchange rate 00:22:20.240 --> 00:22:24.240 have and and there are sort of the deal 00:22:22.720 --> 00:22:26.200 seems pretty obvious that you don't want 00:22:24.240 --> 00:22:28.880 to have a fixed exchange rate and I said 00:22:26.200 --> 00:22:30.519 well be careful because flexible 00:22:28.880 --> 00:22:31.919 exchange rate are also not a panasa you 00:22:30.519 --> 00:22:33.918 may get lots of volatility in the 00:22:31.919 --> 00:22:37.840 exchange rate because the role of 00:22:33.919 --> 00:22:40.440 expectations is sort of is is very 00:22:37.839 --> 00:22:42.000 important um anyways this looks 00:22:40.440 --> 00:22:43.960 complicated but it's essentially what we 00:22:42.000 --> 00:22:45.599 did later on when we price equity and 00:22:43.960 --> 00:22:48.798 things like that we use sort of the same 00:22:45.599 --> 00:22:50.399 sort of iterated substitutions of things 00:22:48.798 --> 00:22:53.158 this was just meant to say that in a 00:22:50.400 --> 00:22:55.038 flexible exchange rate really and if 00:22:53.159 --> 00:22:56.720 once you endogenize Spector exchange you 00:22:55.038 --> 00:22:58.960 don't take it as a constant it gets to 00:22:56.720 --> 00:23:00.240 be very complicated because effectively 00:22:58.960 --> 00:23:03.079 The Exchange is spin down by the 00:23:00.240 --> 00:23:05.558 expectations of infinite Horizon of 00:23:03.079 --> 00:23:07.599 interest rate at home and abroad so so 00:23:05.558 --> 00:23:09.519 there's lots of space for creativity and 00:23:07.599 --> 00:23:13.158 moving things around and that's the 00:23:09.519 --> 00:23:13.158 reason exchanges can be very 00:23:14.240 --> 00:23:21.440 volatile okay good so anyway so all that 00:23:17.759 --> 00:23:23.038 that was it for ER Mandel flaming plus 00:23:21.440 --> 00:23:26.000 okay any question about that because now 00:23:23.038 --> 00:23:28.798 I'm going to move to the next part okay 00:23:26.000 --> 00:23:31.558 so then then uh The Next Step uh was to 00:23:28.798 --> 00:23:34.839 look at the asset prices really and or 00:23:31.558 --> 00:23:38.440 valuations of Assets in general that 00:23:34.839 --> 00:23:40.199 that have cash flows in the future or or 00:23:38.440 --> 00:23:43.480 or and exchange it's a little bit like 00:23:40.200 --> 00:23:44.519 that by the way but we talk a lot about 00:23:43.480 --> 00:23:48.278 current 00:23:44.519 --> 00:23:51.200 events but the key thing was this no we 00:23:48.278 --> 00:23:55.000 said okay you know many 00:23:51.200 --> 00:23:57.600 things ER many Financial or real assets 00:23:55.000 --> 00:23:59.079 actually or even your human wealth we 00:23:57.599 --> 00:24:01.399 discuss later on 00:23:59.079 --> 00:24:02.678 you know you you you you you you are 00:24:01.400 --> 00:24:04.159 receiving some income today but you're 00:24:02.679 --> 00:24:07.080 also expecting to receive income in the 00:24:04.159 --> 00:24:08.600 future and this part was about how do we 00:24:07.079 --> 00:24:10.359 value those things that we receive in 00:24:08.599 --> 00:24:12.719 the future those cash flows that come in 00:24:10.359 --> 00:24:13.918 the future and so we developed this 00:24:12.720 --> 00:24:16.720 concept 00:24:13.919 --> 00:24:18.840 of expected present discounted value and 00:24:16.720 --> 00:24:20.679 we said well very natural way of 00:24:18.839 --> 00:24:23.399 bringing dollars receiving the future to 00:24:20.679 --> 00:24:26.440 the present is to discount them by the 00:24:23.400 --> 00:24:28.120 interest rate between now and then okay 00:24:26.440 --> 00:24:30.640 and and the reason the logic behind that 00:24:28.119 --> 00:24:32.479 is because if you give me a dollar today 00:24:30.640 --> 00:24:34.480 I can do a lot more than if you give me 00:24:32.480 --> 00:24:36.399 a dollar five years from now because I 00:24:34.480 --> 00:24:38.519 can invest the dollar today and earn the 00:24:36.398 --> 00:24:40.918 interest rate return up to five years 00:24:38.519 --> 00:24:42.599 from now so a dollar today is worth a 00:24:40.919 --> 00:24:45.159 lot more than five years a dollar five 00:24:42.599 --> 00:24:46.719 years from now therefore a dollar five 00:24:45.159 --> 00:24:49.120 years from now is worth a lot less than 00:24:46.720 --> 00:24:50.880 a dollar today how much less one over 00:24:49.119 --> 00:24:53.158 one plus the interest rate over that 00:24:50.880 --> 00:24:55.760 period which is 00:24:53.159 --> 00:24:58.520 okay so that's what we did then I show 00:24:55.759 --> 00:25:00.480 you sort of a general a general cash 00:24:58.519 --> 00:25:03.079 flow this is an asset that gives a cash 00:25:00.480 --> 00:25:04.880 flow ZT at the beginning of this period 00:25:03.079 --> 00:25:07.439 ZT plus one at the beginning of the next 00:25:04.880 --> 00:25:09.039 one or at the end of this one something 00:25:07.440 --> 00:25:10.720 like that well this one you don't need 00:25:09.038 --> 00:25:12.079 to Discount that one you do need to 00:25:10.720 --> 00:25:14.159 Discount because you're not receiving it 00:25:12.079 --> 00:25:15.839 now you're receiving it a year from now 00:25:14.159 --> 00:25:17.679 this when you need it's two years from 00:25:15.839 --> 00:25:19.158 now you need to discount it more because 00:25:17.679 --> 00:25:21.720 you know it's two years that you could 00:25:19.159 --> 00:25:25.720 be earning interest rate and so on so 00:25:21.720 --> 00:25:25.720 forth okay this formula you need to 00:25:27.079 --> 00:25:31.079 understand uh and I said well that's if 00:25:29.599 --> 00:25:33.319 you know the future if you don't know 00:25:31.079 --> 00:25:35.079 the future then you just replace the 00:25:33.319 --> 00:25:36.678 things you don't know for the respected 00:25:35.079 --> 00:25:38.960 value that's what and that's the 00:25:36.679 --> 00:25:41.200 approximation in real I mean if you were 00:25:38.960 --> 00:25:43.440 to do this formally it's a little more 00:25:41.200 --> 00:25:46.000 complicated but for this course that's 00:25:43.440 --> 00:25:48.440 all that you do 00:25:46.000 --> 00:25:52.079 okay and then I look at some particular 00:25:48.440 --> 00:25:53.960 cases this this is a case the same case 00:25:52.079 --> 00:25:55.519 but in one in which the interest rate is 00:25:53.960 --> 00:25:57.159 constant suppose that you expect the 00:25:55.519 --> 00:25:58.798 interest rate to be constant then is a 00:25:57.159 --> 00:26:01.480 little simpler expression because rather 00:25:58.798 --> 00:26:03.639 than getting these products of one plus 00:26:01.480 --> 00:26:06.640 one the interest rates at different 00:26:03.640 --> 00:26:08.880 times H you get just powers of one plus 00:26:06.640 --> 00:26:10.440 I then another one that is simpler 00:26:08.880 --> 00:26:13.640 obviously is one in which all these 00:26:10.440 --> 00:26:16.320 expected payments are constant and so on 00:26:13.640 --> 00:26:18.278 and then even simpler if you spec if the 00:26:16.319 --> 00:26:21.079 con if the interest rate is constant and 00:26:18.278 --> 00:26:23.839 the payment is constant H you get some 00:26:21.079 --> 00:26:26.199 simple formulas like that simpler 00:26:23.839 --> 00:26:28.398 formulas and then cases in which asset 00:26:26.200 --> 00:26:31.000 lives forever of that kind then that's 00:26:28.398 --> 00:26:32.879 value if you don't pay for if you don't 00:26:31.000 --> 00:26:34.240 receive the the First Cash Flow now but 00:26:32.880 --> 00:26:35.919 you receive it at the beginning of next 00:26:34.240 --> 00:26:38.798 year or at the end of this one then it 00:26:35.919 --> 00:26:40.840 gets even simpler like that and I you're 00:26:38.798 --> 00:26:42.759 going to get a question of this kind 00:26:40.839 --> 00:26:45.639 okay and which you're going to be asked 00:26:42.759 --> 00:26:49.319 to compare two different assets that 00:26:45.640 --> 00:26:50.440 have a different profiles of cash flows 00:26:49.319 --> 00:26:53.759 and you're going to have to compare 00:26:50.440 --> 00:26:56.200 between those two okay then we talk 00:26:53.759 --> 00:26:57.720 about bonds and bond yields and 00:26:56.200 --> 00:27:00.798 essentially we use expected present 00:26:57.720 --> 00:27:02.720 discounted value formula just for bonds 00:27:00.798 --> 00:27:04.798 and bonds bonds have a very particular 00:27:02.720 --> 00:27:07.679 form profile of payment typically some 00:27:04.798 --> 00:27:09.398 coupons and some final payment which is 00:27:07.679 --> 00:27:12.038 we call it the face value of the bond or 00:27:09.398 --> 00:27:14.319 something like that and we said a very 00:27:12.038 --> 00:27:17.919 important Concept in bonds is 00:27:14.319 --> 00:27:20.359 maturity maturity is the date or the 00:27:17.919 --> 00:27:22.679 number of years till the last payment on 00:27:20.359 --> 00:27:24.359 that Bond okay doesn't matter whether 00:27:22.679 --> 00:27:26.840 you receive lots of little coupons along 00:27:24.359 --> 00:27:28.558 the way and one final payment whether 00:27:26.839 --> 00:27:31.278 you receive no payment what whatever 00:27:28.558 --> 00:27:34.839 until the last date that doesn't matter 00:27:31.278 --> 00:27:36.798 the maturity of a bond is the date the 00:27:34.839 --> 00:27:38.439 number of years till the last time you 00:27:36.798 --> 00:27:41.079 your last payment 00:27:38.440 --> 00:27:43.519 okay so we give some examples there a 00:27:41.079 --> 00:27:47.599 bond that pays nothing now but pays 101 00:27:43.519 --> 00:27:50.480 year from now ER has a has a price is a 00:27:47.599 --> 00:27:52.398 pres is discounted value of 100 no one 00:27:50.480 --> 00:27:54.000 year divided by one plus the one year 00:27:52.398 --> 00:27:57.879 interest rate at time 00:27:54.000 --> 00:28:00.440 T um a bond that pays nothing up to two 00:27:57.880 --> 00:28:03.159 years and then in the second at the end 00:28:00.440 --> 00:28:05.080 then after two years pays $100 then 00:28:03.159 --> 00:28:09.120 that's a value the price of that bond 00:28:05.079 --> 00:28:11.960 which is 100 discounted by that 00:28:09.119 --> 00:28:15.479 okay H then we look at Arbitrage which 00:28:11.960 --> 00:28:17.440 is says suppose that you you hold a bond 00:28:15.480 --> 00:28:20.240 that that you're considering 00:28:17.440 --> 00:28:21.798 investing your money for one year but 00:28:20.240 --> 00:28:24.079 you have two options one is to buy a 00:28:21.798 --> 00:28:25.759 one-year Bond the alternative is to buy 00:28:24.079 --> 00:28:27.879 a two-year Bond now and sell it at the 00:28:25.759 --> 00:28:29.079 end of the year those two strategies 00:28:27.880 --> 00:28:32.880 should would give you more or less the 00:28:29.079 --> 00:28:34.319 same return H well you know if you if 00:28:32.880 --> 00:28:37.679 you buy a one-year Bond you're going to 00:28:34.319 --> 00:28:40.678 get 1 plus i1t at the end of the year if 00:28:37.679 --> 00:28:43.360 you go through the two-year Bond 00:28:40.679 --> 00:28:45.200 strategy then H you're going to pay this 00:28:43.359 --> 00:28:48.599 today but you're going to you're going 00:28:45.200 --> 00:28:51.038 to H ER rece expect you expect to 00:28:48.599 --> 00:28:53.719 receive the price of a oneyear bond one 00:28:51.038 --> 00:28:56.679 year from now and we said these two 00:28:53.720 --> 00:28:59.159 things have to be equal more or less 00:28:56.679 --> 00:29:01.919 equal I mean again we're not adding risk 00:28:59.159 --> 00:29:03.679 to these things H if there's no risk 00:29:01.919 --> 00:29:06.278 consideration of agents at risk neutral 00:29:03.679 --> 00:29:08.200 then these two things have to be equal H 00:29:06.278 --> 00:29:10.960 that allows you to solve for the price 00:29:08.200 --> 00:29:12.919 of a two-year Bond as expected price of 00:29:10.960 --> 00:29:14.440 a oneyear bond one year from now divided 00:29:12.919 --> 00:29:17.200 by one plus the interest rate but the 00:29:14.440 --> 00:29:19.679 expected price of one year bond one year 00:29:17.200 --> 00:29:22.600 from now is going to be like a oneyear 00:29:19.679 --> 00:29:26.360 bond but one year from now so it's 100 00:29:22.599 --> 00:29:28.480 divided 1 + i1 t + 1 expected value I 00:29:26.359 --> 00:29:30.278 can stick that in there and I get EX the 00:29:28.480 --> 00:29:33.919 same expression okay so these are two 00:29:30.278 --> 00:29:38.759 different ways of pricing a 00:29:33.919 --> 00:29:40.960 bond or any other asset by 00:29:38.759 --> 00:29:43.398 actually and then we Define the yield to 00:29:40.960 --> 00:29:46.000 maturity so that's an important 00:29:43.398 --> 00:29:51.000 concept yield to 00:29:46.000 --> 00:29:53.319 maturity is is is is a is a rate that is 00:29:51.000 --> 00:29:57.599 a constant 00:29:53.319 --> 00:29:58.639 rate that gives you Thea exactly the 00:29:57.599 --> 00:30:00.079 same 00:29:58.640 --> 00:30:03.600 that gives you the current price of the 00:30:00.079 --> 00:30:07.158 bond okay so we already determined the 00:30:03.599 --> 00:30:10.639 the price of a two-year bond is that 00:30:07.159 --> 00:30:12.679 okay and now I'm saying well suppose 00:30:10.640 --> 00:30:14.519 that let me look for a rate that is the 00:30:12.679 --> 00:30:17.440 same in both 00:30:14.519 --> 00:30:18.359 periods that gives me the same price and 00:30:17.440 --> 00:30:21.080 that's that's the reason I have a 00:30:18.359 --> 00:30:25.038 subscript two here at time T so what is 00:30:21.079 --> 00:30:29.519 the rate that if I put a constant rate 00:30:25.038 --> 00:30:33.599 so I have 1 + I2 T * 1 + 00:30:29.519 --> 00:30:36.038 i2t gives me exactly the same price as 00:30:33.599 --> 00:30:37.038 the one we already determined okay and 00:30:36.038 --> 00:30:40.038 that's what we call the yield to 00:30:37.038 --> 00:30:41.558 maturity or the yield or or the end in 00:30:40.038 --> 00:30:45.720 this case would be a two-year rate if 00:30:41.558 --> 00:30:49.158 you hear what is a two-year rate is that 00:30:45.720 --> 00:30:51.759 okay H so so we know what this price is 00:30:49.159 --> 00:30:53.480 which is equal to that that's this 00:30:51.759 --> 00:30:57.278 expression there so the whole trick here 00:30:53.480 --> 00:30:59.079 is to find the 2-year rate at time T 00:30:57.278 --> 00:31:01.038 that that gives exactly the same value 00:30:59.079 --> 00:31:03.398 that means obviously since 100 is equal 00:31:01.038 --> 00:31:07.119 to 100 it means to find the i2t that 00:31:03.398 --> 00:31:08.798 gives you this equal to that which would 00:31:07.119 --> 00:31:10.599 say is approximate implies that 00:31:08.798 --> 00:31:12.960 approximately the twoyear rate is like 00:31:10.599 --> 00:31:16.199 an average of the two rate of the two 00:31:12.960 --> 00:31:18.079 onee rates okay but this concept you 00:31:16.200 --> 00:31:21.038 should know what it 00:31:18.079 --> 00:31:23.918 is I said there are two forms of risk in 00:31:21.038 --> 00:31:26.038 a bond there one one type of risk is the 00:31:23.919 --> 00:31:27.720 fall risk what if the issuer of the bond 00:31:26.038 --> 00:31:30.679 doesn't pay you now there's a huge issue 00:31:27.720 --> 00:31:32.639 with the US you know Deb ceiling because 00:31:30.679 --> 00:31:34.759 if they somehow they don't fix that 00:31:32.638 --> 00:31:36.479 there will be a default on some treasury 00:31:34.759 --> 00:31:39.759 bonds let's hope that it doesn't happen 00:31:36.480 --> 00:31:42.159 but but but that's theault risk is that 00:31:39.759 --> 00:31:43.960 whoever issued the debt at the time in 00:31:42.159 --> 00:31:47.278 which he should be paying you a coupon 00:31:43.960 --> 00:31:49.399 or or the principal the face value it 00:31:47.278 --> 00:31:52.960 doesn't pay you that's the fall risk 00:31:49.398 --> 00:31:55.558 okay and and and typically US Treasury 00:31:52.960 --> 00:31:58.519 bonds don't have the risk so nobody 00:31:55.558 --> 00:32:01.398 worries about that at this moment 00:31:58.519 --> 00:32:03.798 the default risk price in US bonds for 00:32:01.398 --> 00:32:07.359 one month bonds is higher than that of 00:32:03.798 --> 00:32:09.558 Mexico the bonds in Mexico or Brazil 00:32:07.359 --> 00:32:13.798 that tells you that the kind of things 00:32:09.558 --> 00:32:16.000 we have but in any EV so so this is a 00:32:13.798 --> 00:32:17.879 temporary default risk I mean nobody 00:32:16.000 --> 00:32:20.119 expects in the US that this will not be 00:32:17.880 --> 00:32:20.919 eventually repaid but you can cause a 00:32:20.119 --> 00:32:24.638 big 00:32:20.919 --> 00:32:26.679 mess by just ER delaying a a coupon 00:32:24.638 --> 00:32:28.359 payment I mean when when when these 00:32:26.679 --> 00:32:31.159 coupons are huge no 00:32:28.359 --> 00:32:33.599 and so so that's what's leading to all 00:32:31.159 --> 00:32:36.080 this concern but but in any 00:32:33.599 --> 00:32:37.439 EV that's one type of risk but we didn't 00:32:36.079 --> 00:32:39.599 look at that type of risk a lot the 00:32:37.440 --> 00:32:41.200 corporate bonds have a lot of that risk 00:32:39.599 --> 00:32:42.798 but we didn't look at that kind of risk 00:32:41.200 --> 00:32:45.919 we look at the another kind of risk 00:32:42.798 --> 00:32:47.798 which is price risk no if you have a one 00:32:45.919 --> 00:32:49.038 you invest in your oneyear bond there no 00:32:47.798 --> 00:32:51.038 price risk you're going to get your 00:32:49.038 --> 00:32:52.960 coupon your face value of 100 at the end 00:32:51.038 --> 00:32:54.919 of the year that's it if you go through 00:32:52.960 --> 00:32:56.240 a two-year strategy there's a risk there 00:32:54.919 --> 00:32:58.000 because you don't know exactly what the 00:32:56.240 --> 00:33:00.319 price of the two oneyear Bond will will 00:32:58.000 --> 00:33:03.480 be one year from now and there's a risk 00:33:00.319 --> 00:33:06.839 there we are not looking at what risk 00:33:03.480 --> 00:33:09.440 Avers cons investors do and so on but in 00:33:06.839 --> 00:33:11.558 reality there is such a risk okay and 00:33:09.440 --> 00:33:13.798 just the way we mold that is we said 00:33:11.558 --> 00:33:16.839 well then if I'm going to go through two 00:33:13.798 --> 00:33:19.278 years through a two-year bone route for 00:33:16.839 --> 00:33:23.000 a one-year investment then I don't have 00:33:19.278 --> 00:33:25.398 to H set this equal to the return I get 00:33:23.000 --> 00:33:27.480 in the sh Bond the oneyear bond I have 00:33:25.398 --> 00:33:29.079 to add an extra risk premium and then 00:33:27.480 --> 00:33:32.440 where right to this formula using the 00:33:29.079 --> 00:33:34.240 same steps we said well the one the the 00:33:32.440 --> 00:33:37.399 the two-year rate is really the average 00:33:34.240 --> 00:33:39.079 of the one expected onee rates plus a a 00:33:37.398 --> 00:33:40.239 premium and we call that actually the 00:33:39.079 --> 00:33:42.599 term 00:33:40.240 --> 00:33:44.399 premium you're more likely to face a 00:33:42.599 --> 00:33:45.719 question about the top of this slide and 00:33:44.398 --> 00:33:48.518 the bottom of the slide but I don't 00:33:45.720 --> 00:33:48.519 remember 00:33:48.558 --> 00:33:53.000 fully 00:33:50.278 --> 00:33:55.440 ER stock prices and Present Value well 00:33:53.000 --> 00:33:56.558 it's the same sort of idea know the only 00:33:55.440 --> 00:34:02.360 difference is 00:33:56.558 --> 00:34:04.678 that that that uh equities do not have 00:34:02.359 --> 00:34:07.479 maturity stocks do not have maturity in 00:34:04.679 --> 00:34:10.200 principle a company would last forever 00:34:07.480 --> 00:34:12.519 and and and so there's no there's no 00:34:10.199 --> 00:34:15.279 maturity and there is also the 00:34:12.519 --> 00:34:17.440 commitment of the coupons are a lot 00:34:15.280 --> 00:34:19.119 shakier in the sense that you know yeah 00:34:17.440 --> 00:34:20.760 compan is likely to give dividends they 00:34:19.119 --> 00:34:21.679 may announce a dividend policy but it's 00:34:20.760 --> 00:34:24.040 not a 00:34:21.679 --> 00:34:26.358 commitment if you know Regional Banks 00:34:24.039 --> 00:34:28.279 now are not giving any dividend because 00:34:26.358 --> 00:34:30.918 they want to preserve the capital okay 00:34:28.280 --> 00:34:32.879 they could but they're not because they 00:34:30.918 --> 00:34:34.440 want to build Capital just to be more 00:34:32.878 --> 00:34:38.279 resilient 00:34:34.440 --> 00:34:40.039 to any fly bad news okay but anyway so 00:34:38.280 --> 00:34:42.079 Equity that that means that you always 00:34:40.039 --> 00:34:44.440 have this future price floating around 00:34:42.079 --> 00:34:46.879 and you can keep substituting this 00:34:44.440 --> 00:34:49.720 multiple times and essentially you get 00:34:46.878 --> 00:34:51.759 to an expression that says look the the 00:34:49.719 --> 00:34:54.118 price of equity is really this the 00:34:51.760 --> 00:34:57.000 spected present discounted value of the 00:34:54.119 --> 00:34:57.960 dividends H and that includes lots of 00:34:57.000 --> 00:34:59.119 uncertainty because because you don't 00:34:57.960 --> 00:35:01.000 know exactly where the interest rate 00:34:59.119 --> 00:35:03.838 will be in that period and so on and 00:35:01.000 --> 00:35:06.480 there's always a a a remaining term out 00:35:03.838 --> 00:35:08.799 there which also causes a lot of trouble 00:35:06.480 --> 00:35:12.400 in practice 00:35:08.800 --> 00:35:13.800 assets equities move a lot more than 00:35:12.400 --> 00:35:16.119 than what you can justify with the 00:35:13.800 --> 00:35:18.320 Spector present value of 00:35:16.119 --> 00:35:20.920 dividends there's a lot of 00:35:18.320 --> 00:35:25.200 volatility ER there are bubbles and all 00:35:20.920 --> 00:35:28.838 sort of things I told you the story of 00:35:25.199 --> 00:35:31.239 Newton and and so on so so this formula 00:35:28.838 --> 00:35:33.159 for the bonds those formulas are great 00:35:31.239 --> 00:35:35.078 for Equity you're going to be pretty far 00:35:33.159 --> 00:35:37.319 off actual prices if you use this type 00:35:35.079 --> 00:35:40.359 of formulas still people call this the 00:35:37.320 --> 00:35:43.160 fundamental value of equity and then the 00:35:40.358 --> 00:35:44.759 rest is sort of more speculative but the 00:35:43.159 --> 00:35:47.639 point is that the speculative component 00:35:44.760 --> 00:35:49.040 moves at all is is responsible for a 00:35:47.639 --> 00:35:51.358 very large share of the volatility in 00:35:49.039 --> 00:35:54.079 asset in equity price in any event I'm 00:35:51.358 --> 00:35:56.920 not going to ask you about this kind of 00:35:54.079 --> 00:35:58.280 yeah for that final equation on the SL 00:35:56.920 --> 00:36:02.680 uh there's no 00:35:58.280 --> 00:36:06.119 like expression for Q it's here keep 00:36:02.679 --> 00:36:08.358 going forever it doesn't stop yeah it 00:36:06.119 --> 00:36:09.880 just discounted more and more and more 00:36:08.358 --> 00:36:11.880 so you would expect it to be less and 00:36:09.880 --> 00:36:15.519 less important but if the thing is 00:36:11.880 --> 00:36:18.000 blowing up then you know it maybe it may 00:36:15.519 --> 00:36:19.559 dominate the the the the heavier and 00:36:18.000 --> 00:36:22.039 heavier discounting because it's further 00:36:19.559 --> 00:36:23.960 further out in the future and that's the 00:36:22.039 --> 00:36:25.800 way you create theories of bubbles you 00:36:23.960 --> 00:36:29.000 can even come up with rational bubbles 00:36:25.800 --> 00:36:32.680 into the way but again that's what of 00:36:29.000 --> 00:36:34.039 course uh what else ah then we look at 00:36:32.679 --> 00:36:36.078 what is the effect of an expansionary 00:36:34.039 --> 00:36:38.039 monetary policy on asset prices and we 00:36:36.079 --> 00:36:39.200 said well obviously it's going to if 00:36:38.039 --> 00:36:41.440 lower interest rate that's going to 00:36:39.199 --> 00:36:44.118 increase the value of any asset that 00:36:41.440 --> 00:36:45.760 pays in the future returns and so it 00:36:44.119 --> 00:36:48.640 typically is typically the case that 00:36:45.760 --> 00:36:50.400 that expansion in Monet monetary policy 00:36:48.639 --> 00:36:53.920 will lead to an appreciation of all 00:36:50.400 --> 00:36:56.720 assets uh most assets but certainly 00:36:53.920 --> 00:36:58.159 bonds will go up directly because that's 00:36:56.719 --> 00:37:00.279 where the interest rate has the maximum 00:36:58.159 --> 00:37:01.639 the clearest effect but it's also the 00:37:00.280 --> 00:37:04.119 case that it tends to be bullish for 00:37:01.639 --> 00:37:07.559 Equity as well no it's that got interest 00:37:04.119 --> 00:37:11.160 rate and that a lot of the response of 00:37:07.559 --> 00:37:13.719 equity to news has to do with expected 00:37:11.159 --> 00:37:14.960 behavior of the FED in the future do you 00:37:13.719 --> 00:37:16.399 think that this will lead them to 00:37:14.960 --> 00:37:18.679 increase interest rate or to lower 00:37:16.400 --> 00:37:20.280 interest rate and things of that kind 00:37:18.679 --> 00:37:22.078 and again I think that's a little too 00:37:20.280 --> 00:37:24.319 complicated for you for 00:37:22.079 --> 00:37:26.079 now it said what is the effect of an 00:37:24.318 --> 00:37:29.800 increase in consumer spending on asset 00:37:26.079 --> 00:37:32.200 prices well that depends I mean it's 00:37:29.800 --> 00:37:33.800 clear that that if consumers become more 00:37:32.199 --> 00:37:36.480 bullish that's going to tend to lead to 00:37:33.800 --> 00:37:38.400 more cash flows for the firms so Equity 00:37:36.480 --> 00:37:40.519 at least will go up bonds no because 00:37:38.400 --> 00:37:42.480 they don't the coupon is set fixed 00:37:40.519 --> 00:37:44.440 doesn't depend on whether the econom is 00:37:42.480 --> 00:37:47.199 doing better or worse I'm assuming 00:37:44.440 --> 00:37:48.720 there's no default risk ER but it 00:37:47.199 --> 00:37:51.199 depends a lot of what you expect the FED 00:37:48.719 --> 00:37:53.039 to do if the FED if you think that this 00:37:51.199 --> 00:37:55.598 is going to trigger a Fed hike then it's 00:37:53.039 --> 00:37:58.480 bad news for bonds you know because the 00:37:55.599 --> 00:38:00.680 F the bonds do not benefit from the 00:37:58.480 --> 00:38:03.000 economic activity and and they get hurt 00:38:00.679 --> 00:38:04.799 by higher interest rate so it depends a 00:38:03.000 --> 00:38:07.000 lot on what you anticipate the FED to do 00:38:04.800 --> 00:38:08.839 or not but again I think this is a bit 00:38:07.000 --> 00:38:13.000 more complicated than what you need to 00:38:08.838 --> 00:38:16.000 know okay the last step was 00:38:13.000 --> 00:38:17.960 to H bring expectations into the aslm 00:38:16.000 --> 00:38:20.440 model I said the model we discussed 00:38:17.960 --> 00:38:22.400 through the course on the aslm except 00:38:20.440 --> 00:38:25.280 for the part where we put the exchange 00:38:22.400 --> 00:38:26.720 rate where we you know we we have to 00:38:25.280 --> 00:38:28.880 think about the future exchange rates 00:38:26.719 --> 00:38:31.000 and things like that it was really 00:38:28.880 --> 00:38:33.119 overweight the present in reality 00:38:31.000 --> 00:38:35.559 expectations matter a lot for consu 00:38:33.119 --> 00:38:37.640 consumers decisions for firm's decisions 00:38:35.559 --> 00:38:40.920 and so on probably matters even more 00:38:37.639 --> 00:38:46.118 than the future than the present okay 00:38:40.920 --> 00:38:49.159 ER and so so what we did is we expanded 00:38:46.119 --> 00:38:51.800 H the islm to include expectation we see 00:38:49.159 --> 00:38:54.799 well consumers not only worry about 00:38:51.800 --> 00:38:57.318 disposable income this part will show up 00:38:54.800 --> 00:38:59.440 in your test so so you should understand 00:38:57.318 --> 00:39:02.318 what what the eslm model is and do the 00:38:59.440 --> 00:39:04.920 comparative Statics that correspond to 00:39:02.318 --> 00:39:06.800 this model so what we did here is as 00:39:04.920 --> 00:39:09.480 well consumers not only worry about the 00:39:06.800 --> 00:39:11.318 current disposable income H they also 00:39:09.480 --> 00:39:13.719 worry about the income they receive in 00:39:11.318 --> 00:39:15.960 the future through financial asset 00:39:13.719 --> 00:39:17.719 Financial wealth or through their future 00:39:15.960 --> 00:39:19.800 labor income that's what we call human 00:39:17.719 --> 00:39:21.959 wealth but the point is that 00:39:19.800 --> 00:39:24.160 expectations about the future matter for 00:39:21.960 --> 00:39:27.079 consumption in the first part of the 00:39:24.159 --> 00:39:28.879 course we we summarize all that in that 00:39:27.079 --> 00:39:31.000 little parameters c0 which said 00:39:28.880 --> 00:39:32.960 consumers can be bullish or not but a 00:39:31.000 --> 00:39:35.519 lot of what happens here is what shifts 00:39:32.960 --> 00:39:37.880 c0 in the first part of the of the 00:39:35.519 --> 00:39:40.559 course and and this also highlight an 00:39:37.880 --> 00:39:42.480 important concept which is typically if 00:39:40.559 --> 00:39:45.199 you expect something to have only a 00:39:42.480 --> 00:39:47.519 temporary transitory consequence it will 00:39:45.199 --> 00:39:49.159 move consumption little relative to when 00:39:47.519 --> 00:39:52.039 you expect that change to be permanent 00:39:49.159 --> 00:39:53.960 so you expect current income to be up 00:39:52.039 --> 00:39:55.838 but but future income to go back to a 00:39:53.960 --> 00:39:57.960 lower level that's not going to change 00:39:55.838 --> 00:39:58.960 current consumption a lot however if you 00:39:57.960 --> 00:40:01.440 think there's a change that will 00:39:58.960 --> 00:40:03.400 increase in consumers income permanently 00:40:01.440 --> 00:40:05.400 up well that will increase not only this 00:40:03.400 --> 00:40:07.000 but also wealth human wealth and that 00:40:05.400 --> 00:40:08.960 will lead to a much larger response of 00:40:07.000 --> 00:40:11.280 consumption 00:40:08.960 --> 00:40:13.039 okay we did more or less for the same 00:40:11.280 --> 00:40:15.519 for investment obviously what matters 00:40:13.039 --> 00:40:17.960 for investment is the is future cash 00:40:15.519 --> 00:40:20.199 flows and and there we talk about the 00:40:17.960 --> 00:40:21.800 concept of depreciation but really was 00:40:20.199 --> 00:40:24.358 this was expected present discounted 00:40:21.800 --> 00:40:28.280 value of the cash flow generated by by 00:40:24.358 --> 00:40:30.559 an extra unit of capital so expected per 00:40:28.280 --> 00:40:34.079 Val discounted value 00:40:30.559 --> 00:40:36.000 formula so we said you know we we in the 00:40:34.079 --> 00:40:38.240 first part of the course we just look at 00:40:36.000 --> 00:40:39.719 an investment function that has output 00:40:38.239 --> 00:40:40.959 here and then we have an interest rate 00:40:39.719 --> 00:40:43.559 here where now we have something that's 00:40:40.960 --> 00:40:45.519 more complicated has future output which 00:40:43.559 --> 00:40:47.639 has appr proxim for future cash flows 00:40:45.519 --> 00:40:50.119 but also current and future interest 00:40:47.639 --> 00:40:52.679 rates because those affect the value of 00:40:50.119 --> 00:40:53.838 those future cash flows H in terms of 00:40:52.679 --> 00:40:56.919 today's 00:40:53.838 --> 00:40:59.480 dollars and we put all of this together 00:40:56.920 --> 00:41:03.599 and we ended up with an expanded 00:40:59.480 --> 00:41:05.838 aggregate demand in which ER you know in 00:41:03.599 --> 00:41:09.920 which we had the same parameters that we 00:41:05.838 --> 00:41:12.719 had ER when we did the static 00:41:09.920 --> 00:41:15.838 model without expectations but now we 00:41:12.719 --> 00:41:18.279 get sort of the same things repeated 00:41:15.838 --> 00:41:20.078 here one year ahead because it it 00:41:18.280 --> 00:41:22.160 matters not only for aggregate demand 00:41:20.079 --> 00:41:24.720 not only the income the consumers are 00:41:22.159 --> 00:41:26.358 receiving today or the sales that firms 00:41:24.719 --> 00:41:29.318 are making today but also what they 00:41:26.358 --> 00:41:31.000 expect to have next year here it matters 00:41:29.318 --> 00:41:32.400 what the taxes they're paying today but 00:41:31.000 --> 00:41:35.119 also what they expect to pay in the 00:41:32.400 --> 00:41:37.000 future the interest rate matters not 00:41:35.119 --> 00:41:38.519 only today but also what they expect the 00:41:37.000 --> 00:41:42.440 interest rate to be in the future and so 00:41:38.519 --> 00:41:45.800 on okay so the bottom line is that we if 00:41:42.440 --> 00:41:47.679 we now look at the slm model I said now 00:41:45.800 --> 00:41:48.960 we have lots of more parameters all 00:41:47.679 --> 00:41:50.199 these things that happen in the future 00:41:48.960 --> 00:41:54.039 are new 00:41:50.199 --> 00:41:57.838 parameters H I said notice notice that 00:41:54.039 --> 00:41:59.440 also this curve now is a lot steeper 00:41:57.838 --> 00:42:01.880 why is that well because if you change 00:41:59.440 --> 00:42:03.838 the interest rate today without without 00:42:01.880 --> 00:42:07.119 changing the interest rate in the future 00:42:03.838 --> 00:42:10.838 then that has a small effect okay and so 00:42:07.119 --> 00:42:12.358 I said now this is becomes very steep 00:42:10.838 --> 00:42:14.880 but the equivalent to what we did the 00:42:12.358 --> 00:42:16.880 static model is a is a situation where 00:42:14.880 --> 00:42:18.280 you cut the interest rate today say the 00:42:16.880 --> 00:42:20.838 Central Bank cuts the interest rate 00:42:18.280 --> 00:42:22.559 today but it also convinces the public 00:42:20.838 --> 00:42:25.039 that they will also keep the interest 00:42:22.559 --> 00:42:27.880 rate low in the next period that is not 00:42:25.039 --> 00:42:30.279 only you move along the SAS but you also 00:42:27.880 --> 00:42:32.079 persuade the public that the interest 00:42:30.280 --> 00:42:34.880 rate will be lower in the future that 00:42:32.079 --> 00:42:35.839 will shift yes to the right and then 00:42:34.880 --> 00:42:37.800 therefore therefore you're going to get 00:42:35.838 --> 00:42:40.480 a much larger kick out of monetary 00:42:37.800 --> 00:42:42.800 policy and pol monetary policy is a lot 00:42:40.480 --> 00:42:44.318 about forward guidance is that you know 00:42:42.800 --> 00:42:46.000 you cut interest rate today but you're 00:42:44.318 --> 00:42:48.039 also telling there's always a speech 00:42:46.000 --> 00:42:50.318 after they they take the policy action 00:42:48.039 --> 00:42:52.239 which they talk about how they see 00:42:50.318 --> 00:42:54.558 interest rates going in the future and 00:42:52.239 --> 00:42:57.759 all of that that's because you want to 00:42:54.559 --> 00:42:59.079 have maximum power okay if you if if you 00:42:57.760 --> 00:43:00.160 just tell the market I'm going to change 00:42:59.079 --> 00:43:02.079 the interest rate for now and then 00:43:00.159 --> 00:43:04.679 nothing else that's going to have a very 00:43:02.079 --> 00:43:06.720 limited impact to have a large impact 00:43:04.679 --> 00:43:08.358 out of monetary policy you have to 00:43:06.719 --> 00:43:11.039 convince them that you will also affect 00:43:08.358 --> 00:43:13.799 the interest R path in the 00:43:11.039 --> 00:43:16.239 future same sort of situation here the 00:43:13.800 --> 00:43:18.960 other parameters is what happens if for 00:43:16.239 --> 00:43:21.759 example you expect future output to go 00:43:18.960 --> 00:43:23.920 up H well that's going to shift a yes to 00:43:21.760 --> 00:43:25.200 the right that's yet another reason why 00:43:23.920 --> 00:43:27.559 convincing people that you're going to 00:43:25.199 --> 00:43:29.000 cut interest rate in the future as well 00:43:27.559 --> 00:43:31.839 they going to keep them low in the 00:43:29.000 --> 00:43:33.199 future shift yes even more because if 00:43:31.838 --> 00:43:34.679 you're going to keep the interest rate 00:43:33.199 --> 00:43:36.919 low in the future that means probably 00:43:34.679 --> 00:43:38.358 the future output will be higher and 00:43:36.920 --> 00:43:40.440 since future output is higher that 00:43:38.358 --> 00:43:43.358 increases human wealth and that means 00:43:40.440 --> 00:43:46.920 consumption will tend to go up okay but 00:43:43.358 --> 00:43:49.279 do play with this and and again the the 00:43:46.920 --> 00:43:51.440 it's important to have this distinction 00:43:49.280 --> 00:43:54.440 between the impact of temporary things 00:43:51.440 --> 00:43:56.079 which is much smaller and and the the 00:43:54.440 --> 00:43:57.720 impact of permanent things which is 00:43:56.079 --> 00:44:00.680 bigger because it affect 00:43:57.719 --> 00:44:00.679 wealth 00:44:01.400 --> 00:44:08.760 okay oh that's an example okay so 00:44:04.199 --> 00:44:10.318 monetary policy again ER that's just if 00:44:08.760 --> 00:44:11.359 if you don't persuade the public that 00:44:10.318 --> 00:44:12.960 you're going to change the interest rate 00:44:11.358 --> 00:44:16.440 in the future then it just a movement 00:44:12.960 --> 00:44:19.639 along but if you also convince them that 00:44:16.440 --> 00:44:22.400 you will remain sort of H lose monetary 00:44:19.639 --> 00:44:24.118 conditions in next year then that that 00:44:22.400 --> 00:44:25.639 effectively shift the yes to the right 00:44:24.119 --> 00:44:29.920 for for a variety of Reon for two 00:44:25.639 --> 00:44:32.078 reasons at least that's much more 00:44:29.920 --> 00:44:34.400 expansionary the last thing we did is 00:44:32.079 --> 00:44:36.160 fiscal policy I said well fiscal policy 00:44:34.400 --> 00:44:39.079 fiscal policy today is contraction and 00:44:36.159 --> 00:44:40.799 there's no doubt of that but it can have 00:44:39.079 --> 00:44:43.359 but there are episodes and I show you 00:44:40.800 --> 00:44:45.720 the Irish episode in which actually may 00:44:43.358 --> 00:44:47.480 end up going the other way around in 00:44:45.719 --> 00:44:49.318 which you cut expenditure today which is 00:44:47.480 --> 00:44:51.599 contractionary but you end up actually 00:44:49.318 --> 00:44:54.039 having an expansion but for that the 00:44:51.599 --> 00:44:55.838 only way that can happen is that if 00:44:54.039 --> 00:44:58.079 somehow you affect expectations in a 00:44:55.838 --> 00:45:01.279 very significant way so that's what I 00:44:58.079 --> 00:45:04.079 said if if you ever get sort of a a a 00:45:01.280 --> 00:45:06.119 strange correl response to to a policy 00:45:04.079 --> 00:45:09.039 announcement is probably because there 00:45:06.119 --> 00:45:10.480 has been a big effect on expectations so 00:45:09.039 --> 00:45:12.480 I show you the case of Ireland because 00:45:10.480 --> 00:45:14.119 there a case that was famous in which 00:45:12.480 --> 00:45:16.119 all the people talk about there was a 00:45:14.119 --> 00:45:18.480 fiscal deficit as the big drug in the 00:45:16.119 --> 00:45:21.000 economy that there was going to be a big 00:45:18.480 --> 00:45:23.199 Day of Reckoning and that you and so on 00:45:21.000 --> 00:45:25.358 so forth so once they dealt with it sort 00:45:23.199 --> 00:45:27.000 of expectations they realize they could 00:45:25.358 --> 00:45:30.159 cut interest rates then they could 00:45:27.000 --> 00:45:31.760 realiz that that that also that that 00:45:30.159 --> 00:45:33.558 this Malay and the economy was going to 00:45:31.760 --> 00:45:35.400 go away so people became optimistic 00:45:33.559 --> 00:45:38.200 about the future and so on and they end 00:45:35.400 --> 00:45:41.280 up with an expansion okay that shows you 00:45:38.199 --> 00:45:44.358 how important expectations are so 00:45:41.280 --> 00:45:46.359 economic policy in general you the the 00:45:44.358 --> 00:45:48.519 direct immediate effect is what we have 00:45:46.358 --> 00:45:51.119 been discussing throughout the course 00:45:48.519 --> 00:45:53.920 but a lot of its power and even the sort 00:45:51.119 --> 00:45:55.800 of perverse or or or or good synergies 00:45:53.920 --> 00:45:58.519 that you get out of them has to do with 00:45:55.800 --> 00:46:01.519 what you do to with expect patience okay 00:45:58.519 --> 00:46:01.519 good