[00:16] let me um continue with the eslm PC
[00:20] model in fact I want to I Rush a little
[00:23] because I was over excited with the svb
[00:26] bank event H and and I want to make sure
[00:30] that you
[00:31] certainly understand this this mle it's
[00:34] going to be very
[00:36] important and I think it's one of the
[00:38] most important moles in in this course
[00:40] as I said
[00:41] before also I want to use a little bit
[00:45] more the this Mo itself to explain what
[00:47] is going on right now today we got hit
[00:49] by a second shock from the financial
[00:51] system and uh so so it's getting it's
[00:55] getting exciting these days so let me
[00:59] skip all this and remind you that that's
[01:02] what we we that's that's the ISL MPC
[01:05] model which I said is nothing else and
[01:08] just integrating the islm analysis with
[01:11] the Philips curve this is the part and I
[01:13] said and at this point I will follow the
[01:16] book and and assume that the central
[01:18] bank can control the real interest rate
[01:20] rather than the nominal interest rate
[01:22] which is what really controls in
[01:23] practice H but I'm going to make that
[01:26] assumption so the pictures have less
[01:27] curves moving around when when things
[01:29] are mov moving H as when we do Dynamics
[01:33] okay but that's just a eslm nothing
[01:37] different um then we look at the Philips
[01:42] curve and I said well we can we can uh I
[01:46] this is not very useful because you know
[01:48] in the as part I have output here and in
[01:52] the Philips curves I have inflation but
[01:54] then I have an employment and I don't
[01:55] want to be carrying around sort of three
[01:57] variables endogenous variables
[02:00] ER and and and so it's you know it's
[02:03] difficult to diagrams in in three
[02:05] dimension is everything less clear so
[02:07] I'm going to replace H this unemployment
[02:11] here for for output and it's very easy
[02:14] to do that with the production function
[02:15] we have because output is just equal to
[02:18] employment and employment is just equal
[02:21] to the labor force time one minus the
[02:23] rate of unemployment and we could Define
[02:25] a concept of potential output as simply
[02:28] that output that happens when employment
[02:30] is equal to the Natural level of
[02:32] employment which is equal to the labor
[02:34] force Time 1 minus the natural rate of
[02:37] unemployment and taking the difference
[02:39] subtracting the second line from the
[02:41] first one you get a concept that is used
[02:43] very frequently in microeconomics which
[02:45] is called is a concept of the output gap
[02:47] an output Gap refers to the difference
[02:49] between actual output and potential
[02:51] output in which potential output is
[02:53] nothing else of the level of output that
[02:55] you get when employment when an
[02:57] employment is at the natural rate of an
[02:59] employment
[03:00] so we get this output Gap is related to
[03:02] the employment gap and now we can
[03:05] replace the employment gap from here
[03:08] with the output Gap and we end up with a
[03:11] Philip Cur in the space of inflation and
[03:13] output gap which is something we can
[03:16] integrate very easily withm model that
[03:19] has output in it okay so that's H so the
[03:23] snpc model is
[03:25] really combining this equation with that
[03:29] equation and some model about expected
[03:31] inflation that's what the MPC model is
[03:35] so I gave you one example here one model
[03:38] of inflation this is a case of that
[03:40] central banks do not like the an Anor
[03:42] unanchor inflation expectation that's my
[03:45] model of expectation then my Philips
[03:47] curve I plug this into my Philips curve
[03:50] and I get this relationship between the
[03:52] change in inflation and the output Gap
[03:55] and it's an increasing relationship and
[03:57] that's what I'm plotting here for any
[03:59] given
[04:00] level for any given level of YN then as
[04:03] a increase output the Philips curve the
[04:07] change in inflation the left hand side
[04:09] the difference between inflation expect
[04:10] to inflation Rises that's the reason
[04:12] this upward is sloping and the reason
[04:14] this Rises has to do with all the things
[04:16] that happen in the labor market no if an
[04:18] employment if output Rises meaning an
[04:21] employment is falling you need more
[04:23] employment to produce more output if
[04:24] that's the case it's more wage pressure
[04:26] that leads to a price pressure because
[04:29] there is a the market in between wages
[04:30] and prices and that's the way you get
[04:33] into inflation okay so I gave you one
[04:37] example says okay
[04:40] suppose that we have some equilibrium
[04:42] level of output this which is the result
[04:45] of this monetary policy this rate set by
[04:48] by by the central bank and and that's
[04:52] the is which is a function of you know
[04:54] the fiscal policy of the country how
[04:55] confident are consumers and all these
[04:57] kind of things so in quiz one we really
[05:01] worry only about this top diagram okay
[05:03] and all the shocks we had were shocks
[05:05] that happen in this top diagram and we
[05:08] and we look at what happened to Output
[05:10] to equilibrium output as a
[05:12] result now this hasn't changed it hasn't
[05:15] change that block is the same as it used
[05:17] to be the only difference that we have
[05:19] here is that this level of output H
[05:22] which is the equilibrium level of output
[05:24] at any point in time needs not be equal
[05:26] to potential output and if it is not
[05:28] equal to potential output that will lead
[05:30] to something with inflation either
[05:32] inflation disinflation or something of
[05:34] that kind in this particular case the
[05:37] equilibrium level of output which is
[05:39] still determined as we used to determine
[05:40] it happens to be higher than the natural
[05:43] rate of
[05:44] output and if if output is higher than
[05:47] the rate of output that means this is
[05:50] positive which means inflation is rising
[05:52] and that's exactly what we see here it
[05:55] means inflation is above expected
[05:56] inflation when expected inflation is
[05:58] equal to lag inflation
[06:00] then that means inflation is rising okay
[06:03] and that's what we have
[06:05] here so any question about that so this
[06:08] is we just what we did is kept analysis
[06:11] we used to have and now we added this
[06:14] diagram here at the bottom because it
[06:16] turns out that yes any equilibrium here
[06:19] if I move the inter around I'm going to
[06:21] change the equilibrium level of output
[06:22] those all those are equilibrium levels
[06:24] output but that doesn't mean that that
[06:27] they're consistent with the natural ER H
[06:29] with potential output and if it's not
[06:32] equal to potential output it's a valid
[06:34] equilibrium at any point in time but
[06:35] it's going to lead to issues on the
[06:38] inflation front that's all that the the
[06:40] second diagram here tells you that we
[06:43] get issues on the inflation front with
[06:46] any equilibrium level of output that is
[06:49] different from the natural rate of
[06:51] output that's what this diagram
[06:54] does so then I said well and that's what
[06:57] happen in the short run that's what it
[06:58] does so we keep doing what we used to do
[07:00] in the first seven lectures or so and uh
[07:04] this diagram just tells us what are the
[07:05] implications for inflation that's in the
[07:07] short run the medium run we said is when
[07:10] we is that process in which output
[07:13] converges back to the Natural rate to
[07:16] potential output how does that happen
[07:19] well it involves the central bank but
[07:22] it's not that the central bank is doing
[07:23] crazyy things effect Central Bank is
[07:25] reacting to what the economy is telling
[07:27] it needs to do here is a central bank
[07:29] that supposed had
[07:31] was before doing whatever change in the
[07:33] interest rate or in the deliver this
[07:36] equilibrium output here had an inflation
[07:38] of around 2% that was consistent with
[07:40] the target it had now suddenly it finds
[07:42] itself in a situation like this and
[07:44] inflation starts climbing okay you get
[07:47] 3% one year 4% the next one 6 nine in a
[07:51] situation like that well it's very
[07:53] natural for that Central Bank if it's a
[07:54] responsible Central Bank to react to
[07:56] that and the only reaction a central
[07:58] bank can have
[08:00] the main the main reaction can have is
[08:01] to raise interest rates okay and that's
[08:03] exactly what it starts happening if the
[08:05] Central Bank finds itself with inflation
[08:07] in this Cas is that is accelerating it
[08:10] will start increasing interest rate and
[08:13] this process of acceleration of
[08:14] inflation in this case would only stop
[08:17] when output is equal to the Natural to
[08:19] potential output okay and output is
[08:22] equal we can Define implicitly what that
[08:25] interest rate is and we can call it the
[08:26] natural rate of interest rate sometimes
[08:28] we call it we sell
[08:30] interest rate of interest rate neutral
[08:32] interest rate R star lots of names for
[08:35] this interest rate but this interest is
[08:37] simply the one that gives us an
[08:39] equilibrium output in our asln diagram
[08:41] that is equal to potential output that's
[08:46] that's all that this RN means and here
[08:48] I'm solving it you know it's is the rate
[08:51] that implicitly gives us an equilibrium
[08:53] output here H that is equal to the
[08:55] Natural rate of output okay that defines
[08:58] it implicitly
[08:59] okay there we are is all that
[09:04] clear yes okay I think you're going to
[09:07] have a a big chunk of your current pie
[09:09] set is about this model and so on and
[09:12] and that's a good thing and you'll see
[09:13] it also in the next one this again I
[09:15] think this is important then I talk
[09:17] about the difference between anchor and
[09:20] an anchor expectations I said look here
[09:23] we have a situation that suppose we
[09:25] started at 2% and then we found ourself
[09:28] in a situation like that that means
[09:30] inflation start building up we got to 9%
[09:33] or so so now the FED gets scared and it
[09:35] starts raising interest rates so that's
[09:37] what we're moving up lower in output and
[09:39] as it lowers output reduces the output
[09:41] Gap and therefore reduces the change in
[09:45] inflation here but inflation keeps
[09:47] rising in this particular model because
[09:49] expected inflation is an anchor and I
[09:52] said well suppose that eventually the
[09:53] FED gets to that interest rate here so
[09:56] we get to situation like that and I
[09:58] asked the question has the FED solved
[10:00] the problem now okay finally we got to
[10:03] situation where the the interest rate is
[10:05] equal to an natural rate of interest
[10:07] rate that tells me that output is equal
[10:09] to potential output that tells me here
[10:11] that inflation is not changing problem
[10:14] is that we already had inflation of 9%
[10:17] at some point so so here inflation stops
[10:20] rising in this particular model with
[10:22] expected inflation an anchor expected
[10:24] inflation but stopping is not enough
[10:27] because that's gives leaves us level of
[10:29] inflation of
[10:30] 9% that means that the FED in order to
[10:33] bring back inflation to 2% it needs to
[10:36] go into this region so inflation starts
[10:39] coming down from 9% 7% 6% 5% and so on
[10:44] okay so if you have an anchor
[10:46] expectation and and inflation overshoots
[10:49] you're going to have to cause a
[10:50] recession and probably a severe
[10:52] recession there's no way around that and
[10:55] that's what the FED has been struggling
[10:56] to do is is struggling not to because
[10:59] the Fed we are in a situation not only
[11:01] in the US but in the US in particular
[11:03] where inflation is way above the target
[11:05] level H but expected inflation has been
[11:08] more or less stable and so this when
[11:11] people talk about being able to restore
[11:14] sort of reasonable levels of inflation
[11:17] in a soft landed manner with a soft
[11:20] Landing that means that you don't need
[11:22] to cost a b recession to bring inflation
[11:25] back to 2% you just can bring it
[11:28] smoothly here with this model of
[11:30] expected inflation doesn't work but if
[11:32] expect if the Bank Central Bank has
[11:34] credibility H and inflation remain Anor
[11:37] people continue to believe that the FED
[11:39] will go back to 2% then you don't need
[11:41] to cause a big recession otherwise you
[11:43] need to invest in bringing expectations
[11:45] down and that the only way you can
[11:47] invest in doing that is causing a
[11:48] recession okay but that's the reason I
[11:51] said central banks worry so much about
[11:54] keeping inflation credibility because
[11:56] otherwise they need to
[11:57] overshoot in order to restore um long
[12:03] run balance
[12:05] okay
[12:07] good
[12:09] now you may Wonder well this I mean this
[12:12] looks pretty simple to do no just if you
[12:15] have a problem like this just go quickly
[12:18] to that point there no and then the
[12:21] problem is over you don't let inflation
[12:23] build to 9% or something like that you
[12:26] react immediately the problem is there's
[12:28] a f sentence that was going by Milton
[12:31] fredman is that monetary policy acts on
[12:34] the economy with long and variable lags
[12:37] so first of all it's very difficult at
[12:39] any point in time to know where is
[12:41] potential output or what is the natural
[12:43] rate of unemployment I mean you sort of
[12:45] sense it but the truth is that the only
[12:47] way you really know is is by looking at
[12:50] inflation so it's inflation that really
[12:52] tells you that you're one side of the
[12:53] other it's very difficult to you you
[12:56] have some historical average and so on
[12:58] but these things do move move around so
[13:00] it's difficult at any point in time to
[13:01] know whether you you are at our end or
[13:04] not the second thing is that here
[13:07] everything happens immediately if I move
[13:10] immediately then output immediately
[13:11] jumps here that's not the way monetary
[13:13] policy operates in practice it takes
[13:15] time for monetary policy to to to affect
[13:18] the economy and so this the situation
[13:22] that happened I I would say until last
[13:25] week was the FED knew that the inflation
[13:28] was still to too high but it but it also
[13:31] knew that it had done a lot he had hiked
[13:33] rates very aggressively by a lot and
[13:35] since there are lags between the the
[13:38] increasing interest rate and and the
[13:40] declining output the fed's concern was
[13:44] well it's clear that I still have
[13:45] inflation but it may well be the case
[13:47] that when this thing finally hits the
[13:49] economy it hits us too much and we end
[13:51] up in a recession and an unwanted
[13:53] recession that was a concern okay H now
[13:58] with what is happening right now there's
[13:59] a little bit of a concern that we got to
[14:01] that point because things were very slow
[14:03] for a variety of reasons but now
[14:05] something broke and the question is now
[14:08] that something has broken well will we
[14:11] sort of decelerate the economy very very
[14:13] fast and that's a concern that's what is
[14:15] happening right now okay but that's what
[14:18] makes monetary policy much more
[14:20] difficult than this little diagram is
[14:21] that you you have all this lags these
[14:23] uncertainties and all these
[14:25] nonlinearities and Sly things happen
[14:30] okay let me tell you when things can go
[14:33] really really wrong it's not the issue
[14:35] now but but we're very close to that
[14:38] during the global recession Japan has
[14:41] experienced several episodes like this
[14:43] which is the following suppose you have
[14:45] a situation where ER your inflation is
[14:50] low typically these things happen in
[14:52] situations where your inflation is low
[14:54] and for whatever reason your natural
[14:57] rate of unemployment is is
[14:59] negative so you have inflation close to
[15:02] zero say and then the natural rate
[15:06] of interest rate is
[15:08] negative what's the problem suppose you
[15:11] have a zero lower
[15:12] bound well if you have a zero lower
[15:14] bound means that you're not going to hit
[15:16] this
[15:17] rate the best you can do if inflation is
[15:20] around zero then you set the nominal
[15:21] interest rate to zero and then the real
[15:23] interest rate is around
[15:24] zero well the problem is that at zero
[15:29] you generate negative
[15:33] inflation but if you generate negative
[15:36] inflation and the nominal interest rate
[15:38] is fixed at zero then now you get a
[15:40] positive real interest rate because the
[15:42] real interest rate is equal to the
[15:44] nominal interest rate which is zero
[15:46] minus inflation expected inflation but
[15:49] if expected inflation or inflation is
[15:52] negative minus minus is positive so that
[15:54] means your real interest rate is
[15:56] actually positive so your really you you
[15:59] wanted something negative but you end up
[16:00] with something
[16:02] positive that means now you have a big
[16:04] gap
[16:05] here so
[16:07] inflation you get into a deflation now
[16:10] now inflation is very very low it gets
[16:11] very negative well your real as
[16:14] inflation gets more and more negative
[16:16] your real interest keeps climbing so you
[16:18] keep moving further and further away
[16:20] from the natural rate of interest rate
[16:23] that's something that is very scary for
[16:26] an economy is a def deflationary trap
[16:29] and that's the way you get
[16:31] into deep recessions in fact that's what
[16:34] happened during the Great Recession in
[16:36] the
[16:36] US the
[16:38] no during the Great Depression in the US
[16:42] okay during the Great Recession we were
[16:44] close to it but we didn't get quite
[16:46] there in in because lots of things were
[16:48] done to prevent a repeat of the Great
[16:52] Depression the one of the biggest
[16:54] problems with the Great Depression ER
[16:57] was that ER monetary policy was not
[17:01] against the zero lower bound but it was
[17:03] very slow to
[17:04] react okay they were in a situation like
[17:07] in this diagram
[17:10] here and and but they kept the interest
[17:12] rate high and they moveed very slowly
[17:16] and when they tried to catch up well
[17:18] they were into deflation environment so
[17:20] the real interet was moving away from
[17:22] them despite the fact that they were
[17:24] moving the nominal interest rate down
[17:26] and that you can see here so there the
[17:28] Great depression starts around 1929 it
[17:31] starts really in
[17:33] 1929 H an employment initially was low
[17:36] then nominal interest rate was around 5%
[17:39] and inflation rate growth declined very
[17:41] rapidly in inflation rate was around
[17:44] zero so you had a one year the real
[17:47] interest rate was around 5% as well okay
[17:50] well things got worse and employment
[17:53] began to climb very rapidly and so the
[17:57] FED began to lower interest rates
[17:58] nominal interest rate you know it went
[18:00] from 5% to 4% those were unusually low
[18:04] interest rate for the time but the
[18:06] problem is that the inflation by then
[18:08] was minus 2 and a half% so the real
[18:11] interest rate they were lowering the
[18:13] nominal interest rate but the real
[18:14] interest rate was rising and
[18:16] unemployment accordingly was Rising as
[18:19] well it kept going no look see then they
[18:23] began to cut the interest rate more
[18:24] aggressively okay but but we got into
[18:28] real deflation minus 10% or so so the
[18:31] real interest rate kept
[18:33] climbing at that point was a very poor
[18:36] Le time interest rate hike was a
[18:39] disaster for unemployment and because it
[18:42] really hied the interest rate real
[18:44] interest rate even more and eventually
[18:46] got got out of it with a bunch of
[18:48] policies that were non monetary policies
[18:49] but but
[18:51] um but that's that's what happened so so
[18:53] the Great Depression was very much a
[18:55] story of this
[18:57] kind in which essentially we get we fall
[19:01] fell into depression so that interest
[19:03] rate when began to climb and got the
[19:05] economy deeper and deeper into recession
[19:07] and employment Higher and Higher and so
[19:09] on and at some point monetary policy
[19:11] just didn't work so that's the reason
[19:13] you have essentially do massive fiscal
[19:15] policy to get out of
[19:19] it let's let me talk about some of the
[19:22] shocks we have discussed in the context
[19:24] of this more complete model now ER and
[19:27] and actually okay let me go let me talk
[19:31] about sort of two canonical type shocks
[19:33] you can have two broad type of shocks or
[19:36] or policies in in this
[19:38] Ms that you want to
[19:40] analyze some of them are aggregate
[19:42] demand either policies or shocks
[19:44] whatever those are things that you know
[19:46] aggregate demand policies move the is
[19:48] curve okay the is and the LM but moves
[19:52] operates in the in the in the in the
[19:54] Goods Market so this is one case of a
[19:57] contractionary f policy no a fiscal
[20:00] consolidation so what happens here
[20:02] suppose you start an equilibrium level
[20:04] of output H equal to Natural rate of
[20:07] output but now for whatever reason we're
[20:08] running deficits that are very large you
[20:10] want to reduce the size of the deficit
[20:13] well you move the is to the left no you
[20:15] cut government expenditure you increase
[20:17] taxes that will bring output below the
[20:19] natural rate of output you go to the
[20:21] Philips curve here that means inflation
[20:23] now you you get into deflationary forces
[20:26] or inflation starts declining the result
[20:29] of that so in the short run you get
[20:30] exactly what we had in lecture five six
[20:32] or whatever know you get a contraction
[20:35] in real output but on top of that you
[20:37] start getting inflation coming down or
[20:40] even going negative and as a result of
[20:42] that the central bank will react and it
[20:45] will react and that reaction will stop
[20:47] when in the long run well when output
[20:49] goes back to the initial level of output
[20:52] it's natural rate of output okay so the
[20:54] point of this picture that is new
[20:57] relative to things you already knew
[20:59] is that in the short run you get very
[21:01] much the type of responses we had
[21:02] earlier on in the medium run that is
[21:05] when now in the medium run you don't get
[21:07] that a fiscal consolation does not
[21:09] reduce output in the medium Run Okay a
[21:12] fiscal consolation what does is reduces
[21:14] the real interest rate in the in the in
[21:16] the long in the medium run okay so you
[21:18] see here output eventually goes back to
[21:21] that level with a much lower real
[21:23] interest rate and and
[21:25] U the the point is sometimes this this
[21:29] path this path that takes you output
[21:31] down initially and then comes back can
[21:33] be very painful it can take a long time
[21:36] generate a recession and so on and
[21:38] sometimes it can happen in easier
[21:41] conditions and be faster and so on many
[21:43] of the policies agreements that people
[21:45] have people that understand what they're
[21:47] talking about had to do with the speed
[21:50] at which these things happen so
[21:51] sometimes you know people can agree that
[21:53] you need a fiscal consolidation but
[21:55] someone think no this stuff is going to
[21:56] be very slow and so I don't want to
[21:59] incur in a very deep recession for very
[22:00] long just to adjust a little bit the
[22:01] fiscal deficit and others may think the
[22:04] opposite okay it's it's mostly about the
[22:06] speed but shorter response to a fiscal
[22:09] consolidation or to any aggregate demand
[22:11] contraction is different than the medium
[22:14] ter
[22:18] response and again the signals for the
[22:21] central bank that it needs to move
[22:22] interest rate they all come from this
[22:23] block here inflation falling that tells
[22:25] the Central Bank oops we may have a
[22:28] problem and so on another kind of shock
[22:32] that is is is is is more complicated and
[22:35] that has played a role actually very
[22:37] much in the recovery from covid is some
[22:39] sort of supply side shock for example an
[22:43] oil shock okay price of energy goes up
[22:45] or something like that well that one how
[22:49] do you analyze that the a supply size
[22:51] shock is not something that comes from
[22:53] the that we go to the slm part of the
[22:56] mall a supply size shock remember we
[22:58] analyze it when we did analyze the
[23:00] natural rate of natural rate of
[23:01] unemployment it's something that affects
[23:03] the supply side of the economy we can
[23:06] model that as an increase in the markup
[23:09] and we know that an increase in the
[23:11] markup will increase the natural rate of
[23:14] unemployment that means that that that
[23:18] this shock will do what to potential
[23:24] output so an energy shock especially if
[23:27] it's a persist one will operate like a
[23:30] markup shock and that we know will
[23:34] increase the natural rate of
[23:36] unemployment so what happens to the to
[23:39] potential
[23:41] output goes down of course it's it's
[23:44] know output is equal to employment to
[23:46] labor force times 1 minus the natural
[23:48] rate of unemployment if the natural rate
[23:49] of unemployment goes up then the
[23:51] potential output goes down so that is
[23:54] not a shift in the top diagram it's a
[23:56] shift in the lower diagram it says we
[23:58] used to have this Philips curve and now
[24:01] the Philips curve has shifted to the
[24:03] left because we have a new natural rate
[24:06] of an output and remember the natural
[24:08] rate of output is that point when a ER
[24:12] output equal to the Natural rate of
[24:14] output doesn't produce inflationary
[24:16] forces okay so what happened with this
[24:20] shock here so suppose the economy was in
[24:22] this equilibrium here and now it gets
[24:25] hit by an oil shock
[24:29] in the short run if no one reacts
[24:31] nothing happens to Output doesn't move
[24:33] much but what
[24:41] happens you see if I don't move
[24:43] something in this part of the diagram
[24:45] and not move equilibrium output in the
[24:47] short run equilibrium output is
[24:49] determined exactly in the same way we
[24:50] have determined up to now so if we get a
[24:52] markup shock nothing happens to Output
[24:56] if no no one no if no moves nothing
[24:59] happens to help in the short but what
[25:05] happens that we may not like yeah
[25:08] exactly what happen is the the Philips
[25:11] curve went up before that level of
[25:13] output was consistent with no changes in
[25:16] inflation now it's not we get an
[25:20] increase in inflation so the first place
[25:22] where you'll see a the effect of the of
[25:26] of of the oil shock here is inflation
[25:28] will pick up remember the price of
[25:29] gasoline going up and all those things
[25:31] well that's where you see it first
[25:33] before activity Falls you see it there
[25:36] that's what mess up the Philips curve
[25:37] also in the 70s and 80s we going to see
[25:40] lots of shocks of this kind initially
[25:42] unemployment didn't move M much but
[25:44] inflation keeps
[25:46] climbing so that's what happens well
[25:48] obviously when that happens if it's
[25:50] persistent typically central banks if
[25:51] they think it's very short live they're
[25:53] not going to react to this stuff but if
[25:54] if it is persistent and they think it's
[25:56] persistent then the reaction is what
[25:59] well they need to this only means that
[26:02] the natural rate of
[26:03] an the the natural rate of interest has
[26:06] gone up no because I need to for that
[26:08] same is I need to bring down equilibrium
[26:12] output that means I need a higher
[26:14] natural rate of interest rate or a
[26:16] higher rst star so what the FED needs to
[26:19] do the Central Bank needs to do is just
[26:20] start increasing interest rate that's an
[26:22] natural
[26:23] response a lot of what happened during
[26:25] the covid why inflation pick up so much
[26:28] much in in Co is because we had a shock
[26:30] of this kind it was not energy the
[26:33] energy shock came later but it was
[26:35] supply side transport transport cost and
[26:38] stuff like that the network the
[26:40] production Network and things like that
[26:41] that broke down but they thought it was
[26:44] going to be very temporary so
[26:47] understanding this model they thought
[26:48] okay look this this Curve will come back
[26:51] come back that but by itself so better
[26:54] not react right now why cause a
[26:55] recession if really this Curve will come
[26:58] down back down by itself well the
[27:02] problem is that it didn't come back by
[27:03] itself that fast some things came up
[27:06] fairly fast some others did not in
[27:09] particular labor for participation did
[27:11] not come sufficiently fast back and so
[27:15] that's the reason we stay too long in a
[27:17] situation like this and that's one of
[27:20] the main reasons inflation sort of creep
[27:23] up in in the US and also in other places
[27:25] in the world in Europe the big reason
[27:29] for for why inflation picked up there is
[27:31] because this curve move a lot up why is
[27:40] that exactly you know they had a massive
[27:43] energy shock and so that moved that
[27:45] curve up a
[27:48] lot
[27:50] good let's I want to now return to what
[27:54] is going on right
[27:55] now ER oh actually first I'm going to
[27:59] yeah right now meaning the last few days
[28:01] so it turns out that this diagram that
[28:04] that I use for the fiscal consolidation
[28:06] shock can also be used to understand a
[28:09] little bit what happens with
[28:12] the um Silicon Valley Bank event okay
[28:16] remember we model that as a credit shock
[28:19] we say like like that X we had it's like
[28:21] X going up well X going up that's
[28:24] exactly that it moves the yes to the
[28:26] left so a shock to
[28:30] X to to the a panic of the kind that we
[28:34] saw is like that it moves the to the
[28:37] left why is
[28:38] that so for any given level of the safe
[28:41] real interest rate a panic a shock to
[28:44] credit and so on moves the a to the left
[28:47] why is
[28:52] that exactly so so the real the safe
[28:55] interest rate doesn't go up but but but
[28:58] what goes up is is is the cost of
[29:01] borrowing because you know firms need to
[29:04] pay this this extra risk premium and and
[29:07] then for any given safe interest rate
[29:09] real interest rate firms have to pay
[29:12] more which means there is less
[29:14] investment for any given level of the
[29:15] real interest rate and so the is moves
[29:17] to the left and if that happens then you
[29:20] start getting deflationary
[29:23] forces okay so again all this happens
[29:27] very quickly here in reality I told you
[29:30] there are lots of lags and so on but
[29:32] markets begin to anticipate what will
[29:35] happen and
[29:37] so so markets begin to anticipate so so
[29:40] in the in the immediate output doesn't
[29:43] collapse immediately anything and
[29:44] inflation doesn't be doesn't collapse
[29:47] immediately but markets realize that
[29:49] there are Long Bar there lcks but but
[29:52] there is a shock already so so it's
[29:54] likely that these things will
[29:56] happen and and and and it's likely that
[29:59] this will happen and it's also likely
[30:01] that the FED will react to
[30:04] that what should be the reaction of the
[30:06] FED if this stuff gets to be
[30:12] persistent how do you get out of a shock
[30:14] like that if you really want to go back
[30:18] there you cut interest rates okay in the
[30:21] case of the US they were hiking
[30:23] interestate because we're deing with
[30:25] dealing with high inflation this tells
[30:27] you well you should slow down the pace
[30:29] of hiking again they don't do it
[30:32] immediately they meet next week but the
[30:34] markets don't need to wait for the FED
[30:36] they anticipate what the FED is likely
[30:38] to do okay and they start betting on
[30:40] that so let me show you next a bunch of
[30:44] charts that show you that someone in the
[30:47] market understand these mechanics okay a
[30:49] lot of people because the prices are
[30:51] moving exactly that
[30:56] way so
[30:58] this is the ER oh this is something this
[31:02] is the one year ahead inflation
[31:04] expectation as traded in the market it's
[31:06] called inflation break even the one-ear
[31:08] inflation break even so if you these
[31:11] things are traded in the market and you
[31:12] can trade expected inflation at all the
[31:15] maturities you want so this is what the
[31:18] market was expecting before this shock
[31:21] you know infl we getting hotter and
[31:22] hotter numbers so the economy was
[31:24] inflation expected inflation as price in
[31:27] the market Market was climbing okay one
[31:31] year out and then the shock came and
[31:34] look what happened to expect the
[31:35] inflation boom it
[31:39] collapse okay why is that well people
[31:44] thought this shock that leads to that
[31:48] okay that's what they thought this
[31:50] bounce was markets got a little excited
[31:53] yesterday it was a little risk on
[31:55] environment today they lost all that
[31:58] but but for a shock I'm going to tell
[32:01] you about in a few minutes
[32:03] but anyways but the point I wanted to
[32:05] highlight is again expected inflation
[32:08] was getting a little out of control and
[32:11] then this x shock came the the Panic
[32:13] shock and then immediately expected
[32:15] inflation decline because people
[32:17] anticipated something like this okay the
[32:20] market anticipated something like that
[32:23] what is
[32:24] that this is the the
[32:28] [Music]
[32:29] um the markets expected next hike so
[32:34] March 22nd the the FED will decide on
[32:37] the increase in interest rate remember
[32:39] the FED had decided as I said in the
[32:41] previous lecture to go for a path of 50
[32:43] basis points initially very high but
[32:46] since a couple of meetings ago they
[32:47] decided to slow down to 25 basis points
[32:49] precisely because they want to wait and
[32:51] see a bit what what a mess do we have I
[32:53] mean there's long variable lacks they
[32:55] have increased rates a lot and and so on
[32:58] but so they had gone back to a pace of
[33:00] 25 so if you see in you know somewhere
[33:02] here in in February 22nd if you ask the
[33:05] market what what do you think will be
[33:07] the next
[33:08] hike there will be lots of answers
[33:11] trades and so on but the the when I say
[33:14] answers I mean what is price what is
[33:17] traded this financial instrument the the
[33:20] average answer was 30 basis points 30
[33:23] basis point is that most of the people
[33:25] thought that they were going to increase
[33:27] the the interest rate by 25 basis points
[33:29] and there were a few guys out there that
[33:30] thought the FED doesn't increase the
[33:32] interest rate by 33 basis points that's
[33:34] 25 50 75 okay so this 30 is meant that
[33:39] almost everyone thought it was going to
[33:41] be 25 but there were a few people that
[33:42] were concerned that could be higher than
[33:44] that what happened here we start getting
[33:47] very hot numbers on inflation and so all
[33:50] of a sudden the equilibrium changed
[33:51] dramatically and we went to 45 which
[33:54] means most people then thought in the
[33:56] market that the next hike in in in on on
[34:00] March 22nd was going to be 50 basis
[34:02] points and a few people St stay at 25
[34:05] that's the reason H this is not 0. five
[34:09] but it was almost price in that point
[34:12] when people say price in they're talking
[34:13] about this what is the hike that price
[34:15] in is this statistic look that's what
[34:19] happened with
[34:21] the Silicon Valley Bank event okay a
[34:25] collapse in this thing now now is is
[34:28] trading at around 13 basis points that
[34:31] means most of the people think that the
[34:34] Traders here think that there will be no
[34:37] hike at all okay so a few days ago they
[34:41] all thought there was going to be 50
[34:43] basis point which is a big hike H and
[34:45] now most people think there will be no
[34:47] hike whatsoever but a few think that
[34:49] it's going to be 25 me actually it's
[34:52] almost 50/50 no I think today is a
[34:54] little lower than that but it's almost
[34:55] 50/50 that is 25 or zero that's that's
[34:59] what what it is but had you ask anyone
[35:02] around here and certainly around here is
[35:04] there any chance of zero and there would
[35:06] be no one literally is that contract was
[35:09] not traded okay well you see things
[35:12] happen accidents happen so now that's
[35:15] where where we are
[35:17] at
[35:20] now if this all last a week and and
[35:23] everything gets resolved it doesn't have
[35:26] a lot of macro iic consequences okay
[35:29] it's just a little Panic you know some
[35:31] people make money some people lose money
[35:32] and so on but but but but this can be a
[35:36] very problematic shock actually because
[35:39] what you see here is that this is a size
[35:42] this is Silicon Valley
[35:44] Bank these are all the rest the banks
[35:46] smaller than
[35:48] that H it turns out that all these bank
[35:51] at this moment are reshuffling their
[35:53] portfolios they're becoming very
[35:55] conservative because they don't want to
[35:56] be exposed to similar risk they realized
[35:58] the environment became very unfriendly
[36:00] to you know that can be runs on banks in
[36:03] any moment despite the fact that it's a
[36:05] big policy package out there but people
[36:06] are still withdrawing lots of deposits
[36:08] from a small Banks small and Regional
[36:10] Banks and they all deposi it in JP
[36:12] Morgan you know the big Banks so there's
[36:14] lots of deposits that despite the the
[36:18] the the insurance the the the the the
[36:21] blanket insurance that is implicit at
[36:23] least at the moment lots of deposits
[36:24] from these sectors are moving to these
[36:26] major Banks here okay that's called it's
[36:29] called a flight to
[36:31] Quality now the problem of that for the
[36:34] economy as a whole is that small Banks
[36:37] and Regional Banks play a huge role in
[36:40] in
[36:41] lending okay I
[36:45] think a little more than 50% for example
[36:48] of the commercial and Industrial loans
[36:50] are made by small Banks ER 80% of the
[36:53] mortgages are given by a small Banks so
[36:55] it so it has a big
[36:58] potential consequence what I'm trying to
[36:59] say is that X may stay high for quite a
[37:01] bit of time okay and that's a
[37:05] reason this is start there is
[37:08] anticipation that this will have
[37:09] macroeconomic consequences and as a
[37:11] result of that that the FED will react
[37:13] that inflation will change and all
[37:17] that okay so that's where we were at on
[37:20] Monday remember when we had the lecture
[37:21] I was telling you more or less that
[37:24] story ER what is this
[37:28] you can read it there but it may not
[37:30] mean M to much to you but I'm what I'm
[37:32] highlighting is this this is pretty big
[37:35] huh 35% decline this is an equity it's a
[37:39] share so this is
[37:41] the the value of the
[37:44] equity of a pretty major Bank credit
[37:47] Swiss okay so credit Swiss have been in
[37:51] trouble for a while but today got into
[37:54] really big trouble okay and and and you
[37:58] saw sort of a massive collap collapse in
[38:00] the equity shares in fact they stopped
[38:02] trading for a while and so
[38:04] on this thing here is H you know I
[38:09] updated your slides many times today
[38:12] because I began to look at this event
[38:14] around here and then this thing kept
[38:17] going then they stop kept going and so
[38:18] and I I'm not sure where it's at now I
[38:20] stopped at what time did I stop 9 in the
[38:23] morning I was awake at 4:44 today so
[38:26] they tell you this was this was a pretty
[38:30] intense um but this what this is is the
[38:33] credit default swaps on a credit swis
[38:37] credit swap is whenever it's a bond
[38:39] issued by a bank you can buy an
[38:42] insurance on that Bond okay so it's so
[38:44] so if the bond defaults on you you then
[38:47] use the insurance and you get
[38:50] paid so these things for banks normally
[38:52] are very small numbers but for credit SS
[38:56] bigger than for other big Banks because
[38:57] I've been in in trouble for a while all
[38:59] sort of trouble but look at that Spike
[39:02] there I mean that's pretty big for these
[39:03] kind of things you know it's not Lon yet
[39:06] but
[39:07] big so anyway that caused a little Panic
[39:10] today
[39:13] ER this is the the stock prices of the
[39:16] main European Banks this is all today
[39:20] yeah so look at this it was a little
[39:23] rally yesterday and so on I mean this is
[39:25] this is the decline as a result of the
[39:28] US problem the Silicon Valley Banks then
[39:31] a rally yesterday and then credit Swiss
[39:34] happen and you has a big decline in h in
[39:39] in all the major banks in in Europe the
[39:43] US banks are also declining but but that
[39:46] was bigger for the major
[39:49] Banks the vix remember I told you last
[39:51] last week last Monday about this
[39:54] indicator of fear in the market which is
[39:56] really the price put options I'm
[39:58] simplifying things I mean protection for
[40:01] for big declines on the equity Market H
[40:04] again it began to spike very very
[40:08] sharply as a result of this is what
[40:10] happened with the US event then
[40:12] yesterday we got a rally Rison type
[40:15] thing and then today we got a new
[40:18] event look at this I like this
[40:22] picture what this is let me let me tell
[40:24] you what the the the the the blue line
[40:28] is the blue line is is the
[40:32] market ER
[40:35] expected federal funds rate at different
[40:38] days in the future okay so you know
[40:42] today the federal funds rate is is is
[40:44] around four and a half and this is what
[40:47] what the market expects okay so they
[40:51] expected so they expected the FED to
[40:53] continue to hike interest rate and to
[40:56] reach a peak
[40:58] ER around in June 14th in that meeting
[41:02] of the order of five five 5.3% or so
[41:05] that's that's what the average there
[41:07] lots of dispersion there people betting
[41:09] on 6% but that's the average that's what
[41:11] people expected the yellow thinks it's
[41:14] the number of hikes that you're likely
[41:16] to see so you know you're likely to see
[41:18] one hike in the next meeting another one
[41:20] in the next meeting and another one in
[41:22] the next meeting and then stop and begin
[41:26] sort of cutting rates that's expect that
[41:28] was expected path on Friday 10th was
[41:31] Friday more or less around there maybe
[41:33] Thursday I don't remember but anyway
[41:35] that was expected path you see so still
[41:38] hike rates reach a peak of five 5.3% and
[41:42] still sort of pretty high interest rates
[41:45] by the end of the year okay that was
[41:48] expected
[41:51] path that's the way it looks
[41:54] now very different no now
[41:58] people are expecting very small changes
[42:00] now I show you it's like 13 basis points
[42:02] what people expect okay the still people
[42:05] expect sort of a hike but but small one
[42:09] now they expect a peak to be sort of in
[42:12] May and then the FED to start cutting
[42:15] very aggressively to at the end of the
[42:17] year end up with much lower rates than
[42:20] today
[42:22] okay so this is exactly what I was
[42:24] telling you before the market is
[42:25] anticipating that that we had a huge
[42:28] contraction in the is because X went up
[42:31] a lot ER the immediate consequences
[42:35] that's going to be lower inflation yes
[42:37] we have a problem because I mean if if
[42:39] the US did not have a 5 and a half% of
[42:42] inflation
[42:44] today I can assure you that the FED
[42:47] would have come out and said we cut the
[42:48] rates right now the only reason they're
[42:51] not cutting right now is because we have
[42:53] a two problems we have the the financial
[42:55] Panic on one side and we have the High
[42:57] inflation on the other side so so they
[42:59] have to balance these two
[43:00] forces but but the expectation of the
[43:03] market is that the balance of two forces
[43:05] going to be dominated by the contraction
[43:06] and aggregate demand much sooner than
[43:09] people were expecting okay so that's
[43:11] what the market is pricing at the moment
[43:13] and what I'm saying is I was trying to
[43:15] highlight is that this is very
[43:16] consistent with
[43:21] h with that okay it's just the market
[43:25] looking ahead of what it's likely to
[43:27] Happ happen it started from a situation
[43:29] which is a little bit more complicated
[43:31] again because we already had high
[43:32] inflation well I do not know really I
[43:35] mean it is on one end more complicated
[43:39] because we have a problem of high
[43:41] inflation on the other hand having high
[43:45] inflation allows you to cut the real
[43:47] interest rate much more aggressively
[43:48] because if you bring the nominal
[43:50] interest rate to zero and you have
[43:51] inflation of 5% that allows you to cut
[43:53] the real interest rate to minus 5% well
[43:56] if you start with a situation where your
[43:57] inflation is zero you don't have any
[44:00] space to cut the real interest rate so
[44:02] the FED can be very aggressive here and
[44:04] the only reason is not being very very
[44:06] aggressive they were very aggressive in
[44:07] terms of supporting deposits and all
[44:09] that but the the the the the they can be
[44:13] very aggressive in terms of interest
[44:15] rate cut if the need arises hopefully
[44:17] won't but but they have a space because
[44:19] we're starting from a much higher level
[44:21] of inflation that
[44:22] helps it it hurts in the sense that it
[44:25] will delay the reaction but it helps in
[44:28] the sense that they have much more space
[44:30] for for
[44:34] policy what is
[44:39] this oh this is just interest one year
[44:42] interest rates okay that that reflects
[44:45] the the the previous picture as well
[44:47] people you know one year out rates were
[44:52] over
[44:53] 5% uh a few days ago and now are in the
[44:57] low
[44:58] force and this picture I kept updating
[45:01] as you can see it was really dropping
[45:06] fast that's a big change me look the one
[45:09] year rate 60 basis points that's a big
[45:14] change so that's where we're
[45:17] at I'm from the next lecture I want to
[45:19] start with growth but any questions
[45:21] about this or
[45:25] no okay I don't want to start growth now
[45:27] in four minutes but uh so the set of
[45:30] topics we're going to discuss from the
[45:31] next lecture are very
[45:33] different ER subject to not having any
[45:36] major events if there is a major major
[45:38] event I'm going to reffle things so we
[45:40] can talk about financial panics and
[45:43] things of that kind let's hope that it
[45:45] can stick to the program and do
[45:47] growth in the in the next week okay good
[45:51] or would we do