WEBVTT 00:00:00.000 --> 00:00:01.964 align:middle line:90% [SQUEAKING] 00:00:01.964 --> 00:00:03.437 align:middle line:90% [RUSTLING] 00:00:03.437 --> 00:00:04.910 align:middle line:90% [CLICKING] 00:00:04.910 --> 00:00:18.170 align:middle line:90% 00:00:18.170 --> 00:00:20.650 align:middle line:84% RICARDO CABALLERO: OK, let's start. 00:00:20.650 --> 00:00:25.010 align:middle line:84% So by now, you know the IS-LM model, 00:00:25.010 --> 00:00:29.570 align:middle line:84% and if you don't fully control it, please spend a lot of time 00:00:29.570 --> 00:00:30.980 align:middle line:90% on it. 00:00:30.980 --> 00:00:34.280 align:middle line:84% As I said, 2/3 of your quiz will be about that. 00:00:34.280 --> 00:00:37.740 align:middle line:84% But we're going to start adding a few-- 00:00:37.740 --> 00:00:40.640 align:middle line:84% it's a very basic model, but still we 00:00:40.640 --> 00:00:43.610 align:middle line:84% can squeeze a lot of insight from it. 00:00:43.610 --> 00:00:47.180 align:middle line:84% And there are some very natural extensions 00:00:47.180 --> 00:00:53.750 align:middle line:84% that I think we should also go over and cover because, again, 00:00:53.750 --> 00:00:56.630 align:middle line:84% they have a high return in terms of investment 00:00:56.630 --> 00:00:59.400 align:middle line:90% to knowledge acquired from them. 00:00:59.400 --> 00:01:02.720 align:middle line:84% And today, I want to extend this IS-LM model 00:01:02.720 --> 00:01:06.650 align:middle line:90% along two realistic dimensions. 00:01:06.650 --> 00:01:11.930 align:middle line:84% The first one is to make a distinction 00:01:11.930 --> 00:01:14.630 align:middle line:84% between nominal and real interest rates. 00:01:14.630 --> 00:01:19.380 align:middle line:84% Now, nominal, up to now, since we assume in the model, 00:01:19.380 --> 00:01:21.660 align:middle line:84% since we assume that prices were completely fixed, 00:01:21.660 --> 00:01:24.600 align:middle line:84% constant, there is no inflation, and then 00:01:24.600 --> 00:01:27.820 align:middle line:84% there is no distinction between nominal and real interest rates. 00:01:27.820 --> 00:01:30.210 align:middle line:84% But needless to say, we live in an environment 00:01:30.210 --> 00:01:32.730 align:middle line:84% with inflation is positive, typically, not always, 00:01:32.730 --> 00:01:33.910 align:middle line:90% but typically. 00:01:33.910 --> 00:01:36.700 align:middle line:84% And in fact, nowadays we're having very high inflation. 00:01:36.700 --> 00:01:39.480 align:middle line:84% And that's part of one of the big macroeconomic headaches 00:01:39.480 --> 00:01:42.090 align:middle line:84% that we have at this moment is a very high inflation rate 00:01:42.090 --> 00:01:43.230 align:middle line:90% we're experiencing. 00:01:43.230 --> 00:01:46.170 align:middle line:84% Now, we're not going to talk about the determination 00:01:46.170 --> 00:01:48.130 align:middle line:84% of inflation until later in the course. 00:01:48.130 --> 00:01:50.790 align:middle line:84% I'm going to start talking about that in the next lecture, 00:01:50.790 --> 00:01:53.220 align:middle line:84% and it will not be part of your quiz, though. 00:01:53.220 --> 00:01:55.350 align:middle line:84% Sorry, not in the next lecture, next week, 00:01:55.350 --> 00:01:58.410 align:middle line:84% but will not be part of your quiz. 00:01:58.410 --> 00:02:01.410 align:middle line:84% It will be a very important part of quiz 2, but not of quiz 1. 00:02:01.410 --> 00:02:04.560 align:middle line:84% But we can still say a few things 00:02:04.560 --> 00:02:09.509 align:middle line:84% about what happens to the framework we have, conditional 00:02:09.509 --> 00:02:11.873 align:middle line:84% or taking as a parameter inflation. 00:02:11.873 --> 00:02:14.040 align:middle line:84% We're not going to determine inflation [INAUDIBLE],, 00:02:14.040 --> 00:02:16.643 align:middle line:84% but we say, well, what happens if inflation is not really 0? 00:02:16.643 --> 00:02:18.060 align:middle line:84% And more importantly, what happens 00:02:18.060 --> 00:02:21.510 align:middle line:84% if people don't expect inflation to be really 0? 00:02:21.510 --> 00:02:26.490 align:middle line:84% And we'll see how that modifies the analysis. 00:02:26.490 --> 00:02:33.100 align:middle line:84% The second extension is that we simplify financial markets 00:02:33.100 --> 00:02:39.490 align:middle line:84% enormously and we customize it to-- 00:02:39.490 --> 00:02:41.660 align:middle line:84% we could have simplified along many dimensions, 00:02:41.660 --> 00:02:44.080 align:middle line:84% but the simplification that we have is we 00:02:44.080 --> 00:02:49.720 align:middle line:84% look at something that is closest to what central banks do 00:02:49.720 --> 00:02:50.990 align:middle line:90% in setting monetary policy. 00:02:50.990 --> 00:02:54.700 align:middle line:84% And that's really the trade between cash deposits 00:02:54.700 --> 00:02:58.840 align:middle line:90% at the central bank and bonds. 00:02:58.840 --> 00:03:01.570 align:middle line:84% US government bonds, in the case of the US, 00:03:01.570 --> 00:03:03.490 align:middle line:84% typically have very short maturity, 00:03:03.490 --> 00:03:07.180 align:middle line:84% and that's what we had in mind, and that's 00:03:07.180 --> 00:03:08.900 align:middle line:84% the way we determine the interest rate. 00:03:08.900 --> 00:03:11.080 align:middle line:84% Now, needless to say, there are many, 00:03:11.080 --> 00:03:15.250 align:middle line:84% many interest rates in the economy, different duration, 00:03:15.250 --> 00:03:19.090 align:middle line:84% one-year rate, two-year rate, three, ten, 30-year rates. 00:03:19.090 --> 00:03:22.520 align:middle line:84% Some countries have 100 year rates. 00:03:22.520 --> 00:03:26.470 align:middle line:84% But there is also another dimension, which 00:03:26.470 --> 00:03:28.510 align:middle line:84% is very important, is the one that I highlighted 00:03:28.510 --> 00:03:30.670 align:middle line:90% there, which is riskiness. 00:03:30.670 --> 00:03:33.500 align:middle line:84% US Treasury bonds, especially of short duration, 00:03:33.500 --> 00:03:35.070 align:middle line:90% are riskless assets. 00:03:35.070 --> 00:03:36.640 align:middle line:84% There's no risk associated to it. 00:03:36.640 --> 00:03:41.270 align:middle line:84% Now we have a little event with the debt ceiling fight 00:03:41.270 --> 00:03:43.310 align:middle line:84% that may happen in August, September. 00:03:43.310 --> 00:03:46.790 align:middle line:84% But nobody's really concerned that something major 00:03:46.790 --> 00:03:50.330 align:middle line:84% will happen, except for a few disruptions for a few days. 00:03:50.330 --> 00:03:51.675 align:middle line:90% Let's hope that's true. 00:03:51.675 --> 00:03:53.300 align:middle line:84% Up to now, if you look at all the risk, 00:03:53.300 --> 00:03:56.040 align:middle line:84% markets are behaving as if nothing will happen there. 00:03:56.040 --> 00:04:01.160 align:middle line:84% But corporations don't typically borrow at those rates. 00:04:01.160 --> 00:04:02.930 align:middle line:84% Corporations issue their own bonds 00:04:02.930 --> 00:04:06.470 align:middle line:84% or take loans from the banks, and those bonds often 00:04:06.470 --> 00:04:07.640 align:middle line:90% have a risk premium. 00:04:07.640 --> 00:04:10.970 align:middle line:84% That is, they're equal to the safe interest rate, the Treasury 00:04:10.970 --> 00:04:13.630 align:middle line:84% rate, if you want, plus something else. 00:04:13.630 --> 00:04:18.410 align:middle line:84% And so you can anticipate that will be important 00:04:18.410 --> 00:04:22.730 align:middle line:84% because interest rates enter into our IS-LM analysis 00:04:22.730 --> 00:04:26.570 align:middle line:84% precisely through the borrowing costs of firms in the investment 00:04:26.570 --> 00:04:27.360 align:middle line:90% function. 00:04:27.360 --> 00:04:29.810 align:middle line:84% So if there is a wedge there, if there 00:04:29.810 --> 00:04:35.120 align:middle line:84% is a spread between what the rates we've been talking about 00:04:35.120 --> 00:04:37.610 align:middle line:84% and the rate at which firms can actually borrow, 00:04:37.610 --> 00:04:41.474 align:middle line:90% then that wedge will matter. 00:04:41.474 --> 00:04:43.162 align:middle line:84% And so that's what we want to do. 00:04:43.162 --> 00:04:44.370 align:middle line:90% So we want to introduce this. 00:04:44.370 --> 00:04:46.350 align:middle line:84% I want to explain what these things are, 00:04:46.350 --> 00:04:48.800 align:middle line:84% and then I'm going to modify our IS-LM 00:04:48.800 --> 00:04:52.590 align:middle line:84% model to take into consideration these extensions. 00:04:52.590 --> 00:04:55.770 align:middle line:90% 00:04:55.770 --> 00:04:57.820 align:middle line:84% So what is the nominal interest rate? 00:04:57.820 --> 00:05:01.230 align:middle line:84% Well, we have been talking about the nominal interest rate, which 00:05:01.230 --> 00:05:04.680 align:middle line:84% we typically denote by little i, is the interest 00:05:04.680 --> 00:05:06.180 align:middle line:90% rate in terms of dollars. 00:05:06.180 --> 00:05:11.280 align:middle line:84% So if the interest rate is 10%, you buy a bond today, 00:05:11.280 --> 00:05:13.890 align:middle line:84% that bond will give you 10% of whatever amount of money 00:05:13.890 --> 00:05:16.750 align:middle line:84% you invest in the bond at the end of the year. 00:05:16.750 --> 00:05:18.030 align:middle line:90% So it's a one-year bond. 00:05:18.030 --> 00:05:19.895 align:middle line:84% So that's a nominal interest rate. 00:05:19.895 --> 00:05:22.680 align:middle line:90% 00:05:22.680 --> 00:05:27.720 align:middle line:84% So if you buy 100 in bonds today and the nominal interest 00:05:27.720 --> 00:05:33.270 align:middle line:84% rate 10%, you receive $10 of interest payments one year 00:05:33.270 --> 00:05:37.350 align:middle line:84% from now, $10 of interest payment. 00:05:37.350 --> 00:05:39.840 align:middle line:84% A real interest rate is the interest rate 00:05:39.840 --> 00:05:41.360 align:middle line:90% in terms of a basket of goods. 00:05:41.360 --> 00:05:45.595 align:middle line:90% 00:05:45.595 --> 00:05:51.930 align:middle line:84% So the CPI or something like that will be important in that. 00:05:51.930 --> 00:05:54.030 align:middle line:84% Ex-ante, that is at the moment in which you 00:05:54.030 --> 00:05:55.920 align:middle line:84% are deciding where to invest in the real bond 00:05:55.920 --> 00:05:57.852 align:middle line:90% or the nominal bond. 00:05:57.852 --> 00:06:00.060 align:middle line:84% The difference between the two, the main difference-- 00:06:00.060 --> 00:06:02.153 align:middle line:84% there are other issues that have to do with risk 00:06:02.153 --> 00:06:03.820 align:middle line:84% [INAUDIBLE] I'm not going to talk about. 00:06:03.820 --> 00:06:07.980 align:middle line:84% But the main difference between these two is expected inflation. 00:06:07.980 --> 00:06:12.360 align:middle line:84% In other words, if you expect no inflation, then the distinction 00:06:12.360 --> 00:06:16.210 align:middle line:84% between goods, that is, if you expect p to remain constant, 00:06:16.210 --> 00:06:19.110 align:middle line:84% the distinction between an interest rate in dollars 00:06:19.110 --> 00:06:23.580 align:middle line:90% or in goods isn't existent. 00:06:23.580 --> 00:06:24.840 align:middle line:90% They're the same. 00:06:24.840 --> 00:06:27.060 align:middle line:84% But if you expect inflation, then that's 00:06:27.060 --> 00:06:28.650 align:middle line:84% not the case because the goods are 00:06:28.650 --> 00:06:30.640 align:middle line:84% going to become more expensive over time. 00:06:30.640 --> 00:06:32.850 align:middle line:84% And if the goods become more expensive over time, 00:06:32.850 --> 00:06:35.040 align:middle line:84% that means something that pays you in dollars 00:06:35.040 --> 00:06:38.260 align:middle line:84% is paying you more per equal unit. 00:06:38.260 --> 00:06:40.890 align:middle line:84% So if the r, little r, which is the interest rate, 00:06:40.890 --> 00:06:45.180 align:middle line:84% is equal to i, and you expect inflation to be 10%, 00:06:45.180 --> 00:06:47.400 align:middle line:84% really you're expecting the real instrument 00:06:47.400 --> 00:06:49.050 align:middle line:84% to pay you 10% more than the other. 00:06:49.050 --> 00:06:51.070 align:middle line:84% That cannot happen in equilibrium, 00:06:51.070 --> 00:06:53.752 align:middle line:84% but that's what it means because one is paying you in dollars 00:06:53.752 --> 00:06:55.460 align:middle line:84% and the other one is paying you in goods, 00:06:55.460 --> 00:06:58.150 align:middle line:84% so it will be 10% more expensive next year. 00:06:58.150 --> 00:07:00.970 align:middle line:90% OK, good. 00:07:00.970 --> 00:07:04.030 align:middle line:84% So why do we care about the distinction between nominal 00:07:04.030 --> 00:07:05.560 align:middle line:90% and real interest rate? 00:07:05.560 --> 00:07:09.653 align:middle line:84% Well, because the private sector, important decisions 00:07:09.653 --> 00:07:11.320 align:middle line:84% of the private sector, like the purchase 00:07:11.320 --> 00:07:12.880 align:middle line:84% of durable goods for consumers-- we're 00:07:12.880 --> 00:07:14.255 align:middle line:84% not modeling that in this course, 00:07:14.255 --> 00:07:17.802 align:middle line:84% but investment in the case of physical investment, not 00:07:17.802 --> 00:07:19.510 align:middle line:84% financial investment, physical investment 00:07:19.510 --> 00:07:22.310 align:middle line:84% depends on real rates, not nominal rates. 00:07:22.310 --> 00:07:27.700 align:middle line:84% So what determines whether the opportunity 00:07:27.700 --> 00:07:29.920 align:middle line:84% cost of a real investment is high or low 00:07:29.920 --> 00:07:32.295 align:middle line:84% is the real interest rate, not the nominal interest rate. 00:07:32.295 --> 00:07:35.985 align:middle line:90% 00:07:35.985 --> 00:07:37.360 align:middle line:84% Why do you think that's the case? 00:07:37.360 --> 00:07:48.607 align:middle line:90% 00:07:48.607 --> 00:07:50.940 align:middle line:84% Why do you think it's the real, not the nominal interest 00:07:50.940 --> 00:07:51.690 align:middle line:90% rate that matters? 00:07:51.690 --> 00:07:54.764 align:middle line:90% 00:07:54.764 --> 00:07:56.472 align:middle line:84% AUDIENCE: Because when they're borrowing, 00:07:56.472 --> 00:07:58.990 align:middle line:90% they're going to be [INAUDIBLE]. 00:07:58.990 --> 00:08:00.240 align:middle line:90% RICARDO CABALLERO: Not really. 00:08:00.240 --> 00:08:06.770 align:middle line:84% I mean, most of the borrowing in the US is done in nominal rates. 00:08:06.770 --> 00:08:09.370 align:middle line:84% So it has to come from something else. 00:08:09.370 --> 00:08:12.210 align:middle line:90% Why do you invest? 00:08:12.210 --> 00:08:15.800 align:middle line:84% You invest to produce more goods in the future. 00:08:15.800 --> 00:08:17.360 align:middle line:84% So if those goods are going to be 00:08:17.360 --> 00:08:20.890 align:middle line:84% more expensive in the future because of inflation, 00:08:20.890 --> 00:08:22.640 align:middle line:84% then what matters to you is the difference 00:08:22.640 --> 00:08:25.040 align:middle line:84% between the cost of borrowing and what 00:08:25.040 --> 00:08:26.310 align:middle line:90% you'll get for those goods. 00:08:26.310 --> 00:08:28.640 align:middle line:84% And the goods are going to be 10% more expensive, 00:08:28.640 --> 00:08:32.030 align:middle line:84% so what really matters is the net for you. 00:08:32.030 --> 00:08:34.409 align:middle line:84% In other words, if the real interest remains constant, 00:08:34.409 --> 00:08:36.740 align:middle line:84% and now you give me interest rates that are 10% higher, 00:08:36.740 --> 00:08:38.030 align:middle line:84% but you also tell me that the goods are 00:08:38.030 --> 00:08:40.520 align:middle line:84% going to be selling are going to be 10% more expensive, 00:08:40.520 --> 00:08:42.150 align:middle line:90% I don't change my decision. 00:08:42.150 --> 00:08:44.510 align:middle line:84% If it was a good project with zero inflation, 00:08:44.510 --> 00:08:47.610 align:middle line:84% it's also a good project with 10% inflation. 00:08:47.610 --> 00:08:48.830 align:middle line:90% That hasn't changed. 00:08:48.830 --> 00:08:52.710 align:middle line:84% If I tell you 30%, the same thing. 00:08:52.710 --> 00:08:55.830 align:middle line:84% No, because I'm going to be investing now in order 00:08:55.830 --> 00:08:58.620 align:middle line:84% to get things that are going to be 30% more expensive a year 00:08:58.620 --> 00:08:59.140 align:middle line:90% from now. 00:08:59.140 --> 00:09:01.410 align:middle line:84% So the decision that doesn't depend on that. 00:09:01.410 --> 00:09:03.570 align:middle line:84% So that's the reason the real interest 00:09:03.570 --> 00:09:06.330 align:middle line:84% rate is what you really care about in the case 00:09:06.330 --> 00:09:07.828 align:middle line:90% of real investment. 00:09:07.828 --> 00:09:09.870 align:middle line:84% And remember, we're talking about real investment 00:09:09.870 --> 00:09:10.800 align:middle line:90% at the aggregate level. 00:09:10.800 --> 00:09:13.425 align:middle line:84% All this can make a difference at the level of individual goods 00:09:13.425 --> 00:09:17.670 align:middle line:84% because when inflation goes up, not every goods price goes up 00:09:17.670 --> 00:09:18.610 align:middle line:90% by the same amount. 00:09:18.610 --> 00:09:24.490 align:middle line:84% Some goods go up by more and some prices go up by less. 00:09:24.490 --> 00:09:27.810 align:middle line:84% But on average, it's what I just said. 00:09:27.810 --> 00:09:31.720 align:middle line:84% So let's try to look at this equivalence more formally, 00:09:31.720 --> 00:09:34.260 align:middle line:84% how to derive the real interest rate. 00:09:34.260 --> 00:09:39.000 align:middle line:84% Well, [INAUDIBLE] I said, not in the US, but in many places, 00:09:39.000 --> 00:09:41.490 align:middle line:90% you do borrow in real terms. 00:09:41.490 --> 00:09:44.360 align:middle line:84% For example, in Chile, we have a unit of account 00:09:44.360 --> 00:09:47.030 align:middle line:84% because we had very high inflation many years back, 00:09:47.030 --> 00:09:48.710 align:middle line:84% which is called Unidad de Fomento, 00:09:48.710 --> 00:09:53.510 align:middle line:84% and that unit of account is indexed to inflation. 00:09:53.510 --> 00:10:00.260 align:middle line:84% So you borrow $10 million equivalent in Unidad de Fomento. 00:10:00.260 --> 00:10:02.992 align:middle line:84% And those 10 million pesos equivalent 00:10:02.992 --> 00:10:04.700 align:middle line:84% Unidad de Fomento that means the interest 00:10:04.700 --> 00:10:06.060 align:middle line:90% rate is indexed to that. 00:10:06.060 --> 00:10:08.520 align:middle line:84% But in the US, that happens very rarely. 00:10:08.520 --> 00:10:12.640 align:middle line:90% The US government does do that. 00:10:12.640 --> 00:10:14.810 align:middle line:90% It's called TIPS. 00:10:14.810 --> 00:10:16.590 align:middle line:90% So you have nominal bonds. 00:10:16.590 --> 00:10:18.620 align:middle line:84% The great majority of the US Treasury bonds 00:10:18.620 --> 00:10:21.110 align:middle line:84% are nominal bonds, but there are also some real bonds, 00:10:21.110 --> 00:10:24.230 align:middle line:84% and those are indexed to inflation. 00:10:24.230 --> 00:10:28.190 align:middle line:84% But firms very rarely can issue bonds in the US 00:10:28.190 --> 00:10:30.260 align:middle line:90% that are in real terms. 00:10:30.260 --> 00:10:32.180 align:middle line:90% So that's that [INAUDIBLE]. 00:10:32.180 --> 00:10:34.070 align:middle line:90% Sometimes this is even a-- 00:10:34.070 --> 00:10:38.450 align:middle line:84% so the reason I made that clarification here 00:10:38.450 --> 00:10:41.000 align:middle line:84% is I'm going to derive the real interest rate, 00:10:41.000 --> 00:10:44.300 align:middle line:84% but that doesn't mean that the instrument exists. 00:10:44.300 --> 00:10:48.740 align:middle line:84% I'm saying, given a nominal rate that I see out there, 00:10:48.740 --> 00:10:50.990 align:middle line:84% how do I construct a real interest 00:10:50.990 --> 00:10:52.820 align:middle line:84% rate from that nominal interest rate? 00:10:52.820 --> 00:10:54.030 align:middle line:90% That's what I want to hear. 00:10:54.030 --> 00:10:56.030 align:middle line:84% It doesn't mean that there is an instrument that 00:10:56.030 --> 00:10:58.100 align:middle line:90% is traded in real terms. 00:10:58.100 --> 00:11:00.860 align:middle line:84% But when I go to the bank as a firm 00:11:00.860 --> 00:11:04.070 align:middle line:84% and I borrow at 10% nominal, I need 00:11:04.070 --> 00:11:07.870 align:middle line:84% to calculate, well, what does that imply in real terms. 00:11:07.870 --> 00:11:10.160 align:middle line:84% And that's what I'm going to illustrate now. 00:11:10.160 --> 00:11:13.540 align:middle line:90% OK, good. 00:11:13.540 --> 00:11:16.772 align:middle line:84% Or maybe I shouldn't use the word good 00:11:16.772 --> 00:11:17.980 align:middle line:90% since we're going to do this. 00:11:17.980 --> 00:11:23.620 align:middle line:84% So what we want to pin down is this real interest rate, r. 00:11:23.620 --> 00:11:26.020 align:middle line:84% So the real interest rate in terms of goods 00:11:26.020 --> 00:11:32.140 align:middle line:84% means if I borrow, say, one unit or if I buy an instrument that-- 00:11:32.140 --> 00:11:37.090 align:middle line:84% if I spend one unit of the good, the aggregate good, in a bond, 00:11:37.090 --> 00:11:43.060 align:middle line:84% then I receive 1 plus rt units of goods one year from now, 00:11:43.060 --> 00:11:45.550 align:middle line:84% then rt is the real interest rate. 00:11:45.550 --> 00:11:48.980 align:middle line:84% It's an interest rate in terms of goods. 00:11:48.980 --> 00:11:52.500 align:middle line:84% Now, suppose that I go this route instead. 00:11:52.500 --> 00:11:55.050 align:middle line:84% So OK, that's what I want to get to, 00:11:55.050 --> 00:11:59.120 align:middle line:84% but let me do it through the only instrument I have, say, 00:11:59.120 --> 00:12:01.550 align:middle line:84% the nominal interest rate, the nominal bonds. 00:12:01.550 --> 00:12:06.410 align:middle line:84% So if I buy one unit of goods today, 00:12:06.410 --> 00:12:12.330 align:middle line:84% that means I'm really buying Pt dollars in that bond. 00:12:12.330 --> 00:12:12.830 align:middle line:90% Pt. 00:12:12.830 --> 00:12:14.600 align:middle line:90% Is the deflator we have. 00:12:14.600 --> 00:12:17.270 align:middle line:90% We have Pt dollars. 00:12:17.270 --> 00:12:20.540 align:middle line:84% Well, Pt dollars invested in a nominal bond 00:12:20.540 --> 00:12:24.170 align:middle line:84% will give me 1 plus it, the nominal interest rate, 00:12:24.170 --> 00:12:26.480 align:middle line:90% times those dollars. 00:12:26.480 --> 00:12:34.220 align:middle line:84% So say the price index here is 2 and the nominal interest 00:12:34.220 --> 00:12:39.690 align:middle line:84% rate 10%, then next period, I get a 2 times 1.1. 00:12:39.690 --> 00:12:41.690 align:middle line:84% That's the number of dollars I get. 00:12:41.690 --> 00:12:44.920 align:middle line:90% Now, that's still-- 00:12:44.920 --> 00:12:48.970 align:middle line:84% I cannot compare with this up here, because at this point, 00:12:48.970 --> 00:12:49.840 align:middle line:90% I have dollars. 00:12:49.840 --> 00:12:51.710 align:middle line:84% And really, I want to convert it into goods. 00:12:51.710 --> 00:12:53.770 align:middle line:84% I want to go from goods to goods. 00:12:53.770 --> 00:12:56.430 align:middle line:84% So how do I convert dollars into goods? 00:12:56.430 --> 00:13:01.230 align:middle line:90% 00:13:01.230 --> 00:13:02.730 align:middle line:84% I divide by the price of the goods, 00:13:02.730 --> 00:13:05.460 align:middle line:84% but not here, by the price of the goods at t plus 1 00:13:05.460 --> 00:13:08.130 align:middle line:84% because I'm going to get this amount of dollars at t 00:13:08.130 --> 00:13:10.800 align:middle line:84% plus 1 one year from now, I have to divide 00:13:10.800 --> 00:13:13.320 align:middle line:84% by the price of goods at t plus 1 00:13:13.320 --> 00:13:16.770 align:middle line:84% in order to get the number of goods I'm getting at t plus 1. 00:13:16.770 --> 00:13:18.550 align:middle line:90% So I have to divide by plus 1. 00:13:18.550 --> 00:13:22.740 align:middle line:84% But the problem is that at time t, I don't know what Pt plus 1 00:13:22.740 --> 00:13:24.630 align:middle line:90% will be. 00:13:24.630 --> 00:13:27.120 align:middle line:90% The best I can do-- 00:13:27.120 --> 00:13:28.970 align:middle line:84% and here's where I'm simplifying things 00:13:28.970 --> 00:13:33.050 align:middle line:84% a lot-- is to have an expectation of what the price 00:13:33.050 --> 00:13:35.270 align:middle line:90% level will be one year from now. 00:13:35.270 --> 00:13:38.720 align:middle line:84% So the best I can do when I want to compare things today, 00:13:38.720 --> 00:13:40.940 align:middle line:84% whether I want to go this way or that way, 00:13:40.940 --> 00:13:45.980 align:middle line:90% is to use expected price here. 00:13:45.980 --> 00:13:49.640 align:middle line:84% So these two things are equivalent in the sense 00:13:49.640 --> 00:13:52.050 align:middle line:84% that they require exactly the same investment. 00:13:52.050 --> 00:13:53.460 align:middle line:90% I'm now going this way. 00:13:53.460 --> 00:13:56.090 align:middle line:84% And then in expectation, at least, 00:13:56.090 --> 00:14:00.022 align:middle line:84% these two things are also equivalent because this 00:14:00.022 --> 00:14:01.730 align:middle line:84% is one I'm going to get in terms of goods 00:14:01.730 --> 00:14:03.230 align:middle line:90% from having invested a good. 00:14:03.230 --> 00:14:05.250 align:middle line:84% This is what I expect to get in terms of goods, 00:14:05.250 --> 00:14:09.080 align:middle line:84% but I'm ignoring all that uncertainty around that. 00:14:09.080 --> 00:14:12.770 align:middle line:84% And this is what I get if I go directly to the route, the goods 00:14:12.770 --> 00:14:15.140 align:middle line:84% route, and this is two things have 00:14:15.140 --> 00:14:16.860 align:middle line:90% to be equal by indifference. 00:14:16.860 --> 00:14:20.310 align:middle line:84% If two things give me the same, they have to be priced equally. 00:14:20.310 --> 00:14:21.720 align:middle line:84% They have to have the same price. 00:14:21.720 --> 00:14:24.680 align:middle line:84% And so these two things have to be the same, because here I'm 00:14:24.680 --> 00:14:26.000 align:middle line:90% going from goods to goods. 00:14:26.000 --> 00:14:27.770 align:middle line:84% Here, I'm going through this channel, 00:14:27.770 --> 00:14:29.370 align:middle line:90% but also from goods to goods. 00:14:29.370 --> 00:14:32.600 align:middle line:84% These two things should give us more or less the same return. 00:14:32.600 --> 00:14:35.360 align:middle line:84% And we're going to assume strictly that they give us 00:14:35.360 --> 00:14:38.270 align:middle line:90% the same expected return. 00:14:38.270 --> 00:14:40.760 align:middle line:90% So this relationship holds. 00:14:40.760 --> 00:14:45.580 align:middle line:90% Is this diagram clear? 00:14:45.580 --> 00:14:46.235 align:middle line:90% OK, good. 00:14:46.235 --> 00:14:47.860 align:middle line:84% Because what I'm going to do now is I'm 00:14:47.860 --> 00:14:50.402 align:middle line:84% going to take this expression here and play with it a little. 00:14:50.402 --> 00:14:53.120 align:middle line:90% 00:14:53.120 --> 00:14:56.030 align:middle line:84% So we arrive in the previous slide to the conclusion 00:14:56.030 --> 00:14:57.950 align:middle line:84% that 1 plus the real interest rate 00:14:57.950 --> 00:15:02.270 align:middle line:84% is equal to 1 plus the nominal interest rate times Pt over Pt 00:15:02.270 --> 00:15:04.790 align:middle line:90% plus 1 expected. 00:15:04.790 --> 00:15:09.140 align:middle line:84% I'm going to denote expected inflation, the inflation we 00:15:09.140 --> 00:15:12.673 align:middle line:84% expect, the log change in the price level 00:15:12.673 --> 00:15:14.090 align:middle line:84% or the rate of change of the price 00:15:14.090 --> 00:15:18.350 align:middle line:84% level from year t to year t plus 1 as pi e 00:15:18.350 --> 00:15:20.600 align:middle line:90% t plus 1 is equal to that. 00:15:20.600 --> 00:15:25.160 align:middle line:84% So this is expected inflation at t plus 1. 00:15:25.160 --> 00:15:26.760 align:middle line:90% See that? 00:15:26.760 --> 00:15:30.840 align:middle line:84% Well, do a little algebra, and I can rewrite this guy here 00:15:30.840 --> 00:15:36.160 align:middle line:84% as 1 plus expected inflation between t and t plus 1. 00:15:36.160 --> 00:15:42.390 align:middle line:84% I just replaced this for 1 over 1 plus pi e t plus 1. 00:15:42.390 --> 00:15:45.230 align:middle line:90% Just algebra, I got that. 00:15:45.230 --> 00:15:47.000 align:middle line:90% So now I have a relationship. 00:15:47.000 --> 00:15:50.360 align:middle line:84% And these things, if this interest rate is not too high 00:15:50.360 --> 00:15:53.610 align:middle line:84% and this expected inflation is not too high, not too large, 00:15:53.610 --> 00:15:57.890 align:middle line:84% as it happens in most countries but a few around the world, 00:15:57.890 --> 00:16:02.630 align:middle line:84% then this implies approximately that the real interest 00:16:02.630 --> 00:16:05.720 align:middle line:84% rate is approximately equal to the nominal interest 00:16:05.720 --> 00:16:09.550 align:middle line:90% rate minus expected inflation. 00:16:09.550 --> 00:16:11.050 align:middle line:84% I'm just taking approximations here. 00:16:11.050 --> 00:16:18.340 align:middle line:90% 00:16:18.340 --> 00:16:21.490 align:middle line:84% And that is an intuitive expression. 00:16:21.490 --> 00:16:23.950 align:middle line:84% The real interest rate is equal to the nominal rate 00:16:23.950 --> 00:16:27.140 align:middle line:90% minus the expected inflation. 00:16:27.140 --> 00:16:36.050 align:middle line:84% So if the interest rate is 6% and expected inflation is 3%, 00:16:36.050 --> 00:16:39.500 align:middle line:84% well, the real interest rate is only 3%. 00:16:39.500 --> 00:16:41.450 align:middle line:84% In terms of good, you're going to get 3% less 00:16:41.450 --> 00:16:44.480 align:middle line:90% because that's inflation rate. 00:16:44.480 --> 00:16:45.710 align:middle line:90% Good. 00:16:45.710 --> 00:16:48.860 align:middle line:84% Or if you're borrowing, in terms of your borrowing costs, well, 00:16:48.860 --> 00:16:51.560 align:middle line:84% it's going to cost you 3% less effectively 00:16:51.560 --> 00:16:54.320 align:middle line:84% because the goods you're going to be selling out 00:16:54.320 --> 00:16:58.670 align:middle line:84% of your investment are going to be 3% more expensive. 00:16:58.670 --> 00:17:00.680 align:middle line:90% OK, good. 00:17:00.680 --> 00:17:02.860 align:middle line:90% So, look, this is what happened. 00:17:02.860 --> 00:17:05.060 align:middle line:84% I'm showing you what happened around the years 00:17:05.060 --> 00:17:06.270 align:middle line:90% of the Great Recession. 00:17:06.270 --> 00:17:07.970 align:middle line:84% Remember, the Great Recession happened 00:17:07.970 --> 00:17:11.720 align:middle line:90% end of 2008, 2009, 2010. 00:17:11.720 --> 00:17:14.630 align:middle line:84% Several things you can see in this picture. 00:17:14.630 --> 00:17:17.369 align:middle line:84% The white line here is the nominal interest rate 00:17:17.369 --> 00:17:20.869 align:middle line:84% and the yellow is the real interest rate in the US. 00:17:20.869 --> 00:17:26.210 align:middle line:84% And since in the US you can actually 00:17:26.210 --> 00:17:30.290 align:middle line:84% trade real and nominal bonds, the difference between these two 00:17:30.290 --> 00:17:36.530 align:middle line:84% is expected inflation, as priced by financial markets. 00:17:36.530 --> 00:17:38.750 align:middle line:84% And they're called in the US are called 00:17:38.750 --> 00:17:42.200 align:middle line:84% inflation breakevens, so swaps, inflation swaps, 00:17:42.200 --> 00:17:43.080 align:middle line:90% inflation breakevens. 00:17:43.080 --> 00:17:46.410 align:middle line:84% But anyways, so several things you can see in this picture. 00:17:46.410 --> 00:17:54.680 align:middle line:84% The first one is that typically, unless you're in Japan probably, 00:17:54.680 --> 00:17:57.260 align:middle line:84% the white line, that is, the nominal rate is 00:17:57.260 --> 00:18:02.060 align:middle line:84% above the orange line, which is the yellow line, which 00:18:02.060 --> 00:18:03.900 align:middle line:90% is the real interest rate. 00:18:03.900 --> 00:18:05.540 align:middle line:84% Why do you think that's the case? 00:18:05.540 --> 00:18:08.630 align:middle line:84% Or what does it tell you, the fact 00:18:08.630 --> 00:18:14.440 align:middle line:84% that on average sort of the nominal interest rate 00:18:14.440 --> 00:18:18.050 align:middle line:90% is above the real interest rate? 00:18:18.050 --> 00:18:21.740 align:middle line:84% Yeah, on average, in most advanced economies and even more 00:18:21.740 --> 00:18:24.440 align:middle line:84% so in emerging markets, inflation is positive 00:18:24.440 --> 00:18:28.070 align:middle line:84% and therefore people expect inflation to be positive. 00:18:28.070 --> 00:18:30.680 align:middle line:84% Again, Japan went through this long periods of deflation, 00:18:30.680 --> 00:18:32.590 align:middle line:90% but that's a rarity. 00:18:32.590 --> 00:18:35.390 align:middle line:84% That was an anomaly, what was going on in Japan. 00:18:35.390 --> 00:18:37.490 align:middle line:90% But you see something else here. 00:18:37.490 --> 00:18:41.420 align:middle line:84% There is an episode very clearly when the opposite 00:18:41.420 --> 00:18:44.150 align:middle line:84% was holding, when the real interest rate went much higher 00:18:44.150 --> 00:18:45.600 align:middle line:90% than the nominal interest rate. 00:18:45.600 --> 00:18:48.290 align:middle line:84% And this is despite the fact that you see even they 00:18:48.290 --> 00:18:49.710 align:middle line:90% cross in opposite direction. 00:18:49.710 --> 00:18:53.530 align:middle line:84% Here there was a sharp decline in the nominal interest rate 00:18:53.530 --> 00:18:56.330 align:middle line:84% and a sharp rise in the real interest rate. 00:18:56.330 --> 00:18:56.990 align:middle line:90% What happened? 00:18:56.990 --> 00:18:58.032 align:middle line:90% What was happening there? 00:18:58.032 --> 00:19:07.310 align:middle line:90% 00:19:07.310 --> 00:19:09.470 align:middle line:84% First of all, forget about the picture. 00:19:09.470 --> 00:19:14.210 align:middle line:84% What was happening around 2008, 2009? 00:19:14.210 --> 00:19:16.500 align:middle line:90% The Great Recession. 00:19:16.500 --> 00:19:18.020 align:middle line:90% So that's one observation. 00:19:18.020 --> 00:19:20.450 align:middle line:84% Typically, especially in modern recessions, 00:19:20.450 --> 00:19:22.970 align:middle line:84% certainly in recessions caused by financial crisis, 00:19:22.970 --> 00:19:29.780 align:middle line:84% as this one was, real interest rates 00:19:29.780 --> 00:19:33.170 align:middle line:84% go above nominal interest rate-- can go above nominal interest 00:19:33.170 --> 00:19:33.950 align:middle line:90% rates. 00:19:33.950 --> 00:19:39.760 align:middle line:84% What does it mean in terms of inflation? 00:19:39.760 --> 00:19:41.930 align:middle line:84% Remember, what the Fed is setting 00:19:41.930 --> 00:19:44.053 align:middle line:90% is this one, more or less. 00:19:44.053 --> 00:19:45.470 align:middle line:84% This, I think, is a one-year rate. 00:19:45.470 --> 00:19:48.290 align:middle line:84% So it's not exactly what the Fed set, but more or less. 00:19:48.290 --> 00:19:51.940 align:middle line:84% So why do you think the Fed cut interest rates there very 00:19:51.940 --> 00:19:54.460 align:middle line:90% aggressively? 00:19:54.460 --> 00:19:56.943 align:middle line:84% Yeah, we were in the middle of a big financial crisis, 00:19:56.943 --> 00:19:58.360 align:middle line:84% so we wanted to boost the economy, 00:19:58.360 --> 00:19:59.630 align:middle line:90% so cut the interest rate. 00:19:59.630 --> 00:20:03.217 align:middle line:84% And this is, when you map it into the very short rate, 00:20:03.217 --> 00:20:05.300 align:middle line:84% this is effectively the hit, the zero lower bound. 00:20:05.300 --> 00:20:06.590 align:middle line:90% They couldn't lower it more. 00:20:06.590 --> 00:20:09.760 align:middle line:84% They lower it as much as they could, and that was it. 00:20:09.760 --> 00:20:13.480 align:middle line:84% So what must have happened for this real interest rate 00:20:13.480 --> 00:20:15.090 align:middle line:90% to go up like crazy? 00:20:15.090 --> 00:20:18.760 align:middle line:90% 00:20:18.760 --> 00:20:19.350 align:middle line:90% How can it be? 00:20:19.350 --> 00:20:22.420 align:middle line:84% There's the Fed bringing down the nominal interest rate, 00:20:22.420 --> 00:20:24.420 align:middle line:84% and the real rate, boom, jumps up. 00:20:24.420 --> 00:20:26.990 align:middle line:90% 00:20:26.990 --> 00:20:28.840 align:middle line:84% Expected inflation went down a lot. 00:20:28.840 --> 00:20:32.180 align:middle line:84% So what I was saying is expected inflation 00:20:32.180 --> 00:20:36.800 align:middle line:84% is typically positive in developed economies, around 2%, 00:20:36.800 --> 00:20:37.640 align:middle line:90% 2.5%. 00:20:37.640 --> 00:20:39.540 align:middle line:90% That's the type of numbers. 00:20:39.540 --> 00:20:43.520 align:middle line:84% But in deep recessions, it can go even negative. 00:20:43.520 --> 00:20:44.850 align:middle line:90% And that's what happened. 00:20:44.850 --> 00:20:46.800 align:middle line:84% There is the expected inflation as 00:20:46.800 --> 00:20:50.400 align:middle line:84% extracted from inflation breakevens, from the swaps. 00:20:50.400 --> 00:20:54.240 align:middle line:84% And you see, typically it's around 2% and so on, 00:20:54.240 --> 00:20:58.740 align:middle line:84% because that's more or less the Fed inflation target in the US. 00:20:58.740 --> 00:21:02.550 align:middle line:84% But during this episode here, we entered 00:21:02.550 --> 00:21:06.900 align:middle line:84% into a very deflationary episode, expected 00:21:06.900 --> 00:21:08.990 align:middle line:90% inflation close to minus 4%. 00:21:08.990 --> 00:21:10.380 align:middle line:90% That was very deflationary. 00:21:10.380 --> 00:21:11.590 align:middle line:90% It was very scary. 00:21:11.590 --> 00:21:13.535 align:middle line:84% Deflations can be very complicated objects 00:21:13.535 --> 00:21:15.120 align:middle line:90% for [INAUDIBLE]. 00:21:15.120 --> 00:21:18.920 align:middle line:84% And we'll say more about that later. 00:21:18.920 --> 00:21:23.550 align:middle line:90% But that's what happened there. 00:21:23.550 --> 00:21:24.050 align:middle line:90% Good. 00:21:24.050 --> 00:21:26.970 align:middle line:84% So that's nominal versus real interest rate. 00:21:26.970 --> 00:21:28.820 align:middle line:84% Now, let me talk about credit spreads, 00:21:28.820 --> 00:21:31.280 align:middle line:84% and then we're going to put everything together. 00:21:31.280 --> 00:21:36.880 align:middle line:84% So most bonds issued by corporations are risky. 00:21:36.880 --> 00:21:39.560 align:middle line:84% They are not-- US treasuries are as safe as it gets. 00:21:39.560 --> 00:21:42.430 align:middle line:84% That's considered the safest assets in the world, together 00:21:42.430 --> 00:21:49.840 align:middle line:84% with the German bonds, government bonds, and Swiss. 00:21:49.840 --> 00:21:52.120 align:middle line:84% There are a few, but the US in terms 00:21:52.120 --> 00:21:55.060 align:middle line:84% of liquidity and everything, is the premier safe asset 00:21:55.060 --> 00:21:57.026 align:middle line:90% in the world. 00:21:57.026 --> 00:21:59.280 align:middle line:84% But most corporations don't issue at those rates. 00:21:59.280 --> 00:22:01.030 align:middle line:84% They have to pay a premium because they're 00:22:01.030 --> 00:22:06.080 align:middle line:84% not as safe as those, as the Treasury instruments. 00:22:06.080 --> 00:22:12.490 align:middle line:84% So let me call that the real interest rate paid by this bonds 00:22:12.490 --> 00:22:16.810 align:middle line:84% by issues by firms on average be equal to the safe real interest 00:22:16.810 --> 00:22:18.460 align:middle line:90% rate plus a premium, xt. 00:22:18.460 --> 00:22:21.400 align:middle line:90% 00:22:21.400 --> 00:22:26.410 align:middle line:84% Now, the point that is important is that this risk premium 00:22:26.410 --> 00:22:28.750 align:middle line:84% moves a lot over the business cycle, 00:22:28.750 --> 00:22:31.480 align:middle line:84% especially when you have a financial crisis. 00:22:31.480 --> 00:22:33.405 align:middle line:84% People really want to run away from risk. 00:22:33.405 --> 00:22:36.840 align:middle line:90% 00:22:36.840 --> 00:22:39.840 align:middle line:84% And so it tends to be higher in recessions, 00:22:39.840 --> 00:22:42.750 align:middle line:84% especially when recessions are caused by financial crises 00:22:42.750 --> 00:22:45.030 align:middle line:90% and things of that kind. 00:22:45.030 --> 00:22:47.050 align:middle line:84% Now, why do we care about the risk premium? 00:22:47.050 --> 00:22:50.550 align:middle line:84% Again, because important private sector decisions 00:22:50.550 --> 00:22:52.470 align:middle line:84% depend on that real interest rate, 00:22:52.470 --> 00:22:55.800 align:middle line:84% on the risk-adjusted interest rate. 00:22:55.800 --> 00:23:00.510 align:middle line:84% If a firm has lots of credibility problems 00:23:00.510 --> 00:23:02.828 align:middle line:84% and is considered very risky, the cost of borrowing 00:23:02.828 --> 00:23:04.620 align:middle line:84% is going to be very high and therefore it's 00:23:04.620 --> 00:23:06.510 align:middle line:84% going to have to have a higher threshold 00:23:06.510 --> 00:23:08.700 align:middle line:90% for any physical investment. 00:23:08.700 --> 00:23:12.240 align:middle line:84% It's more costly for that firm to borrow. 00:23:12.240 --> 00:23:13.950 align:middle line:90% So that's a reason to worry. 00:23:13.950 --> 00:23:16.800 align:middle line:84% So the risk premium, that x there, 00:23:16.800 --> 00:23:19.080 align:middle line:84% is determined by two things, essentially, 00:23:19.080 --> 00:23:20.460 align:middle line:90% in the case of bonds. 00:23:20.460 --> 00:23:22.240 align:middle line:84% There's also risk premiums in equity. 00:23:22.240 --> 00:23:24.240 align:middle line:84% But in the case of bonds, one thing 00:23:24.240 --> 00:23:26.220 align:middle line:84% is the probability of default. It 00:23:26.220 --> 00:23:28.710 align:middle line:84% may be that the firm doesn't honor those bonds 00:23:28.710 --> 00:23:31.210 align:middle line:84% and defaults on them, so one thing 00:23:31.210 --> 00:23:32.460 align:middle line:90% is the probability of default. 00:23:32.460 --> 00:23:36.338 align:middle line:84% The other one is the degree of risk aversion of bond holders. 00:23:36.338 --> 00:23:38.130 align:middle line:84% There are sometimes in which you say, look, 00:23:38.130 --> 00:23:39.810 align:middle line:84% I don't want to hold any risk here 00:23:39.810 --> 00:23:41.520 align:middle line:84% or very little risk because everything 00:23:41.520 --> 00:23:43.390 align:middle line:90% looks very complicated to me. 00:23:43.390 --> 00:23:44.380 align:middle line:90% I'd rather go safe. 00:23:44.380 --> 00:23:45.620 align:middle line:90% I go to Treasury bonds. 00:23:45.620 --> 00:23:46.620 align:middle line:90% I don't want this stuff. 00:23:46.620 --> 00:23:49.770 align:middle line:84% So those two reasons make that spread grow. 00:23:49.770 --> 00:23:52.710 align:middle line:84% The second reason, on average, to me 00:23:52.710 --> 00:23:54.790 align:middle line:90% is the most important reason. 00:23:54.790 --> 00:23:56.650 align:middle line:84% But it's easier to model all this stuff 00:23:56.650 --> 00:23:59.057 align:middle line:84% as a probability of default. So that's what I'm assuming. 00:23:59.057 --> 00:24:00.640 align:middle line:84% What I'm going to do here is I'm going 00:24:00.640 --> 00:24:04.275 align:middle line:84% to ignore this, the degree of risk aversion of bondholders, 00:24:04.275 --> 00:24:05.650 align:middle line:84% and I'm going to just concentrate 00:24:05.650 --> 00:24:08.050 align:middle line:84% on the probability of default of a bond. 00:24:08.050 --> 00:24:11.320 align:middle line:84% But in that sense, you can model both as the same 00:24:11.320 --> 00:24:13.900 align:middle line:84% because you can think of risk aversion 00:24:13.900 --> 00:24:16.360 align:middle line:84% as somebody exaggerating the probability of default 00:24:16.360 --> 00:24:17.230 align:middle line:90% of a bond. 00:24:17.230 --> 00:24:21.160 align:middle line:84% If I get very nervous about investing in risky stuff, 00:24:21.160 --> 00:24:23.140 align:middle line:84% there is some true probability of default 00:24:23.140 --> 00:24:25.790 align:middle line:84% that some agency is calculating out there. 00:24:25.790 --> 00:24:27.610 align:middle line:84% But if I'm very nervous about that, 00:24:27.610 --> 00:24:30.430 align:middle line:84% I may as well put a marker up, say, well, you know, 00:24:30.430 --> 00:24:32.572 align:middle line:84% these guys have messed up in the past. 00:24:32.572 --> 00:24:34.030 align:middle line:84% They may think that the probability 00:24:34.030 --> 00:24:37.750 align:middle line:84% they followed this bond is 5% during the next year. 00:24:37.750 --> 00:24:42.040 align:middle line:84% I'm going to treat it as 10% because I want to penalize 00:24:42.040 --> 00:24:43.610 align:middle line:90% for the risk I'm incurring. 00:24:43.610 --> 00:24:47.050 align:middle line:84% So think of this p here as a probability of default, 00:24:47.050 --> 00:24:49.150 align:middle line:90% but as perceived by-- 00:24:49.150 --> 00:24:51.770 align:middle line:84% you don't know what is the true probability of default. 00:24:51.770 --> 00:24:53.280 align:middle line:90% That's an abstract concept. 00:24:53.280 --> 00:24:56.440 align:middle line:90% 00:24:56.440 --> 00:24:59.050 align:middle line:84% But it's whatever you use in your investment decisions 00:24:59.050 --> 00:25:00.580 align:middle line:90% that I'm modeling here. 00:25:00.580 --> 00:25:03.280 align:middle line:84% So by the same principle we had before 00:25:03.280 --> 00:25:07.000 align:middle line:84% between nominal and real bonds, what we need to have is 00:25:07.000 --> 00:25:09.050 align:middle line:84% I need to be indifferent-- in equilibrium, 00:25:09.050 --> 00:25:12.400 align:middle line:84% I need to be indifferent between investing 00:25:12.400 --> 00:25:17.590 align:middle line:84% in Treasury bonds, the safe bonds that pay an interest rt, 00:25:17.590 --> 00:25:21.790 align:middle line:84% and investing in risky bonds that are paying an interest rate 00:25:21.790 --> 00:25:25.030 align:middle line:90% rf, which is greater than rt. 00:25:25.030 --> 00:25:27.670 align:middle line:84% So I have to be indifferent between these two things. 00:25:27.670 --> 00:25:30.200 align:middle line:84% And the spread here will have to adjust 00:25:30.200 --> 00:25:33.280 align:middle line:84% so I'm indifferent between these two things indeed. 00:25:33.280 --> 00:25:35.350 align:middle line:84% It's obvious, if the probability of default 00:25:35.350 --> 00:25:37.972 align:middle line:84% is greater than zero, that this rf is 00:25:37.972 --> 00:25:39.430 align:middle line:84% going to have to be greater than r, 00:25:39.430 --> 00:25:42.610 align:middle line:84% because otherwise I don't want to invest in a bond that pays me 00:25:42.610 --> 00:25:43.880 align:middle line:90% the same as that. 00:25:43.880 --> 00:25:47.050 align:middle line:84% And on top of that, I can experience a default 00:25:47.050 --> 00:25:49.330 align:middle line:84% occasionally, not get my money back. 00:25:49.330 --> 00:25:52.810 align:middle line:84% So what we have here, this indifference condition means, 00:25:52.810 --> 00:25:58.320 align:middle line:84% OK, during the next year, there is a probability of default p. 00:25:58.320 --> 00:26:01.350 align:middle line:84% That means with probability 1 minus p, 00:26:01.350 --> 00:26:03.090 align:middle line:84% I'm going to get this high interest rate. 00:26:03.090 --> 00:26:04.800 align:middle line:90% I'm going to get my money back. 00:26:04.800 --> 00:26:06.668 align:middle line:84% I invest one in a bond, I get my money back, 00:26:06.668 --> 00:26:09.210 align:middle line:84% plus an interest rate, which is higher than the safe interest 00:26:09.210 --> 00:26:10.830 align:middle line:90% rate, this rf. 00:26:10.830 --> 00:26:11.850 align:middle line:90% That's a good thing. 00:26:11.850 --> 00:26:15.450 align:middle line:84% Against that is a probability that the bond there 00:26:15.450 --> 00:26:18.510 align:middle line:84% is a default, and I'm going to assume always in practice 00:26:18.510 --> 00:26:20.342 align:middle line:84% there is some recovery of a bond which is 00:26:20.342 --> 00:26:21.550 align:middle line:90% much less than the principal. 00:26:21.550 --> 00:26:22.920 align:middle line:90% I'm going to assume it's 0. 00:26:22.920 --> 00:26:26.760 align:middle line:84% So if p is positive, as I said before, 00:26:26.760 --> 00:26:29.580 align:middle line:84% then it better be the case that this rf is greater than r, 00:26:29.580 --> 00:26:31.680 align:middle line:84% otherwise I'm not going to invest anything 00:26:31.680 --> 00:26:33.060 align:middle line:90% in the risky bond. 00:26:33.060 --> 00:26:36.990 align:middle line:84% So I'm going to replace this rf by rt plus x 00:26:36.990 --> 00:26:39.000 align:middle line:90% just to calculate xt. 00:26:39.000 --> 00:26:40.920 align:middle line:84% And you can solve this out here, and you 00:26:40.920 --> 00:26:47.670 align:middle line:84% get that this risk premium is xt is an increasing function of p. 00:26:47.670 --> 00:26:51.840 align:middle line:84% Naturally, if I perceive bonds to be more likely to default, 00:26:51.840 --> 00:26:54.540 align:middle line:84% I'm going to require a higher compensation 00:26:54.540 --> 00:27:00.000 align:middle line:84% if the bond doesn't default. And that's what you have here. 00:27:00.000 --> 00:27:04.500 align:middle line:84% Now, what happens is that during severe recessions, 00:27:04.500 --> 00:27:05.850 align:middle line:90% actual defaults go up. 00:27:05.850 --> 00:27:08.250 align:middle line:84% So the probability of default objectively goes up 00:27:08.250 --> 00:27:11.380 align:middle line:84% and people get a lot more scared also that this will happen, 00:27:11.380 --> 00:27:13.380 align:middle line:90% and so p tends to go up a lot. 00:27:13.380 --> 00:27:17.610 align:middle line:84% So during severe recessions-- is always 00:27:17.610 --> 00:27:20.610 align:middle line:84% almost in recession, but especially in severe recessions, 00:27:20.610 --> 00:27:22.980 align:middle line:90% p can rise a lot. 00:27:22.980 --> 00:27:25.230 align:middle line:90% It can rise a lot. 00:27:25.230 --> 00:27:26.950 align:middle line:90% r may fall or not. 00:27:26.950 --> 00:27:28.180 align:middle line:90% We shall see. 00:27:28.180 --> 00:27:32.760 align:middle line:84% But this stuff dominates, actually. 00:27:32.760 --> 00:27:36.910 align:middle line:84% This x can move up a lot during recessions. 00:27:36.910 --> 00:27:39.630 align:middle line:84% And in fact, if I show you what happened 00:27:39.630 --> 00:27:44.040 align:middle line:84% during the Great Recession, same episode as before, 00:27:44.040 --> 00:27:44.920 align:middle line:90% there you have it. 00:27:44.920 --> 00:27:47.670 align:middle line:90% This is our x really. 00:27:47.670 --> 00:27:50.880 align:middle line:90% Look how it jumped in 2008. 00:27:50.880 --> 00:27:54.060 align:middle line:84% So the average-- and this is for-- 00:27:54.060 --> 00:27:56.020 align:middle line:84% I think it's high yield, I think. 00:27:56.020 --> 00:27:57.050 align:middle line:90% But it's not junk. 00:27:57.050 --> 00:27:58.050 align:middle line:90% It's high yield, though. 00:27:58.050 --> 00:28:00.730 align:middle line:90% 00:28:00.730 --> 00:28:03.010 align:middle line:84% I think it's a weighted average of things. 00:28:03.010 --> 00:28:10.680 align:middle line:84% But think of this as the median bond out there, corporate bond. 00:28:10.680 --> 00:28:16.080 align:middle line:84% It had to pay 20% more than a Treasury bond, so big difference 00:28:16.080 --> 00:28:18.510 align:middle line:84% if you are in the private sector and wanted to borrow, 00:28:18.510 --> 00:28:21.540 align:middle line:84% than if the government wanted to borrow. 00:28:21.540 --> 00:28:22.890 align:middle line:90% Big thing. 00:28:22.890 --> 00:28:24.980 align:middle line:90% This was a big issue. 00:28:24.980 --> 00:28:26.480 align:middle line:90% OK, good. 00:28:26.480 --> 00:28:29.810 align:middle line:84% Now, it's almost always-- oh, about that level, 00:28:29.810 --> 00:28:31.250 align:middle line:90% this is high yield. 00:28:31.250 --> 00:28:35.330 align:middle line:84% So you see, typically because these high yield, 00:28:35.330 --> 00:28:38.630 align:middle line:84% these are not the prime companies. 00:28:38.630 --> 00:28:40.140 align:middle line:84% They have a probability of default. 00:28:40.140 --> 00:28:41.182 align:middle line:90% There's a risk out there. 00:28:41.182 --> 00:28:44.210 align:middle line:84% They typically have to pay a spread, 3%, 00:28:44.210 --> 00:28:45.950 align:middle line:90% 4%, things like that. 00:28:45.950 --> 00:28:49.790 align:middle line:84% But during severe events, that can go very, very high. 00:28:49.790 --> 00:28:53.060 align:middle line:84% So if you're a corporation and you're trying to borrow here, 00:28:53.060 --> 00:28:55.340 align:middle line:84% it's going to be pretty difficult to borrow. 00:28:55.340 --> 00:29:01.010 align:middle line:84% That's the point, not a good time to invest in that sense. 00:29:01.010 --> 00:29:04.450 align:middle line:90% It pretty expensive. 00:29:04.450 --> 00:29:06.460 align:middle line:84% So that takes me to the IS-LM model. 00:29:06.460 --> 00:29:11.920 align:middle line:84% I want to now bring in these two ingredients. 00:29:11.920 --> 00:29:16.870 align:middle line:84% So the two modifications I introduce 00:29:16.870 --> 00:29:18.650 align:middle line:90% are relevant for the IS. 00:29:18.650 --> 00:29:19.910 align:middle line:90% The LM doesn't change. 00:29:19.910 --> 00:29:22.720 align:middle line:84% The central bank keeps setting the nominal interest rate, 00:29:22.720 --> 00:29:24.730 align:middle line:90% and that's what it does. 00:29:24.730 --> 00:29:26.170 align:middle line:84% So that's not changing, and that's 00:29:26.170 --> 00:29:29.320 align:middle line:90% the target of the central bank. 00:29:29.320 --> 00:29:31.480 align:middle line:84% The central bank may decide to react 00:29:31.480 --> 00:29:34.180 align:middle line:84% to things that happen in expected inflation and credit 00:29:34.180 --> 00:29:34.850 align:middle line:90% spreads. 00:29:34.850 --> 00:29:37.210 align:middle line:84% But the LM is the same as it used to be. 00:29:37.210 --> 00:29:41.540 align:middle line:84% In the book, at some point, the book makes a simplification 00:29:41.540 --> 00:29:43.540 align:middle line:84% and it starts setting the interest rate in terms 00:29:43.540 --> 00:29:44.623 align:middle line:90% of the real interest rate. 00:29:44.623 --> 00:29:47.710 align:middle line:84% I think that's a bad idea, so I'm not going to do that. 00:29:47.710 --> 00:29:49.330 align:middle line:90% I'm going to keep our IS-- 00:29:49.330 --> 00:29:52.660 align:middle line:84% our LM as it was, but now with the extensions, 00:29:52.660 --> 00:29:56.350 align:middle line:84% we have to modify, well, the only place 00:29:56.350 --> 00:29:59.320 align:middle line:84% where interest rate enters for us, which 00:29:59.320 --> 00:30:00.940 align:middle line:90% is in the investment function. 00:30:00.940 --> 00:30:02.357 align:middle line:84% And so the investment function now 00:30:02.357 --> 00:30:04.315 align:middle line:84% is not a function of the nominal interest rate. 00:30:04.315 --> 00:30:06.490 align:middle line:84% It's a function of the real interest rate adjusted 00:30:06.490 --> 00:30:09.850 align:middle line:84% by credit risk, because that's the relevant opportunity 00:30:09.850 --> 00:30:11.350 align:middle line:90% cost of-- 00:30:11.350 --> 00:30:13.660 align:middle line:84% that's the real cost of borrowing, if you will, 00:30:13.660 --> 00:30:15.795 align:middle line:84% of firms when they want to invest. 00:30:15.795 --> 00:30:18.335 align:middle line:90% 00:30:18.335 --> 00:30:20.050 align:middle line:90% So that's the modification. 00:30:20.050 --> 00:30:23.290 align:middle line:84% Now, for this part of the course, as I said, 00:30:23.290 --> 00:30:26.397 align:middle line:84% I'm going to take this as two new parameters. 00:30:26.397 --> 00:30:27.980 align:middle line:84% We're not going to look at equilibrium 00:30:27.980 --> 00:30:29.570 align:middle line:90% and the termination of that. 00:30:29.570 --> 00:30:32.300 align:middle line:84% When we get into the next part of the course, 00:30:32.300 --> 00:30:34.710 align:middle line:84% then we're never going to do much about that, 00:30:34.710 --> 00:30:35.790 align:middle line:90% but yes, about this. 00:30:35.790 --> 00:30:37.920 align:middle line:84% But for now, these are just two new parameters. 00:30:37.920 --> 00:30:42.230 align:middle line:84% So in our equilibrium lecture, three in the goods market 00:30:42.230 --> 00:30:44.210 align:middle line:84% equilibrium, now we have two more parameters, 00:30:44.210 --> 00:30:45.950 align:middle line:90% expected inflation-- 00:30:45.950 --> 00:30:51.220 align:middle line:84% and remember the ZZ curve, where we have g, p, interest rate, 00:30:51.220 --> 00:30:52.470 align:middle line:90% all those things are constant? 00:30:52.470 --> 00:30:55.730 align:middle line:84% Well, now we have two new parameters, expected inflation 00:30:55.730 --> 00:30:59.620 align:middle line:90% and the credit spread. 00:30:59.620 --> 00:31:00.700 align:middle line:90% So that's it. 00:31:00.700 --> 00:31:02.280 align:middle line:90% That's lecture 3. 00:31:02.280 --> 00:31:05.150 align:middle line:84% Now, so what I'm showing you here 00:31:05.150 --> 00:31:07.280 align:middle line:90% is what happened in lecture 3. 00:31:07.280 --> 00:31:13.390 align:middle line:84% If the credit spreads comes down or expected inflation rises 00:31:13.390 --> 00:31:16.870 align:middle line:84% for any given nominal interest rate, 00:31:16.870 --> 00:31:20.410 align:middle line:84% then that shifts the ZZ curve up. 00:31:20.410 --> 00:31:21.285 align:middle line:90% Why is that? 00:31:21.285 --> 00:31:25.370 align:middle line:90% 00:31:25.370 --> 00:31:26.250 align:middle line:90% I'm sorry. 00:31:26.250 --> 00:31:28.910 align:middle line:84% And if aggregate demand goes up, then the multiplier kicks in 00:31:28.910 --> 00:31:31.570 align:middle line:84% and we end up with an expansion in output. 00:31:31.570 --> 00:31:33.820 align:middle line:84% So I'm saying, for a given nominal interest 00:31:33.820 --> 00:31:37.450 align:middle line:84% rate, if now expected inflation goes up 00:31:37.450 --> 00:31:43.390 align:middle line:84% or the credit spreads go down, then 00:31:43.390 --> 00:31:46.850 align:middle line:84% that acts almost like an expansionary monetary policy, 00:31:46.850 --> 00:31:47.530 align:middle line:90% you see. 00:31:47.530 --> 00:31:49.710 align:middle line:84% You get an expansion in aggregate demand. 00:31:49.710 --> 00:31:50.360 align:middle line:90% Yes. 00:31:50.360 --> 00:31:51.777 align:middle line:84% AUDIENCE: Increase the [INAUDIBLE] 00:31:51.777 --> 00:31:54.418 align:middle line:84% because for increased inflation, the firms 00:31:54.418 --> 00:31:55.960 align:middle line:84% will be expected to reduce cost more, 00:31:55.960 --> 00:31:57.910 align:middle line:84% so they would be more inclined to invest? 00:31:57.910 --> 00:31:59.870 align:middle line:84% And for a risk premium declining, 00:31:59.870 --> 00:32:01.825 align:middle line:84% they can take and borrow [INAUDIBLE].. 00:32:01.825 --> 00:32:02.950 align:middle line:90% RICARDO CABALLERO: Exactly. 00:32:02.950 --> 00:32:03.790 align:middle line:90% That's it. 00:32:03.790 --> 00:32:06.760 align:middle line:84% The cost of borrowing went up or down for firms. 00:32:06.760 --> 00:32:08.480 align:middle line:90% So that's what I'm saying. 00:32:08.480 --> 00:32:11.203 align:middle line:84% Those two things operate almost as monetary policy. 00:32:11.203 --> 00:32:13.120 align:middle line:84% That has not been done by the Fed, by the way, 00:32:13.120 --> 00:32:14.210 align:middle line:90% by the central bank. 00:32:14.210 --> 00:32:16.043 align:middle line:84% But they have the same effect because that's 00:32:16.043 --> 00:32:16.850 align:middle line:90% the way they enter. 00:32:16.850 --> 00:32:19.820 align:middle line:84% They enter exactly the same as an interest rate. 00:32:19.820 --> 00:32:22.210 align:middle line:84% So saying that this guy is going up 00:32:22.210 --> 00:32:24.820 align:middle line:84% or that this guy is going down leads 00:32:24.820 --> 00:32:30.730 align:middle line:84% to the same analysis as when we lower i 00:32:30.730 --> 00:32:32.010 align:middle line:90% because they're identical. 00:32:32.010 --> 00:32:33.750 align:middle line:84% They enter exactly in the same place. 00:32:33.750 --> 00:32:35.030 align:middle line:90% No? 00:32:35.030 --> 00:32:40.050 align:middle line:84% So what I showed you here, I had done diagrams like this before. 00:32:40.050 --> 00:32:42.930 align:middle line:84% That's what you get when you lower the interest rate. 00:32:42.930 --> 00:32:45.930 align:middle line:84% Well, the two strokes describe is effectively 00:32:45.930 --> 00:32:49.140 align:middle line:84% like lowering the interest rate that is the relevant interest 00:32:49.140 --> 00:32:55.020 align:middle line:84% rate for the firms because lower credit 00:32:55.020 --> 00:32:57.030 align:middle line:84% spreads, higher expected inflation 00:32:57.030 --> 00:33:00.950 align:middle line:90% means lower real interest rate. 00:33:00.950 --> 00:33:06.170 align:middle line:84% Now, the episode I described you during 00:33:06.170 --> 00:33:10.340 align:middle line:84% the global financial crisis was exact opposite of this. 00:33:10.340 --> 00:33:16.350 align:middle line:84% In the global financial crisis, we had this x, boom, jumping. 00:33:16.350 --> 00:33:20.980 align:middle line:84% And I had shown you before that expected inflation came down 00:33:20.980 --> 00:33:23.500 align:middle line:90% a lot. 00:33:23.500 --> 00:33:28.870 align:middle line:84% Remember, expected inflation came down a lot when negative, 00:33:28.870 --> 00:33:31.150 align:middle line:90% from around 2% to minus 4. 00:33:31.150 --> 00:33:36.690 align:middle line:84% That's a big shock for the real cost of borrowing for firms. 00:33:36.690 --> 00:33:42.080 align:middle line:90% And the x went up like crazy. 00:33:42.080 --> 00:33:45.080 align:middle line:84% That's the reason in the global financial crisis 00:33:45.080 --> 00:33:47.010 align:middle line:84% what we got is exactly the opposite of this. 00:33:47.010 --> 00:33:50.990 align:middle line:84% We got a massive shift down in the ZZ curve 00:33:50.990 --> 00:33:55.568 align:middle line:84% for the reasons we just described. 00:33:55.568 --> 00:33:59.790 align:middle line:84% Because this is the case for x going down or pi going up. 00:33:59.790 --> 00:34:02.400 align:middle line:84% In the global financial crisis, we got exactly the opposite, 00:34:02.400 --> 00:34:05.300 align:middle line:84% and in massive amounts, massive increase 00:34:05.300 --> 00:34:08.670 align:middle line:84% in x, massive decline in expected inflation. 00:34:08.670 --> 00:34:12.679 align:middle line:84% So it's the exact opposite of this and in a much larger scale. 00:34:12.679 --> 00:34:15.409 align:middle line:90% It was a massive shock. 00:34:15.409 --> 00:34:15.909 align:middle line:90% Good. 00:34:15.909 --> 00:34:19.239 align:middle line:90% 00:34:19.239 --> 00:34:21.230 align:middle line:84% So that's the case I was just describing. 00:34:21.230 --> 00:34:23.397 align:middle line:84% That's what happened in the global financial crisis. 00:34:23.397 --> 00:34:26.440 align:middle line:84% So the first thing is, so if x goes up, 00:34:26.440 --> 00:34:28.480 align:middle line:84% as it did in the global financial crisis 00:34:28.480 --> 00:34:30.429 align:middle line:90% and the Great Recession-- 00:34:30.429 --> 00:34:32.590 align:middle line:84% by the way, when I say the global financial crisis 00:34:32.590 --> 00:34:34.860 align:middle line:84% or the Great Recession, those are the same episode. 00:34:34.860 --> 00:34:36.000 align:middle line:90% They end up being-- 00:34:36.000 --> 00:34:37.489 align:middle line:84% it started from a financial crisis, 00:34:37.489 --> 00:34:41.080 align:middle line:84% and it turned out ended up being a recession everywhere 00:34:41.080 --> 00:34:44.621 align:middle line:84% and a financial crisis everywhere as well. 00:34:44.621 --> 00:34:48.190 align:middle line:84% But anyway, so what I just described is this. 00:34:48.190 --> 00:34:53.790 align:middle line:84% In the IS-LM space, the IS is shifting inwards a lot. 00:34:53.790 --> 00:34:57.660 align:middle line:84% For any given nominal interest rate, if x goes up a lot, 00:34:57.660 --> 00:34:59.790 align:middle line:84% that means there is less investment 00:34:59.790 --> 00:35:03.000 align:middle line:84% and that means that the LM shift to the-- 00:35:03.000 --> 00:35:05.020 align:middle line:90% sorry, the IS shift to the left. 00:35:05.020 --> 00:35:07.580 align:middle line:84% And the same would happen if there is 00:35:07.580 --> 00:35:09.030 align:middle line:90% a fall in expected inflation. 00:35:09.030 --> 00:35:11.450 align:middle line:84% So for the Great Recession, we have two reasons why 00:35:11.450 --> 00:35:13.350 align:middle line:90% this thing move inward a lot. 00:35:13.350 --> 00:35:14.960 align:middle line:84% One, expected inflation came down, 00:35:14.960 --> 00:35:17.840 align:middle line:84% and the other one, x went up a lot, massive movement 00:35:17.840 --> 00:35:19.270 align:middle line:90% to the left. 00:35:19.270 --> 00:35:21.730 align:middle line:84% Now, what do you think a central bank should do faced 00:35:21.730 --> 00:35:23.682 align:middle line:90% with a situation like this? 00:35:23.682 --> 00:35:24.890 align:middle line:90% AUDIENCE: Drop interest rate. 00:35:24.890 --> 00:35:26.570 align:middle line:84% RICARDO CABALLERO: Drop interest rate. 00:35:26.570 --> 00:35:27.660 align:middle line:90% Why do you do that? 00:35:27.660 --> 00:35:30.810 align:middle line:84% Well, because this shocks negative interest rates, 00:35:30.810 --> 00:35:32.638 align:middle line:84% like, shocks to the interest rate. 00:35:32.638 --> 00:35:34.430 align:middle line:84% Effectively, it's like if you had increased 00:35:34.430 --> 00:35:35.640 align:middle line:90% the interest rate a lot. 00:35:35.640 --> 00:35:38.330 align:middle line:84% And so the central bank will try to offset that 00:35:38.330 --> 00:35:40.400 align:middle line:90% by lowering the interest rate. 00:35:40.400 --> 00:35:46.438 align:middle line:84% What problem may the central bank face in doing this? 00:35:46.438 --> 00:35:48.210 align:middle line:84% AUDIENCE: Reaching low-liquidity trap. 00:35:48.210 --> 00:35:49.980 align:middle line:84% RICARDO CABALLERO: Yeah, reaching the zero lower bound 00:35:49.980 --> 00:35:52.025 align:middle line:84% effectively lowered one liquidity trap, exactly. 00:35:52.025 --> 00:35:53.650 align:middle line:84% There's a limit of how much you can do. 00:35:53.650 --> 00:35:57.480 align:middle line:84% And I showed you that that's what happened really here. 00:35:57.480 --> 00:36:00.870 align:middle line:84% Effectively, this is-- the reason 00:36:00.870 --> 00:36:02.300 align:middle line:84% it looks so flat, it doesn't move, 00:36:02.300 --> 00:36:04.020 align:middle line:84% is because it's against the lower bound. 00:36:04.020 --> 00:36:06.050 align:middle line:90% It cannot move. 00:36:06.050 --> 00:36:08.760 align:middle line:84% Let me tell you a little bit about what's happening now. 00:36:08.760 --> 00:36:10.880 align:middle line:90% So this is now. 00:36:10.880 --> 00:36:15.170 align:middle line:84% Remember, the other one was for the period from 2008 to 2013, 00:36:15.170 --> 00:36:15.860 align:middle line:90% I showed you. 00:36:15.860 --> 00:36:18.210 align:middle line:84% Now I'm shifting everything by 10 years. 00:36:18.210 --> 00:36:25.190 align:middle line:84% So still you see, on average, the white line, which 00:36:25.190 --> 00:36:30.403 align:middle line:84% is the nominal interest rate, is above the orange line-- 00:36:30.403 --> 00:36:31.820 align:middle line:84% the orange line-- the yellow line, 00:36:31.820 --> 00:36:35.880 align:middle line:90% which is the real interest rate. 00:36:35.880 --> 00:36:36.490 align:middle line:90% Why is that? 00:36:36.490 --> 00:36:43.710 align:middle line:90% 00:36:43.710 --> 00:36:44.302 align:middle line:90% Yep. 00:36:44.302 --> 00:36:45.510 align:middle line:90% AUDIENCE: Positive inflation? 00:36:45.510 --> 00:36:46.420 align:middle line:84% RICARDO CABALLERO: Positive inflate-- 00:36:46.420 --> 00:36:47.500 align:middle line:90% expected inflation. 00:36:47.500 --> 00:36:49.140 align:middle line:90% But they're correlated. 00:36:49.140 --> 00:36:50.860 align:middle line:84% When inflation is on average positive, 00:36:50.860 --> 00:36:54.920 align:middle line:84% then expected inflation is also, on average, positive. 00:36:54.920 --> 00:36:56.280 align:middle line:90% There's an exception there. 00:36:56.280 --> 00:36:57.180 align:middle line:90% Why is that? 00:36:57.180 --> 00:36:58.300 align:middle line:90% When did that happen? 00:36:58.300 --> 00:37:03.280 align:middle line:90% 00:37:03.280 --> 00:37:07.770 align:middle line:84% There's one point where the real interest 00:37:07.770 --> 00:37:10.714 align:middle line:84% rate went above the nominal interest rate. 00:37:10.714 --> 00:37:12.858 align:middle line:90% AUDIENCE: COVID recession. 00:37:12.858 --> 00:37:13.900 align:middle line:90% RICARDO CABALLERO: Sorry. 00:37:13.900 --> 00:37:14.983 align:middle line:90% AUDIENCE: COVID recession? 00:37:14.983 --> 00:37:16.358 align:middle line:84% RICARDO CABALLERO: Yeah, exactly. 00:37:16.358 --> 00:37:17.240 align:middle line:90% The COVID recession. 00:37:17.240 --> 00:37:20.653 align:middle line:84% So as I said before, that was a massive shock, a scary shock. 00:37:20.653 --> 00:37:22.570 align:middle line:84% And the initial reaction of expected inflation 00:37:22.570 --> 00:37:26.420 align:middle line:84% was to come down enormously, and so that's what we saw. 00:37:26.420 --> 00:37:33.220 align:middle line:84% And also see this big step here in the nominal interest rate, 00:37:33.220 --> 00:37:34.360 align:middle line:90% and then flat. 00:37:34.360 --> 00:37:38.060 align:middle line:84% So what do you think happened there? 00:37:38.060 --> 00:37:39.460 align:middle line:90% Yep. 00:37:39.460 --> 00:37:41.720 align:middle line:84% Again, they went all the way down 00:37:41.720 --> 00:37:43.840 align:middle line:90% to the maximum they could do. 00:37:43.840 --> 00:37:47.460 align:middle line:84% They set the short-term interest rate to 0 effectively. 00:37:47.460 --> 00:37:50.860 align:middle line:84% It's not exactly 0, but to 0, and they stay there 00:37:50.860 --> 00:37:52.690 align:middle line:90% for a very long period of time. 00:37:52.690 --> 00:37:54.430 align:middle line:90% Now, why do you think-- 00:37:54.430 --> 00:37:58.730 align:middle line:84% and this I think helped a lot the recovery of the US economy, 00:37:58.730 --> 00:38:03.490 align:middle line:84% and it also a big reason for the rally 00:38:03.490 --> 00:38:06.670 align:middle line:84% that you saw in the equity market in 2021 00:38:06.670 --> 00:38:09.880 align:middle line:84% you can see in this picture, which is this. 00:38:09.880 --> 00:38:13.185 align:middle line:84% Notice that the real interest rate went very, very low. 00:38:13.185 --> 00:38:16.498 align:middle line:90% 00:38:16.498 --> 00:38:17.040 align:middle line:90% You see that? 00:38:17.040 --> 00:38:19.620 align:middle line:84% The real interest rate went very, very low. 00:38:19.620 --> 00:38:22.000 align:middle line:84% And that's the reason equity markets were flying. 00:38:22.000 --> 00:38:25.200 align:middle line:84% I mean, you had effectively very low real interest rates. 00:38:25.200 --> 00:38:26.610 align:middle line:90% So what happened there? 00:38:26.610 --> 00:38:28.560 align:middle line:90% How did that happen? 00:38:28.560 --> 00:38:30.830 align:middle line:84% What must have happened during this episode? 00:38:30.830 --> 00:38:34.250 align:middle line:84% Yeah, the central bank was injecting everything 00:38:34.250 --> 00:38:37.385 align:middle line:84% possible to it, but even more than monetary policy, 00:38:37.385 --> 00:38:38.760 align:middle line:84% the conventional monetary policy. 00:38:38.760 --> 00:38:42.710 align:middle line:90% But what is the-- 00:38:42.710 --> 00:38:43.690 align:middle line:90% let me say this. 00:38:43.690 --> 00:38:45.280 align:middle line:90% This wedge reflects what? 00:38:45.280 --> 00:38:54.253 align:middle line:90% 00:38:54.253 --> 00:38:58.920 align:middle line:84% What is that wedge as a matter of accounting? 00:38:58.920 --> 00:39:00.540 align:middle line:90% Expected inflation. 00:39:00.540 --> 00:39:01.690 align:middle line:90% It's expected inflation. 00:39:01.690 --> 00:39:04.000 align:middle line:84% So this tells you-- this interest rate was at 0. 00:39:04.000 --> 00:39:06.850 align:middle line:84% The real interest rate was at minus 4 here. 00:39:06.850 --> 00:39:09.443 align:middle line:84% It means that expected inflation must have been 4%. 00:39:09.443 --> 00:39:12.980 align:middle line:90% 00:39:12.980 --> 00:39:15.850 align:middle line:84% So we had a combination in which the nominal interest rate remain 00:39:15.850 --> 00:39:18.700 align:middle line:84% at 0, but inflation was high, which 00:39:18.700 --> 00:39:20.920 align:middle line:84% is not the typical combination we get in recessions, 00:39:20.920 --> 00:39:24.370 align:middle line:84% like the previous one, demand recessions, financial crises, 00:39:24.370 --> 00:39:27.320 align:middle line:84% where inflation goes down when you are in a recession. 00:39:27.320 --> 00:39:28.640 align:middle line:90% This was a different shock. 00:39:28.640 --> 00:39:31.900 align:middle line:84% And after the initial shock, we got lots of bottlenecks 00:39:31.900 --> 00:39:34.000 align:middle line:84% on the supply side of the economy, which 00:39:34.000 --> 00:39:35.780 align:middle line:90% we don't have a good model yet. 00:39:35.780 --> 00:39:37.723 align:middle line:84% Later, we're going to have to model here. 00:39:37.723 --> 00:39:39.640 align:middle line:84% And when you have problems on the supply side, 00:39:39.640 --> 00:39:42.370 align:middle line:84% you can get a situation in which it feels recessionary 00:39:42.370 --> 00:39:44.360 align:middle line:84% because there is low activity and so on, 00:39:44.360 --> 00:39:46.030 align:middle line:90% but inflation is high. 00:39:46.030 --> 00:39:50.210 align:middle line:84% And that's exactly what we had here. 00:39:50.210 --> 00:39:51.495 align:middle line:90% inflation was high. 00:39:51.495 --> 00:39:56.670 align:middle line:84% Now, at some point, for a while we 00:39:56.670 --> 00:39:58.410 align:middle line:84% tolerated this high inflation, thinking 00:39:58.410 --> 00:40:00.910 align:middle line:84% that this was going to be a transitory phenomenon and so on. 00:40:00.910 --> 00:40:04.330 align:middle line:84% But then it began to last for too long. 00:40:04.330 --> 00:40:09.690 align:middle line:84% And when it began to last for too long, then the Fed reacted. 00:40:09.690 --> 00:40:13.590 align:middle line:84% And that's when you see they began to hike interest rates, 00:40:13.590 --> 00:40:15.730 align:middle line:84% And they began to hike interest rate, 00:40:15.730 --> 00:40:21.000 align:middle line:84% and initially it didn't do much to the real rates 00:40:21.000 --> 00:40:24.290 align:middle line:84% because expected inflation kept rising. 00:40:24.290 --> 00:40:26.873 align:middle line:84% And then eventually they convinced everyone 00:40:26.873 --> 00:40:28.290 align:middle line:84% that they were serious about this, 00:40:28.290 --> 00:40:33.800 align:middle line:84% and so real interest rates began to rise a lot here. 00:40:33.800 --> 00:40:36.230 align:middle line:84% And that's when the equity market collapsed, by the way. 00:40:36.230 --> 00:40:38.210 align:middle line:84% You don't know that yet, but I'm going to talk about the equity 00:40:38.210 --> 00:40:38.880 align:middle line:90% market later on. 00:40:38.880 --> 00:40:42.230 align:middle line:84% But believe me, that's what essentially brought down 00:40:42.230 --> 00:40:46.970 align:middle line:84% the NASDAQ, for sure, primarily, and all these memes stocks 00:40:46.970 --> 00:40:48.240 align:middle line:90% and all that. 00:40:48.240 --> 00:40:49.105 align:middle line:90% That's that. 00:40:49.105 --> 00:40:53.570 align:middle line:90% 00:40:53.570 --> 00:40:55.040 align:middle line:90% What about today? 00:40:55.040 --> 00:40:57.675 align:middle line:84% Well, Houston, we have a problem because, you see, 00:40:57.675 --> 00:41:00.050 align:middle line:84% the Fed keeps raising interest rates and inflation is not 00:41:00.050 --> 00:41:03.310 align:middle line:84% coming down as much as we expected. 00:41:03.310 --> 00:41:05.060 align:middle line:84% In fact, expected inflation initially 00:41:05.060 --> 00:41:06.560 align:middle line:84% looked like it was going to decline, 00:41:06.560 --> 00:41:08.530 align:middle line:84% and now it's beginning to pick up again. 00:41:08.530 --> 00:41:10.090 align:middle line:84% So you have a situation here where 00:41:10.090 --> 00:41:13.770 align:middle line:84% the Fed wants to be restrictive, but the real interest rate 00:41:13.770 --> 00:41:15.370 align:middle line:90% is declining, not going up. 00:41:15.370 --> 00:41:16.980 align:middle line:90% That's a problem. 00:41:16.980 --> 00:41:17.790 align:middle line:90% That's a problem. 00:41:17.790 --> 00:41:20.460 align:middle line:84% That's what is happening at this very moment. 00:41:20.460 --> 00:41:22.520 align:middle line:84% The Fed has a big problem because of that. 00:41:22.520 --> 00:41:24.270 align:middle line:84% They are trying to tighten interest rates, 00:41:24.270 --> 00:41:27.870 align:middle line:84% but financial conditions are relaxing in a sense 00:41:27.870 --> 00:41:30.450 align:middle line:84% because of an increase in expected inflation 00:41:30.450 --> 00:41:34.140 align:middle line:84% and even credit spreads were declining, in fact. 00:41:34.140 --> 00:41:38.280 align:middle line:84% So here is what I just said in terms of inflation, 00:41:38.280 --> 00:41:39.370 align:middle line:90% expected inflation. 00:41:39.370 --> 00:41:42.300 align:middle line:84% And you see here the big collapse during COVID, 00:41:42.300 --> 00:41:44.790 align:middle line:84% early on in COVID, but then it recovered very strongly 00:41:44.790 --> 00:41:47.920 align:middle line:90% and went very high. 00:41:47.920 --> 00:41:51.540 align:middle line:84% And actually, in the middle of 2022, it really went up a lot. 00:41:51.540 --> 00:41:53.290 align:middle line:84% And that's when the Fed really got scared, 00:41:53.290 --> 00:41:56.110 align:middle line:84% and that's when they began to increase interest rates by 75 00:41:56.110 --> 00:41:57.800 align:middle line:90% basis points in a hurry. 00:41:57.800 --> 00:41:59.453 align:middle line:90% OK, good. 00:41:59.453 --> 00:42:00.870 align:middle line:84% And this is what you see recently. 00:42:00.870 --> 00:42:04.500 align:middle line:84% I told you that we have a problem now because expected 00:42:04.500 --> 00:42:06.540 align:middle line:90% inflation, they were able-- 00:42:06.540 --> 00:42:11.400 align:middle line:84% there is a famous conference happens in Jackson Hole, 00:42:11.400 --> 00:42:18.330 align:middle line:84% and it's famous mostly because most central chairs 00:42:18.330 --> 00:42:20.400 align:middle line:84% of presidents of central banks, governors 00:42:20.400 --> 00:42:24.610 align:middle line:84% of central banks around the world meet for a few days there. 00:42:24.610 --> 00:42:26.400 align:middle line:84% But there is one speech that everyone 00:42:26.400 --> 00:42:33.270 align:middle line:84% looks at, which is the speech of the Chair of the US Central 00:42:33.270 --> 00:42:34.380 align:middle line:90% Bank, the Fed. 00:42:34.380 --> 00:42:38.430 align:middle line:84% And they were very worried-- that conference happened around 00:42:38.430 --> 00:42:41.700 align:middle line:84% here, and they were very worried because expected inflation 00:42:41.700 --> 00:42:42.940 align:middle line:90% was just exploding. 00:42:42.940 --> 00:42:46.920 align:middle line:84% I mean, 6% or so, those are unheard of numbers for the US 00:42:46.920 --> 00:42:48.450 align:middle line:90% since the '80s. 00:42:48.450 --> 00:42:51.430 align:middle line:84% And so they came up with a very tough speech, 00:42:51.430 --> 00:42:55.030 align:middle line:84% a very hawkish speech, saying, look, this is unacceptable. 00:42:55.030 --> 00:42:58.090 align:middle line:84% We are going to do whatever it takes to bring this stuff down. 00:42:58.090 --> 00:43:01.030 align:middle line:84% And they were very successful persuading people. 00:43:01.030 --> 00:43:02.530 align:middle line:84% In fact, expected inflation began 00:43:02.530 --> 00:43:04.660 align:middle line:84% to decline a lot very quickly, which 00:43:04.660 --> 00:43:08.980 align:middle line:84% is one of the reasons you see real rates rising very fast, 00:43:08.980 --> 00:43:11.890 align:middle line:84% in fact, faster than the nominal rate, 00:43:11.890 --> 00:43:13.640 align:middle line:84% because nominal rates were rising. 00:43:13.640 --> 00:43:16.970 align:middle line:84% And on top of that, expected inflation began to plummet, 00:43:16.970 --> 00:43:19.450 align:middle line:84% and that led to a very sharp rise in real interest rates 00:43:19.450 --> 00:43:25.420 align:middle line:84% and the collapse in the stock market as a result. 00:43:25.420 --> 00:43:28.850 align:middle line:84% What about credit spreads in this episode? 00:43:28.850 --> 00:43:32.040 align:middle line:90% 00:43:32.040 --> 00:43:37.320 align:middle line:84% Well, here you see, during the COVID shock, again 00:43:37.320 --> 00:43:38.980 align:middle line:90% we got a big spike here. 00:43:38.980 --> 00:43:41.190 align:middle line:84% It was not as large as in the other one, which 00:43:41.190 --> 00:43:45.970 align:middle line:84% was a financial crisis per se, but it was a very large spike. 00:43:45.970 --> 00:43:49.180 align:middle line:84% And then eventually of came down, and it came down a lot. 00:43:49.180 --> 00:43:51.680 align:middle line:84% That's again, when you're seeing rallying in all the markets 00:43:51.680 --> 00:43:53.810 align:middle line:90% and so on. 00:43:53.810 --> 00:43:55.080 align:middle line:90% But then began to go up. 00:43:55.080 --> 00:43:57.415 align:middle line:84% And again, here, we began to have a problem 00:43:57.415 --> 00:43:58.790 align:middle line:84% because the Fed wanted to tighten 00:43:58.790 --> 00:44:02.570 align:middle line:84% and these credit spreads were coming down. 00:44:02.570 --> 00:44:05.720 align:middle line:84% I think I did this on Sunday or something. 00:44:05.720 --> 00:44:06.860 align:middle line:90% Today is 27? 00:44:06.860 --> 00:44:07.940 align:middle line:90% Yeah, I did it yesterday. 00:44:07.940 --> 00:44:09.750 align:middle line:90% There it is. 00:44:09.750 --> 00:44:12.690 align:middle line:84% So this pickup here is very recent. 00:44:12.690 --> 00:44:15.120 align:middle line:90% It's last week. 00:44:15.120 --> 00:44:17.020 align:middle line:84% But credit spreads were declining, 00:44:17.020 --> 00:44:20.820 align:middle line:84% and that, again, goes against what the Fed wants to do, 00:44:20.820 --> 00:44:25.200 align:middle line:84% which is to tighten financial conditions for firms. 00:44:25.200 --> 00:44:32.400 align:middle line:84% Now, as I said before, central banks typically intervene only-- 00:44:32.400 --> 00:44:35.460 align:middle line:90% the monetary policy. 00:44:35.460 --> 00:44:40.060 align:middle line:84% involves very short duration Treasury bonds, 00:44:40.060 --> 00:44:44.370 align:middle line:84% so their own bonds, the bonds of that government, in most places 00:44:44.370 --> 00:44:45.980 align:middle line:90% like that. 00:44:45.980 --> 00:44:49.560 align:middle line:84% But this shock was so disconcerting and so large, 00:44:49.560 --> 00:44:52.220 align:middle line:84% and it did affect corporations a lot 00:44:52.220 --> 00:44:54.680 align:middle line:84% because imagine you're in the airline industry, 00:44:54.680 --> 00:44:56.640 align:middle line:90% and then suddenly you get COVID. 00:44:56.640 --> 00:45:02.060 align:middle line:84% So it really was a major shock to corporations, 00:45:02.060 --> 00:45:06.380 align:middle line:84% and so they went beyond traditional conventional 00:45:06.380 --> 00:45:07.457 align:middle line:90% monetary policy. 00:45:07.457 --> 00:45:10.040 align:middle line:84% They certainly-- something that had done already in the global 00:45:10.040 --> 00:45:12.860 align:middle line:84% financial crisis, they began to buy sort of very long-duration 00:45:12.860 --> 00:45:16.840 align:middle line:84% US Treasury bonds, so 10-year bonds and so on, the US 00:45:16.840 --> 00:45:17.340 align:middle line:90% Treasury. 00:45:17.340 --> 00:45:19.640 align:middle line:84% But they went beyond that and they created a facility 00:45:19.640 --> 00:45:22.190 align:middle line:90% to buy corporate bonds. 00:45:22.190 --> 00:45:25.670 align:middle line:84% That facility was meant to deal with x. 00:45:25.670 --> 00:45:29.480 align:middle line:84% You're getting a huge x shock, and they went directly 00:45:29.480 --> 00:45:32.430 align:middle line:84% to that to try to bring that x shock down. 00:45:32.430 --> 00:45:33.770 align:middle line:90% Why do they want to do that? 00:45:33.770 --> 00:45:36.140 align:middle line:84% Well, because of the reasons we have explained here. 00:45:36.140 --> 00:45:40.200 align:middle line:90% 00:45:40.200 --> 00:45:43.080 align:middle line:84% That amounted the x shock, which came together 00:45:43.080 --> 00:45:46.050 align:middle line:84% with expected inflation coming down, amount to a big shift 00:45:46.050 --> 00:45:46.690 align:middle line:90% there. 00:45:46.690 --> 00:45:49.760 align:middle line:84% They did all they could with conventional monetary policy. 00:45:49.760 --> 00:45:50.910 align:middle line:90% They brought this down. 00:45:50.910 --> 00:45:53.490 align:middle line:84% So you can think of their policy of intervention 00:45:53.490 --> 00:45:55.810 align:middle line:84% is called-- they're called large-scale asset purchases. 00:45:55.810 --> 00:45:57.420 align:middle line:90% That's a generic number of that. 00:45:57.420 --> 00:45:59.250 align:middle line:84% Well, what they were trying to do really 00:45:59.250 --> 00:46:00.983 align:middle line:84% is to act on those interest rates that 00:46:00.983 --> 00:46:02.025 align:middle line:90% do not show up in the LM. 00:46:02.025 --> 00:46:04.770 align:middle line:90% They show up in here, in x. 00:46:04.770 --> 00:46:06.690 align:middle line:90% x is a parameter of here. 00:46:06.690 --> 00:46:11.460 align:middle line:84% If I go out there and I buy corporate bonds, 00:46:11.460 --> 00:46:15.745 align:middle line:84% then I'm reducing x, which is a way of shifting the IS back. 00:46:15.745 --> 00:46:18.120 align:middle line:84% Corporations can borrow more cheaply if the government is 00:46:18.120 --> 00:46:19.980 align:middle line:90% buying their bonds. 00:46:19.980 --> 00:46:21.300 align:middle line:90% That's the whole idea. 00:46:21.300 --> 00:46:27.450 align:middle line:84% In Japan, they even bought equity, directly equity, 00:46:27.450 --> 00:46:29.400 align:middle line:84% interventions in the equity market. 00:46:29.400 --> 00:46:32.110 align:middle line:84% So happened in Hong Kong in 1997. 00:46:32.110 --> 00:46:34.540 align:middle line:84% There was a massive intervention in the equity market. 00:46:34.540 --> 00:46:36.220 align:middle line:84% Typically, central banks don't do that. 00:46:36.220 --> 00:46:38.610 align:middle line:84% But when situations get desperate 00:46:38.610 --> 00:46:41.440 align:middle line:84% and you are against the zero lower bound, 00:46:41.440 --> 00:46:45.220 align:middle line:84% so you lost your conventional monetary tool, 00:46:45.220 --> 00:46:47.560 align:middle line:84% they tend to be a little more creative, 00:46:47.560 --> 00:46:49.020 align:middle line:84% and that's what they've been doing. 00:46:49.020 --> 00:46:52.960 align:middle line:90% 00:46:52.960 --> 00:46:54.190 align:middle line:90% OK. 00:46:54.190 --> 00:46:55.960 align:middle line:90% Any questions? 00:46:55.960 --> 00:46:57.260 align:middle line:90% That's it for today. 00:46:57.260 --> 00:46:59.300 align:middle line:84% From the-- yeah, you have a question. 00:46:59.300 --> 00:47:02.930 align:middle line:84% AUDIENCE: Could you put x into more tangible terms? 00:47:02.930 --> 00:47:05.295 align:middle line:84% I think I'm still sort of trying to figure out what a-- 00:47:05.295 --> 00:47:06.670 align:middle line:84% RICARDO CABALLERO: Credit spread. 00:47:06.670 --> 00:47:11.650 align:middle line:90% For example, if Boeing-- 00:47:11.650 --> 00:47:13.195 align:middle line:84% I don't think Boeing is a high yield. 00:47:13.195 --> 00:47:17.350 align:middle line:90% 00:47:17.350 --> 00:47:18.580 align:middle line:90% Well, let's say Boeing. 00:47:18.580 --> 00:47:19.150 align:middle line:90% It's OK. 00:47:19.150 --> 00:47:22.000 align:middle line:84% If Boeing borrows, they're not going to be able to borrow-- 00:47:22.000 --> 00:47:23.480 align:middle line:90% say, the 10-year rate-- 00:47:23.480 --> 00:47:25.780 align:middle line:84% I'm showing it here in 10-year rate spread. 00:47:25.780 --> 00:47:30.820 align:middle line:84% The 10-year rate for the US at this moment is close to 4%. 00:47:30.820 --> 00:47:33.820 align:middle line:84% If Boeing wants to borrow 10 years, 00:47:33.820 --> 00:47:35.720 align:middle line:84% it's not going to be able to borrow at 4%. 00:47:35.720 --> 00:47:37.550 align:middle line:84% They're going to have to borrow at 7%, 00:47:37.550 --> 00:47:39.170 align:middle line:90% so there's a 3% difference. 00:47:39.170 --> 00:47:40.327 align:middle line:90% That's x. 00:47:40.327 --> 00:47:41.640 align:middle line:84% AUDIENCE: And that's the credit-- is that credit? 00:47:41.640 --> 00:47:42.807 align:middle line:90% RICARDO CABALLERO: That's x. 00:47:42.807 --> 00:47:44.910 align:middle line:84% That's credit spread, which is linked 00:47:44.910 --> 00:47:48.760 align:middle line:84% to the perceived probability of default. I said, it's perceived. 00:47:48.760 --> 00:47:51.270 align:middle line:84% When you say perceived, is that, say, 00:47:51.270 --> 00:47:53.610 align:middle line:84% the actual probability of default? 00:47:53.610 --> 00:47:55.253 align:middle line:90% Who knows who can measure that? 00:47:55.253 --> 00:47:56.670 align:middle line:84% They are, again, agencies that try 00:47:56.670 --> 00:47:59.640 align:middle line:84% to measure them, plus whatever extra risk premium you 00:47:59.640 --> 00:48:01.380 align:middle line:90% want to put on top of that. 00:48:01.380 --> 00:48:02.755 align:middle line:84% AUDIENCE: And so this is tracking 00:48:02.755 --> 00:48:07.522 align:middle line:84% the relative, this reliability of [INAUDIBLE]?? 00:48:07.522 --> 00:48:09.230 align:middle line:84% RICARDO CABALLERO: Yeah, how unattractive 00:48:09.230 --> 00:48:12.380 align:middle line:84% it looks to lend to a corporate versus lending 00:48:12.380 --> 00:48:13.682 align:middle line:90% to the US government. 00:48:13.682 --> 00:48:15.140 align:middle line:84% And when this line is very high, it 00:48:15.140 --> 00:48:17.210 align:middle line:84% looks very unattractive to lend to corporations, 00:48:17.210 --> 00:48:20.125 align:middle line:84% and therefore you need to be compensated a lot for that. 00:48:20.125 --> 00:48:22.820 align:middle line:90% 00:48:22.820 --> 00:48:25.330 align:middle line:90% OK, good. 00:48:25.330 --> 00:48:36.000 align:middle line:90%