WEBVTT 00:00:00.000 --> 00:00:01.964 align:middle line:90% [SQUEAKING] 00:00:01.964 --> 00:00:03.928 align:middle line:90% [RUSTLING] 00:00:03.928 --> 00:00:04.910 align:middle line:90% [CLICKING] 00:00:04.910 --> 00:00:16.219 align:middle line:90% 00:00:16.219 --> 00:00:19.040 align:middle line:84% RICARDO CABALLERO: Expectations play a huge role in economics. 00:00:19.040 --> 00:00:22.813 align:middle line:84% So what I want to today, not only in asset pricing-- 00:00:22.813 --> 00:00:24.230 align:middle line:84% I mean, asset pricing-- obviously, 00:00:24.230 --> 00:00:26.390 align:middle line:84% it's all about the future, really, 00:00:26.390 --> 00:00:28.610 align:middle line:84% but also in the kind of issues we 00:00:28.610 --> 00:00:32.880 align:middle line:84% have discussed throughout the course. 00:00:32.880 --> 00:00:35.390 align:middle line:84% And so that's what I want to do, essentially, 00:00:35.390 --> 00:00:39.290 align:middle line:84% is I want to give you a shortcut to think 00:00:39.290 --> 00:00:43.430 align:middle line:84% about the role of expectations in the kind of models 00:00:43.430 --> 00:00:44.670 align:middle line:90% we have already discussed. 00:00:44.670 --> 00:00:46.462 align:middle line:84% And so I'm going to do all that in the most 00:00:46.462 --> 00:00:49.110 align:middle line:84% basic model we have discussed, which is the IS-LM model. 00:00:49.110 --> 00:00:54.050 align:middle line:84% And I hope you'll get the gist of what expectations 00:00:54.050 --> 00:00:56.940 align:middle line:90% can do in economics. 00:00:56.940 --> 00:01:01.160 align:middle line:84% So this is going to be a very compressed version, adapted 00:01:01.160 --> 00:01:03.330 align:middle line:90% version, of chapters 15 and 16. 00:01:03.330 --> 00:01:06.950 align:middle line:84% But in terms of material mapping into the book, 00:01:06.950 --> 00:01:09.180 align:middle line:90% those are the relevant chapters. 00:01:09.180 --> 00:01:12.350 align:middle line:84% And the main idea here is that the IS-LM model 00:01:12.350 --> 00:01:14.510 align:middle line:84% as we have described it up to now 00:01:14.510 --> 00:01:17.405 align:middle line:90% really overweights the present. 00:01:17.405 --> 00:01:20.240 align:middle line:90% 00:01:20.240 --> 00:01:24.350 align:middle line:84% And in practice, expectations about future conditions 00:01:24.350 --> 00:01:27.570 align:middle line:84% play a big role in the decision of all economic actors. 00:01:27.570 --> 00:01:30.360 align:middle line:84% We'll look at investors, asset pricing and so on. 00:01:30.360 --> 00:01:32.040 align:middle line:90% But it's also true of consumers. 00:01:32.040 --> 00:01:33.840 align:middle line:90% It's also true of firms. 00:01:33.840 --> 00:01:36.922 align:middle line:84% I mean, if you think about firms, in investment decision, 00:01:36.922 --> 00:01:38.630 align:middle line:84% we made the function of the interest rate 00:01:38.630 --> 00:01:39.980 align:middle line:90% on our current output. 00:01:39.980 --> 00:01:42.132 align:middle line:84% But it's quite clear that the reason firms 00:01:42.132 --> 00:01:44.090 align:middle line:84% invest is not because of the current condition. 00:01:44.090 --> 00:01:46.680 align:middle line:84% It's because they anticipate making profits in the future. 00:01:46.680 --> 00:01:49.080 align:middle line:84% So it's all about real expectations. 00:01:49.080 --> 00:01:52.220 align:middle line:84% And even governments and foreigners, when they invest, 00:01:52.220 --> 00:01:55.380 align:middle line:84% do foreign direct investment, they go and invest in a country, 00:01:55.380 --> 00:01:58.160 align:middle line:84% it's a lot about expectations of what the country will 00:01:58.160 --> 00:02:00.202 align:middle line:90% do in the future. 00:02:00.202 --> 00:02:01.910 align:middle line:84% I mean, political elections, for example, 00:02:01.910 --> 00:02:06.320 align:middle line:84% have huge impact on asset prices and so on precisely 00:02:06.320 --> 00:02:09.979 align:middle line:84% because they change what people think, for good or for bad, 00:02:09.979 --> 00:02:12.020 align:middle line:90% about future conditions. 00:02:12.020 --> 00:02:15.540 align:middle line:84% So expectations is just huge in economics. 00:02:15.540 --> 00:02:18.090 align:middle line:84% So we want to do things in two steps. 00:02:18.090 --> 00:02:21.510 align:middle line:84% The first, I'm going to revisit the consumption 00:02:21.510 --> 00:02:23.950 align:middle line:84% function and the investment function, 00:02:23.950 --> 00:02:25.950 align:middle line:84% now taking into account expectations 00:02:25.950 --> 00:02:30.030 align:middle line:84% and motivate how you should really think about consumption 00:02:30.030 --> 00:02:32.730 align:middle line:84% and investment in a more realistic model 00:02:32.730 --> 00:02:35.500 align:middle line:90% than we have been discussing. 00:02:35.500 --> 00:02:39.720 align:middle line:84% And then I want to embed not the fully fleshed 00:02:39.720 --> 00:02:41.490 align:middle line:84% out consumption and investment decisions, 00:02:41.490 --> 00:02:48.540 align:middle line:84% but the flavor of the role of the future into the IS-LM model. 00:02:48.540 --> 00:02:52.860 align:middle line:84% And by then, you would have seen-- 00:02:52.860 --> 00:02:56.370 align:middle line:84% you will have seen all that I wanted to communicate, at least, 00:02:56.370 --> 00:02:59.660 align:middle line:90% in this set of lectures. 00:02:59.660 --> 00:03:03.620 align:middle line:84% So let's think about, first, consumption. 00:03:03.620 --> 00:03:08.700 align:middle line:84% And up to now, we assume that consumption depended only 00:03:08.700 --> 00:03:14.280 align:middle line:84% on disposable income, on current disposable income. 00:03:14.280 --> 00:03:17.050 align:middle line:84% But that's not really the way it works. 00:03:17.050 --> 00:03:20.400 align:middle line:84% And one of the first in formulating, more or less, 00:03:20.400 --> 00:03:23.610 align:middle line:84% formally how consumption decisions are really made 00:03:23.610 --> 00:03:25.440 align:middle line:90% is Milton Friedman. 00:03:25.440 --> 00:03:28.890 align:middle line:84% And he called it the permanent income theory of consumption, 00:03:28.890 --> 00:03:32.010 align:middle line:84% meaning what really matters to you in a consumption decision is 00:03:32.010 --> 00:03:34.440 align:middle line:84% not so much your current income, but it's 00:03:34.440 --> 00:03:37.180 align:middle line:84% what you expect to get on average during your lifetime. 00:03:37.180 --> 00:03:39.270 align:middle line:84% And you don't want to be moving consumption 00:03:39.270 --> 00:03:41.940 align:middle line:90% up and down like crazy. 00:03:41.940 --> 00:03:44.610 align:middle line:84% Once you realize, more or less, what you'll get on average, 00:03:44.610 --> 00:03:46.110 align:middle line:84% then you should-- consumption should 00:03:46.110 --> 00:03:49.230 align:middle line:90% be related to that concept. 00:03:49.230 --> 00:03:54.600 align:middle line:84% And in a sense, it's also by thinking in these terms, 00:03:54.600 --> 00:03:57.060 align:middle line:84% you're also drawing a big distinction between things 00:03:57.060 --> 00:03:59.310 align:middle line:84% that are temporary and that shouldn't matter 00:03:59.310 --> 00:04:01.380 align:middle line:84% a lot for your consumption decisions 00:04:01.380 --> 00:04:02.910 align:middle line:84% versus things that are permanent, 00:04:02.910 --> 00:04:06.600 align:middle line:84% that clearly have a potential to have a much larger impact 00:04:06.600 --> 00:04:07.693 align:middle line:90% on your consumption. 00:04:07.693 --> 00:04:09.360 align:middle line:84% Of course, you can have temporary things 00:04:09.360 --> 00:04:10.270 align:middle line:90% that are very large. 00:04:10.270 --> 00:04:13.080 align:middle line:84% I mean, you win the lottery, that's a huge temporary shock. 00:04:13.080 --> 00:04:15.220 align:middle line:84% But probably you're not going to spend the whole lottery right 00:04:15.220 --> 00:04:15.720 align:middle line:90% away. 00:04:15.720 --> 00:04:19.646 align:middle line:84% You're going to smooth it over your lifetime, in any event. 00:04:19.646 --> 00:04:24.760 align:middle line:84% And that actually relates to, more or less at the same time, 00:04:24.760 --> 00:04:30.070 align:middle line:84% Milton Friedman was at Chicago, Franco Modigliani at MIT. 00:04:30.070 --> 00:04:32.800 align:middle line:84% We will develop a life-cycle theory of consumption, which 00:04:32.800 --> 00:04:36.340 align:middle line:84% says, look, even at the level of an individual, 00:04:36.340 --> 00:04:38.633 align:middle line:84% the day-to-day income is not really 00:04:38.633 --> 00:04:40.300 align:middle line:84% what pins down the level of consumption, 00:04:40.300 --> 00:04:41.692 align:middle line:84% because people know early in life 00:04:41.692 --> 00:04:44.150 align:middle line:84% that they have a lower income than they will have later on. 00:04:44.150 --> 00:04:47.750 align:middle line:84% So they will tend to spend and borrow more when they're young. 00:04:47.750 --> 00:04:49.630 align:middle line:84% Then, in the middle, when they're 00:04:49.630 --> 00:04:51.490 align:middle line:84% in the middle of their life cycle, 00:04:51.490 --> 00:04:53.985 align:middle line:84% before retirement, they panic, and you tend to save more. 00:04:53.985 --> 00:04:55.360 align:middle line:84% So you don't consume all you have 00:04:55.360 --> 00:04:57.880 align:middle line:84% because you know there are many years ahead of you where 00:04:57.880 --> 00:05:00.110 align:middle line:84% income will be lower than your consumption needs. 00:05:00.110 --> 00:05:03.400 align:middle line:84% So there is also a sense of intertemporal smoothing 00:05:03.400 --> 00:05:04.640 align:middle line:90% of your consumption. 00:05:04.640 --> 00:05:06.970 align:middle line:84% You don't follow income second by second. 00:05:06.970 --> 00:05:11.020 align:middle line:84% You sort of try to stabilize consumption over time, 00:05:11.020 --> 00:05:11.930 align:middle line:90% more or less. 00:05:11.930 --> 00:05:13.960 align:middle line:84% And that means that you have to think more 00:05:13.960 --> 00:05:16.450 align:middle line:84% about your permanent income, what you'll get on average, 00:05:16.450 --> 00:05:19.280 align:middle line:84% rather than what you get in the short run. 00:05:19.280 --> 00:05:23.540 align:middle line:84% So when you start thinking about consumption in those terms, what 00:05:23.540 --> 00:05:25.370 align:middle line:84% really think, well, what really matters, 00:05:25.370 --> 00:05:28.310 align:middle line:84% then, is total wealth more than income. 00:05:28.310 --> 00:05:30.620 align:middle line:84% How wealthy you are will pin down more or less 00:05:30.620 --> 00:05:35.130 align:middle line:84% the consumption you have more than your current income. 00:05:35.130 --> 00:05:37.840 align:middle line:84% And there are two senses of wealth. 00:05:37.840 --> 00:05:41.960 align:middle line:84% One is financial wealth, all the assets you may have, 00:05:41.960 --> 00:05:44.320 align:middle line:84% you may expect to inherit or whatever, 00:05:44.320 --> 00:05:46.270 align:middle line:90% minus the debts you have. 00:05:46.270 --> 00:05:49.150 align:middle line:84% So very much as we discussed in the previous lecture 00:05:49.150 --> 00:05:52.120 align:middle line:84% in the context of asset pricing, the expected present 00:05:52.120 --> 00:05:54.010 align:middle line:84% discounted value of the cash flows 00:05:54.010 --> 00:05:58.770 align:middle line:84% of all the assets you have, that's your financial wealth. 00:05:58.770 --> 00:05:59.910 align:middle line:90% And that's important. 00:05:59.910 --> 00:06:03.250 align:middle line:84% You have more financial wealth, even if you have no income 00:06:03.250 --> 00:06:05.800 align:middle line:84% today, you will probably borrow against that wealth 00:06:05.800 --> 00:06:07.310 align:middle line:90% to the extent that you can. 00:06:07.310 --> 00:06:11.800 align:middle line:84% And probably the banks will be more willing to lend to you 00:06:11.800 --> 00:06:14.050 align:middle line:84% if they know that you have a lot of wealth. 00:06:14.050 --> 00:06:16.375 align:middle line:84% And so you're going to fund the consumption, which 00:06:16.375 --> 00:06:18.250 align:middle line:84% is above your current income just because you 00:06:18.250 --> 00:06:19.375 align:middle line:90% have more financial wealth. 00:06:19.375 --> 00:06:24.990 align:middle line:90% 00:06:24.990 --> 00:06:29.790 align:middle line:84% In fact, the very rich seldom sell assets. 00:06:29.790 --> 00:06:32.920 align:middle line:84% They borrow against those assets to fund consumption. 00:06:32.920 --> 00:06:35.520 align:middle line:90% That's the way it works. 00:06:35.520 --> 00:06:38.230 align:middle line:84% There are tax advantages of doing that and so on. 00:06:38.230 --> 00:06:40.320 align:middle line:90% But that's the way it works. 00:06:40.320 --> 00:06:44.010 align:middle line:84% And the very rich often have no income, [CHUCKLES] 00:06:44.010 --> 00:06:45.420 align:middle line:90% at least labor income. 00:06:45.420 --> 00:06:48.310 align:middle line:84% All the income comes from returns on assets. 00:06:48.310 --> 00:06:51.510 align:middle line:84% And again, they mostly borrow against that. 00:06:51.510 --> 00:06:54.172 align:middle line:84% But in any event, the point there 00:06:54.172 --> 00:06:56.130 align:middle line:84% is that what really brings out your consumption 00:06:56.130 --> 00:06:59.898 align:middle line:84% is your wealth, not the current flow of income. 00:06:59.898 --> 00:07:01.440 align:middle line:84% And the other very important concept, 00:07:01.440 --> 00:07:06.390 align:middle line:84% which is a bigger thing for most individuals, is human wealth. 00:07:06.390 --> 00:07:09.150 align:middle line:84% I mean, this is huge for all of you here. 00:07:09.150 --> 00:07:11.130 align:middle line:84% It's obvious that your current income 00:07:11.130 --> 00:07:14.230 align:middle line:84% is a lot lower than what your income will be in the future. 00:07:14.230 --> 00:07:17.030 align:middle line:90% You have a lot of human capital. 00:07:17.030 --> 00:07:20.280 align:middle line:84% And so that's also a concept of expected present discounted 00:07:20.280 --> 00:07:25.168 align:middle line:84% value is you expect to earn a lot of income in the future. 00:07:25.168 --> 00:07:27.210 align:middle line:84% And therefore, it makes sense that, at this stage 00:07:27.210 --> 00:07:29.250 align:middle line:90% of your life, you borrow. 00:07:29.250 --> 00:07:32.550 align:middle line:84% Now, banks are a little bit more reluctant of lending you 00:07:32.550 --> 00:07:34.920 align:middle line:84% against your human capital than lending you 00:07:34.920 --> 00:07:36.550 align:middle line:90% against your financial assets. 00:07:36.550 --> 00:07:38.400 align:middle line:84% It's easier to borrow against a house 00:07:38.400 --> 00:07:40.030 align:middle line:90% than against your future income. 00:07:40.030 --> 00:07:42.630 align:middle line:84% But even there, probably you're going to have sort of-- 00:07:42.630 --> 00:07:46.200 align:middle line:84% not going to be saving a lot at this time of your life 00:07:46.200 --> 00:07:49.200 align:middle line:84% because your income is a lot higher in the future. 00:07:49.200 --> 00:07:51.360 align:middle line:90% That we call human wealth. 00:07:51.360 --> 00:07:55.080 align:middle line:84% And total wealth is just a sum of financial wealth 00:07:55.080 --> 00:07:56.470 align:middle line:90% plus human wealth. 00:07:56.470 --> 00:07:59.070 align:middle line:84% So at its most basic level-- and those are-- sorry, 00:07:59.070 --> 00:08:01.890 align:middle line:84% just to relate to things we did in the previous two lectures, 00:08:01.890 --> 00:08:04.930 align:middle line:84% those are two expected present discounted value. 00:08:04.930 --> 00:08:07.450 align:middle line:84% You don't know exactly how much income you're going to get. 00:08:07.450 --> 00:08:08.825 align:middle line:84% You get a sense of, more or less, 00:08:08.825 --> 00:08:10.830 align:middle line:84% what somebody like you does in the future, 00:08:10.830 --> 00:08:12.550 align:middle line:84% more or less on average and so on. 00:08:12.550 --> 00:08:14.010 align:middle line:90% So you have a sense-- 00:08:14.010 --> 00:08:17.770 align:middle line:84% you have an expected cash flow, labor income flow in the future. 00:08:17.770 --> 00:08:19.947 align:middle line:84% You don't know what the interest rates are exactly. 00:08:19.947 --> 00:08:21.780 align:middle line:84% So you're going to guess, more or less, what 00:08:21.780 --> 00:08:23.250 align:middle line:90% the future interest rate is. 00:08:23.250 --> 00:08:26.040 align:middle line:84% And that gives you a sense of human wealth. 00:08:26.040 --> 00:08:28.710 align:middle line:84% And I know that many of these things you are not 00:08:28.710 --> 00:08:31.390 align:middle line:84% calculating every night, what your human wealth is, 00:08:31.390 --> 00:08:35.892 align:middle line:84% and then calculating-- consumes 5% of that or 3.5% of that. 00:08:35.892 --> 00:08:38.350 align:middle line:84% But you know, there are a lot of-- this is very behavioral. 00:08:38.350 --> 00:08:39.940 align:middle line:90% It's really ingrained in you. 00:08:39.940 --> 00:08:44.543 align:middle line:84% And you're probably more likely to spend 00:08:44.543 --> 00:08:46.710 align:middle line:84% more if you think that you're going to be doing well 00:08:46.710 --> 00:08:48.550 align:middle line:90% in the future than not. 00:08:48.550 --> 00:08:50.580 align:middle line:84% Maybe you're too busy now to spend a lot. 00:08:50.580 --> 00:08:52.290 align:middle line:84% But at some point, [CHUCKLES] when 00:08:52.290 --> 00:08:57.420 align:middle line:84% you're given the opportunity, that will make a difference. 00:08:57.420 --> 00:08:59.890 align:middle line:84% Traders, very successful traders-- 00:08:59.890 --> 00:09:01.090 align:middle line:90% they get a very low income. 00:09:01.090 --> 00:09:05.510 align:middle line:84% So essentially, they live out of the income that they get, 00:09:05.510 --> 00:09:07.610 align:middle line:84% they couldn't afford what they normally afford. 00:09:07.610 --> 00:09:09.380 align:middle line:84% But they spent a lot more than that income 00:09:09.380 --> 00:09:12.120 align:middle line:84% because they expect to get a big bonus and things like that. 00:09:12.120 --> 00:09:15.810 align:middle line:84% That's the income that comes in the future. 00:09:15.810 --> 00:09:17.880 align:middle line:84% So in principle, your consumption 00:09:17.880 --> 00:09:19.860 align:middle line:84% should be something that is not proportional 00:09:19.860 --> 00:09:22.860 align:middle line:84% to your disposable income, but really proportional 00:09:22.860 --> 00:09:24.270 align:middle line:90% to your wealth. 00:09:24.270 --> 00:09:28.890 align:middle line:84% And there are estimates of what that proportionality factor is. 00:09:28.890 --> 00:09:31.020 align:middle line:84% And that's what I said, it depends on the type 00:09:31.020 --> 00:09:32.310 align:middle line:90% of assets we're talking about. 00:09:32.310 --> 00:09:36.370 align:middle line:84% But it's about 0.03, that kind of thing, OK? 00:09:36.370 --> 00:09:40.660 align:middle line:90% Now, in reality, that's just-- 00:09:40.660 --> 00:09:43.370 align:middle line:84% it's true this is a better economic concept than just 00:09:43.370 --> 00:09:45.170 align:middle line:90% putting income in there. 00:09:45.170 --> 00:09:48.120 align:middle line:84% But in reality, both things really matter. 00:09:48.120 --> 00:09:50.270 align:middle line:84% So a more realistic consumption function 00:09:50.270 --> 00:09:52.760 align:middle line:84% is something that depends on both things-- 00:09:52.760 --> 00:09:57.390 align:middle line:84% for a variety of reasons, that many people have no savings. 00:09:57.390 --> 00:09:59.820 align:middle line:84% And really, we call them hand-to-mouth. 00:09:59.820 --> 00:10:02.660 align:middle line:84% They live by the income they receive in every single period. 00:10:02.660 --> 00:10:05.750 align:middle line:84% Those people are not thinking about smoothing consumption 00:10:05.750 --> 00:10:06.860 align:middle line:90% over time. 00:10:06.860 --> 00:10:10.820 align:middle line:84% They're consuming whatever income they receive. 00:10:10.820 --> 00:10:13.370 align:middle line:84% As I said before, most banks are not 00:10:13.370 --> 00:10:17.780 align:middle line:84% likely to lend you a lot against your expected present discounted 00:10:17.780 --> 00:10:19.730 align:middle line:90% value of labor income. 00:10:19.730 --> 00:10:22.010 align:middle line:84% So you may be constrained in the short run. 00:10:22.010 --> 00:10:24.770 align:middle line:84% Your income-- you think about how wealthy you'll be, 00:10:24.770 --> 00:10:26.928 align:middle line:84% but you also think about your flows, 00:10:26.928 --> 00:10:28.220 align:middle line:90% the cash flow you're receiving. 00:10:28.220 --> 00:10:30.380 align:middle line:84% That's also part of your considerations. 00:10:30.380 --> 00:10:33.590 align:middle line:84% So in reality, it's a mixture of those two things. 00:10:33.590 --> 00:10:36.350 align:middle line:84% When you look at the micro level at different individuals, 00:10:36.350 --> 00:10:37.890 align:middle line:90% the composition changes. 00:10:37.890 --> 00:10:41.000 align:middle line:84% The richer you are, the more this term matters, 00:10:41.000 --> 00:10:42.320 align:middle line:90% the less this one matters. 00:10:42.320 --> 00:10:46.860 align:middle line:84% The poorer you are, this term overwhelms that term. 00:10:46.860 --> 00:10:49.150 align:middle line:84% That's, more or less, how it works. 00:10:49.150 --> 00:10:52.610 align:middle line:84% But on average, it looks like that. 00:10:52.610 --> 00:10:56.710 align:middle line:84% So we weren't wrong when we did IS-LM, 00:10:56.710 --> 00:10:58.990 align:middle line:84% having the consumption function as increasing 00:10:58.990 --> 00:11:01.780 align:middle line:90% in disposable income. 00:11:01.780 --> 00:11:04.960 align:middle line:84% But I always told you there is a lot of interesting stuff hidden 00:11:04.960 --> 00:11:07.060 align:middle line:90% in that little C0, in the-- 00:11:07.060 --> 00:11:09.110 align:middle line:84% in that autonomous component of consumption. 00:11:09.110 --> 00:11:11.200 align:middle line:84% Well, that-- lots of interesting things 00:11:11.200 --> 00:11:13.602 align:middle line:90% has a lot to do with wealth, OK? 00:11:13.602 --> 00:11:17.458 align:middle line:90% 00:11:17.458 --> 00:11:20.940 align:middle line:84% And again, this term here is something 00:11:20.940 --> 00:11:23.560 align:middle line:84% that captures a lot of things that are permanent. 00:11:23.560 --> 00:11:26.700 align:middle line:84% Well, this one captures a lot of cyclical components and things 00:11:26.700 --> 00:11:27.420 align:middle line:90% of that kind. 00:11:27.420 --> 00:11:30.190 align:middle line:90% 00:11:30.190 --> 00:11:34.000 align:middle line:84% So interpreted this way, the reason-- 00:11:34.000 --> 00:11:38.640 align:middle line:84% people during booms, even though human wealth may not 00:11:38.640 --> 00:11:41.550 align:middle line:84% change much over time, financial wealth 00:11:41.550 --> 00:11:44.570 align:middle line:90% typically changes in a boom. 00:11:44.570 --> 00:11:47.810 align:middle line:84% But it's also the case, in a boom, wages are high. 00:11:47.810 --> 00:11:50.550 align:middle line:84% A lot of people tend to spend more. 00:11:50.550 --> 00:11:53.250 align:middle line:84% Even so, this captures a lot the temporary component. 00:11:53.250 --> 00:11:55.370 align:middle line:84% When you're in a boom, it's likely 00:11:55.370 --> 00:11:57.590 align:middle line:84% that you're going to consume more for any given 00:11:57.590 --> 00:12:00.376 align:middle line:90% level of wealth, OK? 00:12:00.376 --> 00:12:03.850 align:middle line:84% It's temporary, but that's what it is. 00:12:03.850 --> 00:12:06.000 align:middle line:90% What about investment? 00:12:06.000 --> 00:12:07.300 align:middle line:90% That's a decision by the firm. 00:12:07.300 --> 00:12:08.440 align:middle line:90% How much physical capital? 00:12:08.440 --> 00:12:11.220 align:middle line:84% I'm talking about physical investment, real investment, not 00:12:11.220 --> 00:12:13.340 align:middle line:90% financial investment. 00:12:13.340 --> 00:12:17.210 align:middle line:84% The decision also depend on current, but particularly 00:12:17.210 --> 00:12:19.100 align:middle line:90% on expected profits. 00:12:19.100 --> 00:12:21.380 align:middle line:84% And when you think about expected profits, 00:12:21.380 --> 00:12:23.690 align:middle line:84% you need to think about interest rate as well. 00:12:23.690 --> 00:12:25.220 align:middle line:84% We put the interest rate, as I said, 00:12:25.220 --> 00:12:26.660 align:middle line:84% OK, it's more expensive to borrow 00:12:26.660 --> 00:12:27.900 align:middle line:90% if the interest rate is high. 00:12:27.900 --> 00:12:30.560 align:middle line:84% True, but actually it matters a lot more than just 00:12:30.560 --> 00:12:35.630 align:middle line:84% that because it matters also through the expected present 00:12:35.630 --> 00:12:37.422 align:middle line:84% discounted value of your future cash flows. 00:12:37.422 --> 00:12:38.922 align:middle line:84% If the interest rates are very high, 00:12:38.922 --> 00:12:40.700 align:middle line:84% and they're expected to remain very high, 00:12:40.700 --> 00:12:42.800 align:middle line:84% that means a project that gives you 00:12:42.800 --> 00:12:45.470 align:middle line:84% lots of return in the future, lots of cash flow in the future, 00:12:45.470 --> 00:12:48.257 align:middle line:84% may not be worth a lot simply because interest rates 00:12:48.257 --> 00:12:48.840 align:middle line:90% are very high. 00:12:48.840 --> 00:12:52.140 align:middle line:84% So the discounting of the future cash flows is very high. 00:12:52.140 --> 00:12:54.560 align:middle line:84% And in that environment, investments 00:12:54.560 --> 00:12:56.390 align:middle line:84% that give you a return, a quick return, 00:12:56.390 --> 00:12:58.790 align:middle line:84% are worth more than things that have 00:12:58.790 --> 00:13:01.370 align:middle line:90% a pay-off in the very long run. 00:13:01.370 --> 00:13:07.042 align:middle line:84% So the decision, for example, of buying a machine 00:13:07.042 --> 00:13:08.750 align:middle line:84% needs to look at the price of the machine 00:13:08.750 --> 00:13:11.330 align:middle line:84% right now and then at the expected present discounted 00:13:11.330 --> 00:13:14.290 align:middle line:90% value of the cash flows, OK? 00:13:14.290 --> 00:13:19.570 align:middle line:84% So let's think a bit more carefully about that decision. 00:13:19.570 --> 00:13:21.870 align:middle line:84% So suppose you buy a machine for a price. 00:13:21.870 --> 00:13:24.250 align:middle line:90% Let's normalize that price to 1. 00:13:24.250 --> 00:13:26.520 align:middle line:84% The first thing you need to know is, well, 00:13:26.520 --> 00:13:28.560 align:middle line:84% how long will this machine last because I 00:13:28.560 --> 00:13:31.440 align:middle line:84% need to know for how many years I'm going to get a cash 00:13:31.440 --> 00:13:33.950 align:middle line:90% flow out of these things. 00:13:33.950 --> 00:13:38.640 align:middle line:84% And a reasonable assumption is, for most machines, 00:13:38.640 --> 00:13:42.330 align:middle line:84% is some sort of geometric depreciation-- so meaning, 00:13:42.330 --> 00:13:43.650 align:middle line:90% it's not deterministic. 00:13:43.650 --> 00:13:45.180 align:middle line:90% It's more or less-- 00:13:45.180 --> 00:13:48.090 align:middle line:84% machines break down occasionally, 00:13:48.090 --> 00:13:50.680 align:middle line:84% but there is certain probability that they break down. 00:13:50.680 --> 00:13:54.630 align:middle line:84% We typically call that notation in economics-- 00:13:54.630 --> 00:13:56.770 align:middle line:90% we refer to that as delta. 00:13:56.770 --> 00:13:59.170 align:middle line:84% That's the depreciation probability. 00:13:59.170 --> 00:14:01.500 align:middle line:84% So if you think in terms of expected value, 00:14:01.500 --> 00:14:06.588 align:middle line:84% if you buy a machine today, and you ask, how much of a machine 00:14:06.588 --> 00:14:08.130 align:middle line:84% I'll have next year, well, it's going 00:14:08.130 --> 00:14:10.440 align:middle line:84% to be a weighted average of 0 and 1 probably. 00:14:10.440 --> 00:14:14.090 align:middle line:84% But on average, it's going to be 1 minus delta. 00:14:14.090 --> 00:14:16.940 align:middle line:84% So as a machine depreciates, the probability 00:14:16.940 --> 00:14:19.520 align:middle line:84% of the machine breaking down over a year is 5%, 00:14:19.520 --> 00:14:22.898 align:middle line:90% then 1 minus delta is 0.95, say. 00:14:22.898 --> 00:14:24.940 align:middle line:84% What is the probability that the machine is still 00:14:24.940 --> 00:14:26.570 align:middle line:90% producing two years from now? 00:14:26.570 --> 00:14:29.810 align:middle line:84% Well, 1 minus delta squared and so on and so forth. 00:14:29.810 --> 00:14:31.420 align:middle line:84% So that's the first thing you know. 00:14:31.420 --> 00:14:33.640 align:middle line:84% I have this machine, and it's likely to give me 00:14:33.640 --> 00:14:37.300 align:middle line:84% cash flows over this many years and so on. 00:14:37.300 --> 00:14:40.120 align:middle line:84% And then I have to know how much expected profits 00:14:40.120 --> 00:14:43.540 align:middle line:84% I expect to get in each of those years. 00:14:43.540 --> 00:14:46.660 align:middle line:84% And then I need also to know what are the interest rates that 00:14:46.660 --> 00:14:50.600 align:middle line:84% are likely to prevail during the lifetime of the machine 00:14:50.600 --> 00:14:51.390 align:middle line:90% and so on. 00:14:51.390 --> 00:14:53.410 align:middle line:84% So at the end of the day, when I calculate, 00:14:53.410 --> 00:14:55.360 align:middle line:84% I do my little project, and I need 00:14:55.360 --> 00:14:58.330 align:middle line:84% to decide whether 1, which was the price of the machine or not, 00:14:58.330 --> 00:15:00.400 align:middle line:84% is too expensive or too cheap, I need 00:15:00.400 --> 00:15:04.270 align:middle line:84% to compare it with the expected present discounted value 00:15:04.270 --> 00:15:06.470 align:middle line:90% that I have for that machine. 00:15:06.470 --> 00:15:08.320 align:middle line:90% So here is an example. 00:15:08.320 --> 00:15:10.690 align:middle line:84% This is a machine that gives-- the first expected cash 00:15:10.690 --> 00:15:11.810 align:middle line:90% flow comes next year. 00:15:11.810 --> 00:15:14.350 align:middle line:84% I set it up today, and I generate profits 00:15:14.350 --> 00:15:17.270 align:middle line:84% by the end of the year or at the beginning of the next year. 00:15:17.270 --> 00:15:20.290 align:middle line:84% That's expected profits for the first year of the machine, which 00:15:20.290 --> 00:15:23.410 align:middle line:84% comes at the end of the first year, discounted by an interest 00:15:23.410 --> 00:15:25.030 align:middle line:90% rate that I know today. 00:15:25.030 --> 00:15:28.560 align:middle line:84% I know the interest rate for one year. 00:15:28.560 --> 00:15:31.707 align:middle line:84% What about the cash flow that I expect for two years from now? 00:15:31.707 --> 00:15:32.790 align:middle line:90% Well, that's going to be-- 00:15:32.790 --> 00:15:34.420 align:middle line:90% that's expected cash flow. 00:15:34.420 --> 00:15:36.660 align:middle line:84% If the machine is working properly, 00:15:36.660 --> 00:15:38.850 align:middle line:84% that's the probability that the machine 00:15:38.850 --> 00:15:40.820 align:middle line:90% lasts to the second year. 00:15:40.820 --> 00:15:43.780 align:middle line:90% 00:15:43.780 --> 00:15:46.410 align:middle line:84% Or you can also assume that the machine sort of breaks down 00:15:46.410 --> 00:15:47.890 align:middle line:90% in little pieces every year. 00:15:47.890 --> 00:15:54.195 align:middle line:84% You get 0.95 of the machine in second year, 00:15:54.195 --> 00:16:02.888 align:middle line:84% 1 minus 1.05 squared two years from now and so on and so forth. 00:16:02.888 --> 00:16:04.812 align:middle line:84% But I also now, when I think about the cash 00:16:04.812 --> 00:16:07.270 align:middle line:84% flow in the second year, and I don't know the interest rate 00:16:07.270 --> 00:16:11.980 align:middle line:84% for the second year, so I need to have an expected interest 00:16:11.980 --> 00:16:12.750 align:middle line:90% rate here-- 00:16:12.750 --> 00:16:16.470 align:middle line:90% 00:16:16.470 --> 00:16:18.330 align:middle line:90% and so on, so forth, OK? 00:16:18.330 --> 00:16:21.910 align:middle line:84% If the machine lasts for many, many years, that's what I get. 00:16:21.910 --> 00:16:25.550 align:middle line:90% A question, by the way-- 00:16:25.550 --> 00:16:29.270 align:middle line:84% I'm saying, yeah, I need to have expectations here and so on. 00:16:29.270 --> 00:16:33.492 align:middle line:84% But the truth is that the guy that invests in the machine 00:16:33.492 --> 00:16:35.450 align:middle line:84% doesn't need to have that expectation because I 00:16:35.450 --> 00:16:39.440 align:middle line:84% could replace this for something that is known today. 00:16:39.440 --> 00:16:40.530 align:middle line:90% What would that be? 00:16:40.530 --> 00:16:49.160 align:middle line:90% 00:16:49.160 --> 00:16:52.730 align:middle line:84% I'm saying, when I calculate the expected cash flow, when 00:16:52.730 --> 00:16:54.913 align:middle line:84% I'm discounting the two-years-out cash flow, 00:16:54.913 --> 00:16:56.330 align:middle line:84% I'm going to have an interest rate 00:16:56.330 --> 00:17:00.500 align:middle line:84% that I know, the one from time 0 to the end of the first year. 00:17:00.500 --> 00:17:02.060 align:middle line:84% But I don't know the interest rate 00:17:02.060 --> 00:17:10.940 align:middle line:84% that prevails from the end of year one to the end of year two. 00:17:10.940 --> 00:17:12.060 align:middle line:90% That's what I wrote here. 00:17:12.060 --> 00:17:14.130 align:middle line:84% But I said, hm, but there is something 00:17:14.130 --> 00:17:17.619 align:middle line:84% in the market that I could look at and that I really know. 00:17:17.619 --> 00:17:18.400 align:middle line:90% What is that? 00:17:18.400 --> 00:17:20.175 align:middle line:90% AUDIENCE: Is it the [INAUDIBLE] 00:17:20.175 --> 00:17:21.300 align:middle line:90% RICARDO CABALLERO: Exactly. 00:17:21.300 --> 00:17:25.089 align:middle line:90% I could use 1 plus r2. 00:17:25.089 --> 00:17:26.260 align:middle line:90% These are one-year rates. 00:17:26.260 --> 00:17:29.470 align:middle line:90% R2t squared. 00:17:29.470 --> 00:17:32.830 align:middle line:84% So when you have the term structure, 00:17:32.830 --> 00:17:36.237 align:middle line:84% when you see all the interest rates, a firm deciding 00:17:36.237 --> 00:17:38.570 align:middle line:84% whether to invest or not has the interest rate it needs. 00:17:38.570 --> 00:17:41.500 align:middle line:84% It doesn't need to have expectations, form expectations 00:17:41.500 --> 00:17:42.540 align:middle line:90% about the interest rate. 00:17:42.540 --> 00:17:44.230 align:middle line:90% The market is doing it for them. 00:17:44.230 --> 00:17:46.270 align:middle line:84% Now, the guy may choose to be a trader 00:17:46.270 --> 00:17:48.340 align:middle line:84% and decide that it doesn't like the interest rate 00:17:48.340 --> 00:17:50.912 align:middle line:90% that the market is pricing in. 00:17:50.912 --> 00:17:52.120 align:middle line:90% But that's a different trade. 00:17:52.120 --> 00:17:55.485 align:middle line:84% It's not the investment decision of the firm. 00:17:55.485 --> 00:17:57.860 align:middle line:84% The firm will have to make a forecast about expected cash 00:17:57.860 --> 00:18:04.000 align:middle line:84% flows and so on, but that's it, from the machine and so on, OK? 00:18:04.000 --> 00:18:06.515 align:middle line:84% So obviously, the larger this is, 00:18:06.515 --> 00:18:08.890 align:middle line:84% the more you're going to invest, the more machines you're 00:18:08.890 --> 00:18:10.665 align:middle line:90% going to buy and so on, OK? 00:18:10.665 --> 00:18:14.230 align:middle line:90% 00:18:14.230 --> 00:18:18.580 align:middle line:84% So in principle, a better investment function-- 00:18:18.580 --> 00:18:21.910 align:middle line:84% remember, we wrote an investment function as investment, 00:18:21.910 --> 00:18:25.000 align:middle line:84% a function of output, current output, 00:18:25.000 --> 00:18:27.280 align:middle line:84% which we said is a proxy for sales, and then 00:18:27.280 --> 00:18:28.570 align:middle line:90% the interest rate. 00:18:28.570 --> 00:18:31.957 align:middle line:84% Well, a better concept is that one, which does 00:18:31.957 --> 00:18:33.165 align:middle line:90% depend on aggregate activity. 00:18:33.165 --> 00:18:36.430 align:middle line:84% It depends on many things, but not only today's, 00:18:36.430 --> 00:18:39.840 align:middle line:84% also the ones that you expect for the future, OK? 00:18:39.840 --> 00:18:43.150 align:middle line:84% And it depends on the interest rate, not only today's interest 00:18:43.150 --> 00:18:46.210 align:middle line:84% rate, though, also in the interest rate of the future. 00:18:46.210 --> 00:18:51.707 align:middle line:84% If I look at this expression, even if the interest rate today 00:18:51.707 --> 00:18:54.040 align:middle line:84% doesn't change, but I expect the interest rate to change 00:18:54.040 --> 00:18:56.110 align:middle line:84% in the future, to go up, that will 00:18:56.110 --> 00:18:58.450 align:middle line:90% lower the value of my project. 00:18:58.450 --> 00:19:02.440 align:middle line:84% We had no space for that when we posted the initial investment 00:19:02.440 --> 00:19:03.230 align:middle line:90% function. 00:19:03.230 --> 00:19:07.720 align:middle line:90% But here we have that. 00:19:07.720 --> 00:19:10.150 align:middle line:84% And sorry, and this is an increasing function of that. 00:19:10.150 --> 00:19:13.880 align:middle line:84% The higher is V, the higher is the expected present discounted 00:19:13.880 --> 00:19:17.955 align:middle line:84% value of buying a machine given the price, 00:19:17.955 --> 00:19:20.160 align:middle line:90% the larger is the investment. 00:19:20.160 --> 00:19:21.800 align:middle line:90% Now, this is in principle. 00:19:21.800 --> 00:19:27.030 align:middle line:84% In practice, current cash flows also matter a lot, OK? 00:19:27.030 --> 00:19:29.520 align:middle line:84% So in the same sense as in the case of the consumption 00:19:29.520 --> 00:19:32.860 align:middle line:84% function, we said, in principle, it's only wealth that matters. 00:19:32.860 --> 00:19:35.055 align:middle line:84% But in practice, there's lots of consumers 00:19:35.055 --> 00:19:36.430 align:middle line:84% that are financially constrained, 00:19:36.430 --> 00:19:38.050 align:middle line:90% they're hand-to-mouth and so on. 00:19:38.050 --> 00:19:40.480 align:middle line:90% So current income also matters. 00:19:40.480 --> 00:19:45.890 align:middle line:84% But for firms, the same is true because-- 00:19:45.890 --> 00:19:48.620 align:middle line:84% and the main reason for that, really, 00:19:48.620 --> 00:19:50.780 align:middle line:84% is financial frictions, in the case 00:19:50.780 --> 00:19:54.600 align:middle line:84% of the firm because a firm may arrive with a great project 00:19:54.600 --> 00:19:57.360 align:middle line:84% to a bank, but the bank may decide 00:19:57.360 --> 00:19:59.280 align:middle line:84% that it doesn't trust as much or is not 00:19:59.280 --> 00:20:01.690 align:middle line:84% as optimistic as the firm is and so on. 00:20:01.690 --> 00:20:04.373 align:middle line:90% So it may not borrow-- 00:20:04.373 --> 00:20:05.790 align:middle line:84% the firm may not be able to borrow 00:20:05.790 --> 00:20:07.920 align:middle line:84% as much as it would want given how 00:20:07.920 --> 00:20:11.260 align:middle line:84% optimistic that particular firm is on its own project. 00:20:11.260 --> 00:20:12.960 align:middle line:84% The bank may say, you know, I'm going 00:20:12.960 --> 00:20:17.360 align:middle line:84% to be more conservative here since I'm lending you the money. 00:20:17.360 --> 00:20:19.700 align:middle line:84% And one way that firms use, actually, 00:20:19.700 --> 00:20:22.040 align:middle line:84% to get around financial constraints 00:20:22.040 --> 00:20:24.980 align:middle line:90% is simply by returning-- 00:20:24.980 --> 00:20:28.760 align:middle line:84% retaining their earnings, meaning they generate a cash 00:20:28.760 --> 00:20:30.200 align:middle line:90% flow, and they save. 00:20:30.200 --> 00:20:34.340 align:middle line:90% Firms save a lot, by the way. 00:20:34.340 --> 00:20:37.490 align:middle line:84% Companies like Apple and so on save an enormous amount 00:20:37.490 --> 00:20:41.720 align:middle line:84% in huge deposits, US treasuries, and so on and so forth. 00:20:41.720 --> 00:20:44.690 align:middle line:84% In the case of Apple, it's not to relax financial constraints, 00:20:44.690 --> 00:20:47.420 align:middle line:84% although it has something to do with. 00:20:47.420 --> 00:20:52.190 align:middle line:84% Being opportunistic, having the opportunity to buy things 00:20:52.190 --> 00:20:53.570 align:middle line:90% that are in distress. 00:20:53.570 --> 00:20:56.210 align:middle line:84% But many firms, especially smaller firms, 00:20:56.210 --> 00:20:58.190 align:middle line:84% have deposits and cash flow and so 00:20:58.190 --> 00:21:01.850 align:middle line:84% on mostly because, if they get a good opportunity, 00:21:01.850 --> 00:21:04.010 align:middle line:84% they may face financial constraints. 00:21:04.010 --> 00:21:07.135 align:middle line:84% So if current activity is high, sales are high, 00:21:07.135 --> 00:21:09.260 align:middle line:84% firms are going to be less likely to be financially 00:21:09.260 --> 00:21:09.870 align:middle line:90% constrained. 00:21:09.870 --> 00:21:13.675 align:middle line:84% And that's the reason current profits also end. 00:21:13.675 --> 00:21:16.050 align:middle line:84% Now, current profit is going to be an increasing function 00:21:16.050 --> 00:21:18.933 align:middle line:90% of output over capital that-- 00:21:18.933 --> 00:21:22.400 align:middle line:90% 00:21:22.400 --> 00:21:24.800 align:middle line:84% for any given level of capital, if output goes up, 00:21:24.800 --> 00:21:26.520 align:middle line:84% that's going to generate more profit. 00:21:26.520 --> 00:21:30.380 align:middle line:84% And so we can write our investment function 00:21:30.380 --> 00:21:34.740 align:middle line:84% a little bit like we had in the earlier lectures. 00:21:34.740 --> 00:21:39.400 align:middle line:84% But now we put Vt here, Yt, and the interest rate and-- 00:21:39.400 --> 00:21:43.370 align:middle line:84% interest and then future output and future interest rates 00:21:43.370 --> 00:21:45.260 align:middle line:84% enter all through this term here. 00:21:45.260 --> 00:21:48.950 align:middle line:84% And again, investment here is increasing with respect to Vt, 00:21:48.950 --> 00:21:51.800 align:middle line:84% and it's increasing with respect to Yt. 00:21:51.800 --> 00:21:53.730 align:middle line:84% So that's a far more realistic model. 00:21:53.730 --> 00:21:58.670 align:middle line:84% So you go back to IS-LM and put this type of consumption 00:21:58.670 --> 00:22:01.130 align:middle line:84% function and investment functions, 00:22:01.130 --> 00:22:06.140 align:middle line:84% and they're going to make a lot of sense. 00:22:06.140 --> 00:22:09.350 align:middle line:84% Again, the concept of something persistent-- persistent things 00:22:09.350 --> 00:22:11.310 align:middle line:84% should matter a lot more than temporary things. 00:22:11.310 --> 00:22:11.810 align:middle line:90% OK? 00:22:11.810 --> 00:22:16.037 align:middle line:84% So naturally, if you expect profits to remain high 00:22:16.037 --> 00:22:17.870 align:middle line:84% for a very long period of time, that machine 00:22:17.870 --> 00:22:20.870 align:middle line:84% is going to be worth a lot more than if you only 00:22:20.870 --> 00:22:23.920 align:middle line:84% expect the machine to be very profitable for only one year. 00:22:23.920 --> 00:22:29.210 align:middle line:84% And so anything that is likely to be persistent 00:22:29.210 --> 00:22:32.035 align:middle line:84% is also likely to have a much larger impact. 00:22:32.035 --> 00:22:34.708 align:middle line:90% 00:22:34.708 --> 00:22:36.500 align:middle line:84% There are important exceptions, but I'm not 00:22:36.500 --> 00:22:39.810 align:middle line:90% going to get into that now. 00:22:39.810 --> 00:22:41.580 align:middle line:84% And the same is true for interest rates. 00:22:41.580 --> 00:22:43.770 align:middle line:84% If I expect-- since interest rates are high today, 00:22:43.770 --> 00:22:46.950 align:middle line:84% but we expect them to go down in the near future, 00:22:46.950 --> 00:22:50.520 align:middle line:84% then that's not going to affect a lot the discounting 00:22:50.520 --> 00:22:52.620 align:middle line:90% of future profits. 00:22:52.620 --> 00:22:55.320 align:middle line:84% But if interest rates go up today, 00:22:55.320 --> 00:22:57.870 align:middle line:84% and I expect them to remain high for a long time, 00:22:57.870 --> 00:23:00.870 align:middle line:84% that's going to affect a lot more the present value 00:23:00.870 --> 00:23:01.560 align:middle line:90% of profits. 00:23:01.560 --> 00:23:04.240 align:middle line:84% And therefore, it's going to depress investment a lot more. 00:23:04.240 --> 00:23:11.400 align:middle line:84% In fact, central banks, much more than playing 00:23:11.400 --> 00:23:13.960 align:middle line:84% with the current interest rate, they play with your minds. 00:23:13.960 --> 00:23:15.080 align:middle line:90% That's what they do. 00:23:15.080 --> 00:23:16.860 align:middle line:84% They are always telling you stories 00:23:16.860 --> 00:23:19.050 align:middle line:84% for why interest rates will remain high, for why-- 00:23:19.050 --> 00:23:22.380 align:middle line:84% [CHUCKLES] they don't want-- they want-- 00:23:22.380 --> 00:23:24.060 align:middle line:84% they only control an interest rate 00:23:24.060 --> 00:23:26.560 align:middle line:84% that is an overnight interest rate, really. 00:23:26.560 --> 00:23:30.660 align:middle line:84% But they-- and with that, nobody cares about the overnight rate 00:23:30.660 --> 00:23:33.030 align:middle line:84% except for some traders out there. 00:23:33.030 --> 00:23:35.940 align:middle line:84% But since they want to influence aggregate demand-- that is, 00:23:35.940 --> 00:23:38.105 align:middle line:84% they want to influence consumption and investment-- 00:23:38.105 --> 00:23:40.230 align:middle line:84% they need to convince you that this stuff will last 00:23:40.230 --> 00:23:43.770 align:middle line:84% for some time, because otherwise it would be irrelevant 00:23:43.770 --> 00:23:46.530 align:middle line:84% because if you want to reduce aggregate demand, 00:23:46.530 --> 00:23:50.680 align:middle line:84% you want to convince firms and households 00:23:50.680 --> 00:23:54.090 align:middle line:84% and so on that the interest rate will remain high for a while. 00:23:54.090 --> 00:23:57.660 align:middle line:84% Otherwise, you're going to get very little effect out of that. 00:23:57.660 --> 00:23:59.880 align:middle line:84% One of the problems they're having now, 00:23:59.880 --> 00:24:02.670 align:middle line:84% actually, when the Fed is trying to cool the economy, 00:24:02.670 --> 00:24:04.970 align:middle line:84% is that they keep hiking rates, but the loan rates 00:24:04.970 --> 00:24:07.230 align:middle line:90% have begun to decline already. 00:24:07.230 --> 00:24:08.630 align:middle line:90% And that's a problem for them. 00:24:08.630 --> 00:24:11.160 align:middle line:84% [CHUCKLES] They would like you not to believe, 00:24:11.160 --> 00:24:13.060 align:middle line:84% bankers not to believe that will happen. 00:24:13.060 --> 00:24:15.680 align:middle line:90% And that's a big issue. 00:24:15.680 --> 00:24:18.260 align:middle line:90% 00:24:18.260 --> 00:24:22.490 align:middle line:84% So let's think about this IS-LM with expectations. 00:24:22.490 --> 00:24:25.780 align:middle line:84% So what we said is, what really we're after-- 00:24:25.780 --> 00:24:28.120 align:middle line:84% in the IS-LM model, remember, the IS-LM model 00:24:28.120 --> 00:24:30.800 align:middle line:84% is a model in which aggregate demand determines output. 00:24:30.800 --> 00:24:32.680 align:middle line:84% And that's what happens in the short run. 00:24:32.680 --> 00:24:35.140 align:middle line:84% And the biggest components of aggregate demand, 00:24:35.140 --> 00:24:38.470 align:middle line:84% aside from the government, which is something that moves, 00:24:38.470 --> 00:24:39.910 align:middle line:90% more or less-- 00:24:39.910 --> 00:24:42.353 align:middle line:84% OK, with different behavioral functions. 00:24:42.353 --> 00:24:44.020 align:middle line:84% We're not talking a lot about that here. 00:24:44.020 --> 00:24:46.700 align:middle line:84% But the big drivers are consumption and investment. 00:24:46.700 --> 00:24:48.700 align:middle line:84% Those are at least the private sector drivers 00:24:48.700 --> 00:24:51.490 align:middle line:84% of aggregate demand, consumption and investment. 00:24:51.490 --> 00:24:56.380 align:middle line:84% And what we have said now is that human wealth 00:24:56.380 --> 00:24:58.570 align:middle line:84% is affected not only by current income, 00:24:58.570 --> 00:25:03.370 align:middle line:84% but future after labor income, future real interest rate. 00:25:03.370 --> 00:25:04.790 align:middle line:90% That affects human wealth. 00:25:04.790 --> 00:25:06.760 align:middle line:90% That affects consumption. 00:25:06.760 --> 00:25:11.320 align:middle line:84% Future real dividends plus future real interest rate 00:25:11.320 --> 00:25:13.340 align:middle line:90% affect the value of stocks. 00:25:13.340 --> 00:25:16.190 align:middle line:84% That's very important in financial wealth. 00:25:16.190 --> 00:25:18.900 align:middle line:84% Future nominal interest rate affect the price of bonds. 00:25:18.900 --> 00:25:24.940 align:middle line:84% So all these rates enter here, the price of nominal bonds. 00:25:24.940 --> 00:25:28.330 align:middle line:84% For firms, future after tax profits 00:25:28.330 --> 00:25:30.140 align:middle line:90% affect expected present value. 00:25:30.140 --> 00:25:34.360 align:middle line:84% Future real interest rate affect also the suspected present 00:25:34.360 --> 00:25:35.110 align:middle line:90% value. 00:25:35.110 --> 00:25:39.190 align:middle line:84% So there is a lot that says future in this column here 00:25:39.190 --> 00:25:43.960 align:middle line:84% that enters into the consumption and investment decisions 00:25:43.960 --> 00:25:44.990 align:middle line:90% that we care about. 00:25:44.990 --> 00:25:47.545 align:middle line:84% That's what I showed you in the previous slides. 00:25:47.545 --> 00:25:50.160 align:middle line:90% 00:25:50.160 --> 00:25:52.990 align:middle line:84% So remember the basic IS-LM model. 00:25:52.990 --> 00:25:54.060 align:middle line:90% We wrote it this way. 00:25:54.060 --> 00:25:56.220 align:middle line:84% Output was determined by aggregate demand. 00:25:56.220 --> 00:26:00.450 align:middle line:84% And closed economy-- forget all that, fully sticky prices. 00:26:00.450 --> 00:26:04.240 align:middle line:84% And we wrote consumption as these functions. 00:26:04.240 --> 00:26:06.930 align:middle line:84% So aggregate demand was increasing 00:26:06.930 --> 00:26:09.420 align:middle line:84% in output and government expenditure, 00:26:09.420 --> 00:26:13.690 align:middle line:84% decreasing in taxes, and decreasing on the interest rate. 00:26:13.690 --> 00:26:16.720 align:middle line:84% So a shortcut-- so what I want to do now 00:26:16.720 --> 00:26:19.870 align:middle line:84% is give you a shortcut to integrate 00:26:19.870 --> 00:26:23.860 align:middle line:84% these views of expectations or the concept of expectations 00:26:23.860 --> 00:26:27.670 align:middle line:84% into this very basic IS-LM model, OK? 00:26:27.670 --> 00:26:31.120 align:middle line:84% So think of now of aggregate demand 00:26:31.120 --> 00:26:34.150 align:middle line:84% rather than just being a function of current variables, 00:26:34.150 --> 00:26:38.700 align:middle line:84% be also a function of the same variables, but in the future. 00:26:38.700 --> 00:26:39.270 align:middle line:90% OK? 00:26:39.270 --> 00:26:43.080 align:middle line:84% So aggregate demand is a function, as before, 00:26:43.080 --> 00:26:47.160 align:middle line:84% of current output, current taxes, current interest rate, 00:26:47.160 --> 00:26:50.250 align:middle line:84% current expenditure, but also function-- 00:26:50.250 --> 00:26:51.900 align:middle line:90% and with the same signs-- 00:26:51.900 --> 00:26:53.380 align:middle line:90% of future output. 00:26:53.380 --> 00:26:58.800 align:middle line:84% So it's increasing in expected future output. 00:26:58.800 --> 00:27:01.530 align:middle line:84% It's decreasing in expected future taxes. 00:27:01.530 --> 00:27:04.020 align:middle line:84% It's decreasing in expected future interest rate. 00:27:04.020 --> 00:27:07.090 align:middle line:84% It's increasing in expected future government expenditure, 00:27:07.090 --> 00:27:09.600 align:middle line:84% although I'm not going to play with this here 00:27:09.600 --> 00:27:12.240 align:middle line:84% because of something very specific 00:27:12.240 --> 00:27:15.256 align:middle line:90% that I'll discuss later on. 00:27:15.256 --> 00:27:18.065 align:middle line:90% So that's the shortcut, OK? 00:27:18.065 --> 00:27:20.380 align:middle line:84% The LM is going to be the same as before. 00:27:20.380 --> 00:27:22.480 align:middle line:84% So what I want you to think about now 00:27:22.480 --> 00:27:27.160 align:middle line:84% is a model that is like the one you had before with the same LM 00:27:27.160 --> 00:27:29.850 align:middle line:84% but now the IS is a little bit richer. 00:27:29.850 --> 00:27:33.160 align:middle line:84% It has more parameters-- these are parameters-- because I'm 00:27:33.160 --> 00:27:36.310 align:middle line:84% going to determine today's output, 00:27:36.310 --> 00:27:38.510 align:middle line:84% but it's going to be a function of more parameters. 00:27:38.510 --> 00:27:41.050 align:middle line:84% And all these parameters are essentially the same variables 00:27:41.050 --> 00:27:44.290 align:middle line:84% that we worry about today, but are the variables we 00:27:44.290 --> 00:27:46.720 align:middle line:90% expect of those-- 00:27:46.720 --> 00:27:49.630 align:middle line:84% are the values of respect for those variables in the future 00:27:49.630 --> 00:27:51.080 align:middle line:90% and, again, with the same sign. 00:27:51.080 --> 00:27:56.290 align:middle line:84% So if output-- so if taxes go up today, 00:27:56.290 --> 00:27:59.240 align:middle line:84% aggregate demand will decline, and output will decline. 00:27:59.240 --> 00:28:02.890 align:middle line:84% But if I expect future taxes to go up as well, 00:28:02.890 --> 00:28:05.360 align:middle line:84% then that's going to depress aggregate demand even more. 00:28:05.360 --> 00:28:08.360 align:middle line:84% That's the type of logic I want you to develop. 00:28:08.360 --> 00:28:11.830 align:middle line:84% So that's the way our model will look. 00:28:11.830 --> 00:28:17.480 align:middle line:84% So this is the IS in the same space I had before-- 00:28:17.480 --> 00:28:20.850 align:middle line:84% interest rate and output, current output. 00:28:20.850 --> 00:28:23.930 align:middle line:84% I'm trying to determine current output. 00:28:23.930 --> 00:28:25.610 align:middle line:84% But now I have lots of parameters 00:28:25.610 --> 00:28:28.170 align:middle line:90% that I didn't have before. 00:28:28.170 --> 00:28:33.810 align:middle line:84% I have a-- things that shift to the left. 00:28:33.810 --> 00:28:38.960 align:middle line:84% If taxes go up today, this IS will shift to the left. 00:28:38.960 --> 00:28:42.140 align:middle line:84% Do you think it will shift to the left more or less 00:28:42.140 --> 00:28:44.400 align:middle line:90% than it did in lecture 3 or 4? 00:28:44.400 --> 00:28:49.710 align:middle line:90% 00:28:49.710 --> 00:28:54.610 align:middle line:84% So suppose we increase taxes by 10%. 00:28:54.610 --> 00:28:57.660 align:middle line:84% Will that reduce output more or less 00:28:57.660 --> 00:29:01.360 align:middle line:84% than when we had the static IS-LM model? 00:29:01.360 --> 00:29:01.860 align:middle line:90% Yeah? 00:29:01.860 --> 00:29:03.408 align:middle line:84% AUDIENCE: Depends on the expectation. 00:29:03.408 --> 00:29:05.200 align:middle line:84% RICARDO CABALLERO: OK, but I haven't moved. 00:29:05.200 --> 00:29:06.360 align:middle line:84% These are parameters from my curve. 00:29:06.360 --> 00:29:08.170 align:middle line:84% So I don't get the right to move them. 00:29:08.170 --> 00:29:09.520 align:middle line:90% AUDIENCE: [INAUDIBLE] less. 00:29:09.520 --> 00:29:10.720 align:middle line:90% RICARDO CABALLERO: Less, no? 00:29:10.720 --> 00:29:12.630 align:middle line:84% Less because now we said it's not only 00:29:12.630 --> 00:29:13.630 align:middle line:90% the present that matter. 00:29:13.630 --> 00:29:15.940 align:middle line:84% It's a combination of the present and the future. 00:29:15.940 --> 00:29:21.040 align:middle line:84% So if-- that means that anything that is just the present 00:29:21.040 --> 00:29:22.810 align:middle line:84% will matter less than in the past. 00:29:22.810 --> 00:29:26.610 align:middle line:90% Otherwise, you see that? 00:29:26.610 --> 00:29:28.170 align:middle line:84% Suppose we had a two-period model, 00:29:28.170 --> 00:29:32.600 align:middle line:84% and I give equal weight to the present and the future. 00:29:32.600 --> 00:29:36.643 align:middle line:84% Then I'm going to cut the effect of the present in half. 00:29:36.643 --> 00:29:39.060 align:middle line:84% That's-- I'm exaggerating there, but that's, more or less, 00:29:39.060 --> 00:29:39.620 align:middle line:90% the logic. 00:29:39.620 --> 00:29:43.810 align:middle line:90% 00:29:43.810 --> 00:29:48.860 align:middle line:84% So you correctly said, well, it depends on 00:29:48.860 --> 00:29:52.100 align:middle line:84% whether I expect the future taxes to change or not. 00:29:52.100 --> 00:29:52.790 align:middle line:90% Fine. 00:29:52.790 --> 00:29:54.290 align:middle line:84% That tells you there is a difference 00:29:54.290 --> 00:29:57.560 align:middle line:84% between changing temporarily the taxes 00:29:57.560 --> 00:30:02.030 align:middle line:84% and increasing taxes permanently. 00:30:02.030 --> 00:30:04.790 align:middle line:84% Permanently here means for the two periods. 00:30:04.790 --> 00:30:07.030 align:middle line:84% So what happens with this curve-- 00:30:07.030 --> 00:30:10.220 align:middle line:84% so we decided that increasing taxes reduces 00:30:10.220 --> 00:30:13.830 align:middle line:84% this IS to the left by a smaller amount than in the past. 00:30:13.830 --> 00:30:16.465 align:middle line:84% What happens if you expect taxes to increase in the future? 00:30:16.465 --> 00:30:20.940 align:middle line:90% 00:30:20.940 --> 00:30:23.890 align:middle line:90% Which wealth goes down? 00:30:23.890 --> 00:30:25.580 align:middle line:90% Human wealth, in particular. 00:30:25.580 --> 00:30:27.330 align:middle line:84% Your human wealth will go down because you 00:30:27.330 --> 00:30:30.190 align:middle line:84% expect your disposable income to be taxed more in the future. 00:30:30.190 --> 00:30:33.690 align:middle line:84% So that will also shift IS to the left. 00:30:33.690 --> 00:30:35.460 align:middle line:84% And that's the reason that if you 00:30:35.460 --> 00:30:38.550 align:middle line:84% have a permanent-- expected permanent increase in taxes 00:30:38.550 --> 00:30:43.140 align:middle line:84% today and next year, then that gets us back 00:30:43.140 --> 00:30:45.030 align:middle line:84% to the type of shift in the IS that we had 00:30:45.030 --> 00:30:46.650 align:middle line:90% when we had the static model. 00:30:46.650 --> 00:30:47.770 align:middle line:90% It's the sum of the two. 00:30:47.770 --> 00:30:48.480 align:middle line:90% It's a permanent. 00:30:48.480 --> 00:30:51.780 align:middle line:84% So permanent changes will behave very 00:30:51.780 --> 00:30:57.340 align:middle line:84% similarly to the way the static model worked 00:30:57.340 --> 00:31:01.220 align:middle line:90% if they're permanent, OK? 00:31:01.220 --> 00:31:03.900 align:middle line:84% In a sense, that model was a very good summary 00:31:03.900 --> 00:31:05.370 align:middle line:90% permanent changes-- 00:31:05.370 --> 00:31:07.890 align:middle line:84% permanent changes in taxes, permanent changes in interest 00:31:07.890 --> 00:31:08.830 align:middle line:90% rates and so on. 00:31:08.830 --> 00:31:11.460 align:middle line:90% 00:31:11.460 --> 00:31:13.995 align:middle line:84% Changing government expenditure, same idea-- 00:31:13.995 --> 00:31:16.995 align:middle line:84% it will also move aggregate demand to the right. 00:31:16.995 --> 00:31:19.630 align:middle line:90% 00:31:19.630 --> 00:31:26.310 align:middle line:84% But will it do it by more or less? 00:31:26.310 --> 00:31:27.960 align:middle line:84% Well, think how government expenditure 00:31:27.960 --> 00:31:33.000 align:middle line:84% worked in the basic model, in the static model. 00:31:33.000 --> 00:31:35.340 align:middle line:84% It increased aggregate demand, and that then 00:31:35.340 --> 00:31:36.870 align:middle line:90% led to a multiplier. 00:31:36.870 --> 00:31:39.490 align:middle line:84% And we got a lot more income and so on. 00:31:39.490 --> 00:31:41.440 align:middle line:84% Now, if we expect this government expenditure 00:31:41.440 --> 00:31:43.960 align:middle line:84% it to be temporary, that multiplier also 00:31:43.960 --> 00:31:46.840 align:middle line:84% will be a lot smaller because, yes, it will increase income, 00:31:46.840 --> 00:31:49.388 align:middle line:84% but people are not going to spend all their income today. 00:31:49.388 --> 00:31:51.430 align:middle line:84% That depends on whether they expect future income 00:31:51.430 --> 00:31:53.670 align:middle line:90% to also go up as well or not. 00:31:53.670 --> 00:31:57.000 align:middle line:90% And that's a reason that it's-- 00:31:57.000 --> 00:31:59.730 align:middle line:84% again, if you expect this government expenditure to go up 00:31:59.730 --> 00:32:03.210 align:middle line:84% permanently, and nothing else changes, [CHUCKLES] then 00:32:03.210 --> 00:32:06.160 align:middle line:84% you can expect income to go up in the future as well. 00:32:06.160 --> 00:32:09.060 align:middle line:84% And then you get more or less the same effect. 00:32:09.060 --> 00:32:11.435 align:middle line:84% Now, that's a tricky experiment because if you-- 00:32:11.435 --> 00:32:12.810 align:middle line:84% and it's very relevant for today. 00:32:12.810 --> 00:32:15.540 align:middle line:84% If this government expenditure goes up permanently, 00:32:15.540 --> 00:32:19.240 align:middle line:84% it's unlikely that the central bank will remain unmoved. 00:32:19.240 --> 00:32:21.120 align:middle line:84% And so you also have to start thinking, well, 00:32:21.120 --> 00:32:23.510 align:middle line:90% what will the central bank do? 00:32:23.510 --> 00:32:27.201 align:middle line:84% And that takes me to this variable here-- 00:32:27.201 --> 00:32:28.215 align:middle line:90% this variable here. 00:32:28.215 --> 00:32:32.758 align:middle line:90% 00:32:32.758 --> 00:32:34.300 align:middle line:84% Well, before I discuss this variable, 00:32:34.300 --> 00:32:38.050 align:middle line:84% actually, let me point out that it's not accidental 00:32:38.050 --> 00:32:41.930 align:middle line:84% that I made this curve a lot steeper than it used to look. 00:32:41.930 --> 00:32:44.650 align:middle line:84% I mean, this looks like a pretty steep IS curve, 00:32:44.650 --> 00:32:49.300 align:middle line:84% which is a way of saying that a given change in interest rate 00:32:49.300 --> 00:32:53.670 align:middle line:84% now has a very small effect on current output, OK? 00:32:53.670 --> 00:32:57.900 align:middle line:84% Much smaller than we had in the static model. 00:32:57.900 --> 00:33:02.130 align:middle line:84% And the reason is, again, this is permanent versus transitory. 00:33:02.130 --> 00:33:04.950 align:middle line:84% If you spec the interest rate to decline only for today, 00:33:04.950 --> 00:33:07.530 align:middle line:84% and that's it, that's not going to have a very large effect 00:33:07.530 --> 00:33:08.410 align:middle line:90% on consumption. 00:33:08.410 --> 00:33:12.450 align:middle line:84% It's not going to have a very large effect on investment. 00:33:12.450 --> 00:33:15.810 align:middle line:84% For the interest rate decline to have a very lasting effect, 00:33:15.810 --> 00:33:18.850 align:middle line:84% a very large impact on consumption and investment, 00:33:18.850 --> 00:33:21.330 align:middle line:84% it has to affect the expected present discounted 00:33:21.330 --> 00:33:23.100 align:middle line:90% values in a meaningful way. 00:33:23.100 --> 00:33:25.200 align:middle line:84% And for that, you want those changes 00:33:25.200 --> 00:33:28.440 align:middle line:84% to be more or less permanent, persistent, 00:33:28.440 --> 00:33:31.170 align:middle line:84% that private agents think that this change in the interest rate 00:33:31.170 --> 00:33:34.110 align:middle line:90% will be significant. 00:33:34.110 --> 00:33:37.090 align:middle line:84% So if the-- so it's good to separate the two things. 00:33:37.090 --> 00:33:41.020 align:middle line:84% So if the Fed cuts the interest rate 00:33:41.020 --> 00:33:45.700 align:middle line:84% but doesn't persuade anyone that this rate will remain low 00:33:45.700 --> 00:33:48.340 align:middle line:84% in the future, then it is going to get very small effect 00:33:48.340 --> 00:33:49.530 align:middle line:90% on output. 00:33:49.530 --> 00:33:52.200 align:middle line:84% However, if we convince people that there 00:33:52.200 --> 00:33:56.490 align:middle line:84% will be future changes, that the rates will remain lower 00:33:56.490 --> 00:33:59.880 align:middle line:84% for a long time, that means that this IS now 00:33:59.880 --> 00:34:01.830 align:middle line:90% will shift to the right, OK? 00:34:01.830 --> 00:34:02.900 align:middle line:90% That's what we have here. 00:34:02.900 --> 00:34:05.640 align:middle line:90% 00:34:05.640 --> 00:34:08.820 align:middle line:84% So you have distinguish which is a movement-- when the Fed cuts 00:34:08.820 --> 00:34:11.500 align:middle line:84% the interest rate, you get a small movement along the curve. 00:34:11.500 --> 00:34:13.710 align:middle line:84% But if the Fed persuades you that this 00:34:13.710 --> 00:34:15.929 align:middle line:84% is a long-lasting cut in interest rate, 00:34:15.929 --> 00:34:17.460 align:middle line:90% then the IS shifts to the right. 00:34:17.460 --> 00:34:20.260 align:middle line:84% And you recover the power of monetary policy. 00:34:20.260 --> 00:34:23.850 align:middle line:84% Monetary policy depends a lot on its ability 00:34:23.850 --> 00:34:27.480 align:middle line:84% to convince people that things will remain in the direction 00:34:27.480 --> 00:34:29.070 align:middle line:90% that they want. 00:34:29.070 --> 00:34:32.010 align:middle line:84% If they fail-- there was a famous episode 00:34:32.010 --> 00:34:35.170 align:middle line:84% in US monetary policy during the times of Alan Greenspan. 00:34:35.170 --> 00:34:38.280 align:middle line:84% Alan Greenspan is known as one of the biggest central bankers 00:34:38.280 --> 00:34:41.650 align:middle line:84% that the US has, at least in recent memory. 00:34:41.650 --> 00:34:43.690 align:middle line:84% And he went through a period which 00:34:43.690 --> 00:34:46.750 align:middle line:84% was called-- was known as the Greenspan conundrum. 00:34:46.750 --> 00:34:49.179 align:middle line:84% That is, the economy was overheating. 00:34:49.179 --> 00:34:51.760 align:middle line:90% He kept hiking interest rates. 00:34:51.760 --> 00:34:54.989 align:middle line:84% But the loan rates kept coming down. 00:34:54.989 --> 00:34:56.489 align:middle line:84% So he couldn't cool off the economy. 00:34:56.489 --> 00:34:58.270 align:middle line:84% [CHUCKLES] There was no way around that 00:34:58.270 --> 00:35:02.230 align:middle line:84% because they couldn't persuade the markets that this 00:35:02.230 --> 00:35:03.740 align:middle line:90% would be a long-lasting effect. 00:35:03.740 --> 00:35:05.150 align:middle line:90% The reason was a different one. 00:35:05.150 --> 00:35:06.720 align:middle line:84% It was not that he couldn't persuade the market. 00:35:06.720 --> 00:35:08.137 align:middle line:84% It happens that, at the same time, 00:35:08.137 --> 00:35:11.200 align:middle line:84% you had China sending massive capital flows to the US. 00:35:11.200 --> 00:35:14.200 align:middle line:84% And so-- but the point is that the Fed had couldn't 00:35:14.200 --> 00:35:15.940 align:middle line:84% move the interest rates in the long run, 00:35:15.940 --> 00:35:19.640 align:middle line:84% and so it was very ineffective in terms of its monetary policy. 00:35:19.640 --> 00:35:25.670 align:middle line:84% So again, expectations mattered quite a bit. 00:35:25.670 --> 00:35:27.092 align:middle line:90% So let's think about our-- 00:35:27.092 --> 00:35:28.800 align:middle line:84% well, this is what I was just discussing. 00:35:28.800 --> 00:35:31.430 align:middle line:90% So monetary policy-- 00:35:31.430 --> 00:35:33.540 align:middle line:90% I should have-- this-- 00:35:33.540 --> 00:35:38.180 align:middle line:84% so you're not going to do a lot unless you persuade people 00:35:38.180 --> 00:35:42.540 align:middle line:84% that interest rate will remain low for quite some time. 00:35:42.540 --> 00:35:45.770 align:middle line:84% And notice that there is here this-- 00:35:45.770 --> 00:35:50.437 align:middle line:84% everything comes into line because if the Fed convinced 00:35:50.437 --> 00:35:52.520 align:middle line:84% that the interest rate will be lower in the future 00:35:52.520 --> 00:35:56.440 align:middle line:84% as well, then you get the IS to shift to the right. 00:35:56.440 --> 00:35:58.780 align:middle line:84% But if interest rates will be low in the future, 00:35:58.780 --> 00:36:00.760 align:middle line:84% that means output will be high in the future 00:36:00.760 --> 00:36:05.320 align:middle line:84% as well, which further shifts IS to the right. 00:36:05.320 --> 00:36:07.780 align:middle line:84% If you convince the markets that-- 00:36:07.780 --> 00:36:10.580 align:middle line:84% and the markets and consumers, households, 00:36:10.580 --> 00:36:13.360 align:middle line:84% and so on-- that you're cutting interest rates and that, 00:36:13.360 --> 00:36:16.210 align:middle line:84% with that, you'll be successful in creating a-- 00:36:16.210 --> 00:36:18.550 align:middle line:84% getting out of a recession, for example, in the future, 00:36:18.550 --> 00:36:22.240 align:middle line:84% that also increases human wealth, expected 00:36:22.240 --> 00:36:25.420 align:middle line:84% present constant value of cash flows, of profits, 00:36:25.420 --> 00:36:27.460 align:middle line:84% and so on and so forth because you 00:36:27.460 --> 00:36:29.500 align:middle line:84% are giving sort of better economic conditions 00:36:29.500 --> 00:36:30.400 align:middle line:90% in the future. 00:36:30.400 --> 00:36:34.900 align:middle line:84% So again, for central banks, it's a lot like-- 00:36:34.900 --> 00:36:40.040 align:middle line:84% it's mostly about expectations management. 00:36:40.040 --> 00:36:43.865 align:middle line:84% That's the business of a central bank, really. 00:36:43.865 --> 00:36:45.740 align:middle line:84% I don't know how many of you are soccer fans, 00:36:45.740 --> 00:36:51.180 align:middle line:84% but there was a famous story of Mervyn King. 00:36:51.180 --> 00:36:53.660 align:middle line:84% Mervyn King was also one of the biggest central bankers 00:36:53.660 --> 00:36:56.880 align:middle line:84% that the UK has had, fairly recent. 00:36:56.880 --> 00:36:59.100 align:middle line:90% And he described-- he's British. 00:36:59.100 --> 00:37:01.230 align:middle line:90% It's "Lord" nowadays. 00:37:01.230 --> 00:37:05.990 align:middle line:84% And he described good monetary policy 00:37:05.990 --> 00:37:11.780 align:middle line:84% very much like Maradona's goal scored against the UK, England, 00:37:11.780 --> 00:37:13.980 align:middle line:90% in some World Cup. 00:37:13.980 --> 00:37:16.820 align:middle line:90% I don't remember which one. 00:37:16.820 --> 00:37:19.490 align:middle line:84% And it's essentially Maradona picked the ball 00:37:19.490 --> 00:37:21.200 align:middle line:90% in his side of the field. 00:37:21.200 --> 00:37:25.160 align:middle line:84% And he essentially drew in a straight line to the goal 00:37:25.160 --> 00:37:26.270 align:middle line:90% and scored. 00:37:26.270 --> 00:37:29.690 align:middle line:84% But he persuaded everyone around to move away from his path, 00:37:29.690 --> 00:37:31.620 align:middle line:84% and that was a successful strategy. 00:37:31.620 --> 00:37:33.835 align:middle line:84% And central banks do a lot of that-- lots of talking. 00:37:33.835 --> 00:37:36.230 align:middle line:84% [MUTTERS] And, you know, at the end of the day, 00:37:36.230 --> 00:37:38.540 align:middle line:84% the true actions of moving the interest rate 00:37:38.540 --> 00:37:42.050 align:middle line:84% are the least important part of, really, a monetary policy 00:37:42.050 --> 00:37:44.720 align:middle line:90% strategy. 00:37:44.720 --> 00:37:49.470 align:middle line:84% Fiscal policy can be quite tricky here, actually. 00:37:49.470 --> 00:37:55.130 align:middle line:84% So we know that the fiscal contraction, a reduction 00:37:55.130 --> 00:37:57.620 align:middle line:90% in government expenditure-- 00:37:57.620 --> 00:38:02.030 align:middle line:84% if you just think about the basic IS-LM model, what happens? 00:38:02.030 --> 00:38:03.480 align:middle line:90% Well, it's a fiscal contraction. 00:38:03.480 --> 00:38:06.110 align:middle line:84% You reduce government expenditure, that 00:38:06.110 --> 00:38:10.570 align:middle line:90% will certainly reduce output. 00:38:10.570 --> 00:38:13.660 align:middle line:84% All the IS-LM, you reduce government expenditure, 00:38:13.660 --> 00:38:15.760 align:middle line:90% you shift IS to the left. 00:38:15.760 --> 00:38:19.710 align:middle line:90% And that reduces output. 00:38:19.710 --> 00:38:21.330 align:middle line:84% When you have expectations, things 00:38:21.330 --> 00:38:24.160 align:middle line:84% are a little trickier because it depends 00:38:24.160 --> 00:38:26.530 align:middle line:84% a lot of what you expect the central bank 00:38:26.530 --> 00:38:28.040 align:middle line:90% to do in the future. 00:38:28.040 --> 00:38:33.790 align:middle line:84% And it expects a lot on what the private sector-- 00:38:33.790 --> 00:38:36.790 align:middle line:84% how the private sector responds to that. 00:38:36.790 --> 00:38:43.720 align:middle line:84% So, for example, if you have a fiscal contraction that 00:38:43.720 --> 00:38:46.090 align:middle line:84% leads to an anticipation of a big cut in interest 00:38:46.090 --> 00:38:50.080 align:middle line:84% rates in the future, that may be expansionary. 00:38:50.080 --> 00:38:53.390 align:middle line:84% It can offset quite a bit of the fiscal contraction side. 00:38:53.390 --> 00:38:55.060 align:middle line:84% And in fact, most of the time when 00:38:55.060 --> 00:38:59.140 align:middle line:84% you have episodes of fiscal consolidation 00:38:59.140 --> 00:39:01.900 align:middle line:84% in environments that are not of very high distress, 00:39:01.900 --> 00:39:06.010 align:middle line:84% financial crisis, and so on, it typically sort of-- 00:39:06.010 --> 00:39:07.960 align:middle line:84% how successful that is depends a lot 00:39:07.960 --> 00:39:10.210 align:middle line:84% on whether people expect to be a sort 00:39:10.210 --> 00:39:13.780 align:middle line:84% of implicit deal between the central bank and the Treasury. 00:39:13.780 --> 00:39:16.930 align:middle line:84% If people expect that that fiscal contraction will 00:39:16.930 --> 00:39:19.270 align:middle line:84% come with much looser monetary policy conditions, 00:39:19.270 --> 00:39:23.800 align:middle line:84% then the fiscal contraction is not as contractionary 00:39:23.800 --> 00:39:25.550 align:middle line:90% as could be otherwise. 00:39:25.550 --> 00:39:30.050 align:middle line:84% And if, for some reason, the fiscal deficit, the perception 00:39:30.050 --> 00:39:32.450 align:middle line:84% of fiscal deficit, was really dragging the economy down 00:39:32.450 --> 00:39:34.610 align:middle line:84% because people didn't know when there could 00:39:34.610 --> 00:39:37.550 align:middle line:84% be a financial crisis in the near future and so on, 00:39:37.550 --> 00:39:39.920 align:middle line:84% then you can get a situation in which 00:39:39.920 --> 00:39:42.380 align:middle line:84% the contraction, fiscal contraction today, 00:39:42.380 --> 00:39:44.840 align:middle line:84% improves the perception of stability 00:39:44.840 --> 00:39:46.850 align:middle line:84% of the country in the future, which 00:39:46.850 --> 00:39:49.220 align:middle line:84% in turn may increase expected future income 00:39:49.220 --> 00:39:50.970 align:middle line:90% and be expansionary. 00:39:50.970 --> 00:39:56.090 align:middle line:84% So most of the fiscal contractions are contractionary. 00:39:56.090 --> 00:39:57.980 align:middle line:84% But there are some famous episodes 00:39:57.980 --> 00:40:03.730 align:middle line:84% of what are called expansionary fiscal contractions. 00:40:03.730 --> 00:40:06.470 align:middle line:84% One of the most classic cases, best-known cases, 00:40:06.470 --> 00:40:10.570 align:middle line:90% is Ireland in the late '80s. 00:40:10.570 --> 00:40:13.900 align:middle line:84% Ireland had massive fiscal deficit. 00:40:13.900 --> 00:40:17.020 align:middle line:84% And all they talked about was fiscal deficits 00:40:17.020 --> 00:40:21.040 align:middle line:84% because they had very large fiscal deficits relative to GDP. 00:40:21.040 --> 00:40:25.810 align:middle line:84% And the economy was really sort of stagnating and going 00:40:25.810 --> 00:40:27.650 align:middle line:90% through cycles and so on. 00:40:27.650 --> 00:40:30.580 align:middle line:84% And it was all around this fiscal deficit and so on. 00:40:30.580 --> 00:40:38.860 align:middle line:84% So towards the late '80s, they began a delivery plan of fiscal 00:40:38.860 --> 00:40:39.710 align:middle line:90% consolidation. 00:40:39.710 --> 00:40:41.377 align:middle line:84% Fiscal consolidation means, essentially, 00:40:41.377 --> 00:40:42.460 align:middle line:90% reducing the deficit. 00:40:42.460 --> 00:40:44.740 align:middle line:84% And they were very successful, as you can see. 00:40:44.740 --> 00:40:47.860 align:middle line:84% But contrary to expectations, at least, 00:40:47.860 --> 00:40:50.290 align:middle line:84% output growth did not decline, actually. 00:40:50.290 --> 00:40:52.300 align:middle line:90% They finally sort of-- 00:40:52.300 --> 00:40:54.650 align:middle line:84% they had a very good period like that. 00:40:54.650 --> 00:40:58.180 align:middle line:84% So that's all-- it was all about expectations. 00:40:58.180 --> 00:41:01.240 align:middle line:84% Notice that unemployment, though, did go up. 00:41:01.240 --> 00:41:04.760 align:middle line:84% So despite the fact that you got more unemployment 00:41:04.760 --> 00:41:09.480 align:middle line:84% and so on, output began to grow because firms 00:41:09.480 --> 00:41:12.410 align:middle line:84% began to invest more, consumers became more optimistic. 00:41:12.410 --> 00:41:14.790 align:middle line:84% In fact, you see the house household savings 00:41:14.790 --> 00:41:16.890 align:middle line:90% rate declined dramatically. 00:41:16.890 --> 00:41:22.160 align:middle line:84% It is all-- consumption and investment did that-- 00:41:22.160 --> 00:41:23.360 align:middle line:90% consumption, investment. 00:41:23.360 --> 00:41:27.080 align:middle line:84% People consume more, invest more because sort of everything 00:41:27.080 --> 00:41:27.990 align:middle line:90% looks a lot better. 00:41:27.990 --> 00:41:30.110 align:middle line:84% They have been struggling with this for very long. 00:41:30.110 --> 00:41:35.260 align:middle line:84% And they finally-- they had gotten that behind them. 00:41:35.260 --> 00:41:38.140 align:middle line:84% Now, this example is abused by almost anyone 00:41:38.140 --> 00:41:40.580 align:middle line:84% that wants to cut taxes and things like that. 00:41:40.580 --> 00:41:52.220 align:middle line:84% But-- sorry, by almost anyone that wants 00:41:52.220 --> 00:41:55.640 align:middle line:90% to cut fiscal expenditure. 00:41:55.640 --> 00:41:57.470 align:middle line:90% But there are experiences. 00:41:57.470 --> 00:42:00.150 align:middle line:84% There is a whole spectrum of experiences. 00:42:00.150 --> 00:42:04.610 align:middle line:84% But in situations that are as extreme as this one, 00:42:04.610 --> 00:42:09.310 align:middle line:84% it clearly proved to be very effective. 00:42:09.310 --> 00:42:10.250 align:middle line:90% So that's that. 00:42:10.250 --> 00:42:11.930 align:middle line:90% So let me take a stock. 00:42:11.930 --> 00:42:17.050 align:middle line:84% So the role of this lecture was to say something 00:42:17.050 --> 00:42:19.987 align:middle line:84% that I sort of should have said earlier on, 00:42:19.987 --> 00:42:21.570 align:middle line:84% but I would have been a bit confusing. 00:42:21.570 --> 00:42:23.810 align:middle line:84% So I decided not to talk too much about it. 00:42:23.810 --> 00:42:24.810 align:middle line:90% But it's very important. 00:42:24.810 --> 00:42:28.460 align:middle line:84% Expectations plays play a central role in economics. 00:42:28.460 --> 00:42:32.505 align:middle line:84% In particular, expectations influence aggregate demand. 00:42:32.505 --> 00:42:34.880 align:middle line:84% And for us, this course was a lot about aggregate demand. 00:42:34.880 --> 00:42:37.535 align:middle line:84% Except for the part on growth, it 00:42:37.535 --> 00:42:38.910 align:middle line:84% was a lot about aggregate demand. 00:42:38.910 --> 00:42:41.090 align:middle line:84% Now, we did talk about expectations. 00:42:41.090 --> 00:42:42.830 align:middle line:84% But we did talk about expectations 00:42:42.830 --> 00:42:45.000 align:middle line:84% mostly in the context of aggregate supply. 00:42:45.000 --> 00:42:47.090 align:middle line:84% Remember, when we talk about the Phillips curve, 00:42:47.090 --> 00:42:49.550 align:middle line:84% we did have expectations because wage setting 00:42:49.550 --> 00:42:52.640 align:middle line:84% was a function of expected prices and so on and so forth. 00:42:52.640 --> 00:42:55.460 align:middle line:84% So we did talk about the role of expectations in aggregate supply 00:42:55.460 --> 00:42:57.290 align:middle line:90% very quickly. 00:42:57.290 --> 00:43:00.800 align:middle line:84% But I think a much bigger role is played-- 00:43:00.800 --> 00:43:03.440 align:middle line:84% of expectation is really on aggregate demand, 00:43:03.440 --> 00:43:04.915 align:middle line:90% and certainly on asset prices. 00:43:04.915 --> 00:43:06.290 align:middle line:84% But aggregate demand asset prices 00:43:06.290 --> 00:43:08.210 align:middle line:84% are connected because asset price 00:43:08.210 --> 00:43:13.130 align:middle line:84% is about wealth and the value of future cash flows, which 00:43:13.130 --> 00:43:16.760 align:middle line:84% are, more or less, the same drivers as for investment 00:43:16.760 --> 00:43:19.500 align:middle line:90% and consumption. 00:43:19.500 --> 00:43:22.430 align:middle line:84% And finally, I want to say that, many times when 00:43:22.430 --> 00:43:27.440 align:middle line:84% you find episodes of fiscal, even sometimes monetary policy 00:43:27.440 --> 00:43:32.360 align:middle line:84% that are counterintuitive, it's entirely due to the expectations 00:43:32.360 --> 00:43:32.860 align:middle line:90% part. 00:43:32.860 --> 00:43:35.010 align:middle line:84% So this is case of fiscal consideration 00:43:35.010 --> 00:43:38.450 align:middle line:84% is not that the cutting in fiscal expenditure 00:43:38.450 --> 00:43:39.438 align:middle line:90% was expansionary. 00:43:39.438 --> 00:43:39.980 align:middle line:90% That was not. 00:43:39.980 --> 00:43:40.980 align:middle line:90% That was contractionary. 00:43:40.980 --> 00:43:43.250 align:middle line:84% But it was overwhelmed or offset, 00:43:43.250 --> 00:43:48.200 align:middle line:84% more than offset by the improvement in the outlook 00:43:48.200 --> 00:43:50.880 align:middle line:90% that you had. 00:43:50.880 --> 00:43:52.780 align:middle line:84% And that also happens with monetary policy. 00:43:52.780 --> 00:43:55.370 align:middle line:84% Countries that have high inflation problems 00:43:55.370 --> 00:44:01.460 align:middle line:90% and so on sometimes get-- 00:44:01.460 --> 00:44:04.630 align:middle line:84% and they have to go through dramatic tightenings and so on. 00:44:04.630 --> 00:44:07.087 align:middle line:84% Yes, most of them get very short-lived recession. 00:44:07.087 --> 00:44:09.170 align:middle line:84% But sometimes they are very short-lived recessions 00:44:09.170 --> 00:44:14.360 align:middle line:84% because eventually the reduction of the instability 00:44:14.360 --> 00:44:18.860 align:middle line:84% caused by high and unstable inflation sort of ends 00:44:18.860 --> 00:44:21.440 align:middle line:84% up dominating any direct contractionary 00:44:21.440 --> 00:44:24.850 align:middle line:90% effect of monetary policy. 00:44:24.850 --> 00:44:36.000 align:middle line:90%