WEBVTT 00:00:00.000 --> 00:00:01.467 align:middle line:90% [SQUEAKING] 00:00:01.467 --> 00:00:02.934 align:middle line:90% [RUSTLING] 00:00:02.934 --> 00:00:04.401 align:middle line:90% [CLICKING] 00:00:04.401 --> 00:00:16.613 align:middle line:90% 00:00:16.613 --> 00:00:18.530 align:middle line:84% RICARDO CABALLERO: The main topic in this part 00:00:18.530 --> 00:00:20.310 align:middle line:90% is really open economy. 00:00:20.310 --> 00:00:24.290 align:middle line:84% And so we extended the IS-LM model. 00:00:24.290 --> 00:00:26.120 align:middle line:90% We did not bring in-- 00:00:26.120 --> 00:00:28.830 align:middle line:84% we again shut down price changes, 00:00:28.830 --> 00:00:31.700 align:middle line:84% so we said price is completely fixed. 00:00:31.700 --> 00:00:33.300 align:middle line:90% No Phillips curve here. 00:00:33.300 --> 00:00:38.900 align:middle line:84% So we expanded the IS-LM model to add this open economy 00:00:38.900 --> 00:00:40.040 align:middle line:90% dimension. 00:00:40.040 --> 00:00:43.490 align:middle line:84% And so we start from the same aggregate demand function 00:00:43.490 --> 00:00:46.160 align:middle line:84% that we had in closed economy-- consumption 00:00:46.160 --> 00:00:48.170 align:middle line:84% plus investment plus go in expenditure-- 00:00:48.170 --> 00:00:51.080 align:middle line:84% but now we have to draw a distinction between demand 00:00:51.080 --> 00:00:55.370 align:middle line:84% by domestic households, companies, and the government, 00:00:55.370 --> 00:00:58.140 align:middle line:84% and the demand for domestically-produced goods. 00:00:58.140 --> 00:01:01.370 align:middle line:84% And so z is the demand for domestically-produced goods, 00:01:01.370 --> 00:01:04.879 align:middle line:84% which is equal to demand plus the demand that foreigners have 00:01:04.879 --> 00:01:09.380 align:middle line:84% for the goods produced at home minus the imports, that part 00:01:09.380 --> 00:01:11.750 align:middle line:84% of that expenditure that is going to imports. 00:01:11.750 --> 00:01:15.170 align:middle line:84% That means goods produced by other countries. 00:01:15.170 --> 00:01:17.290 align:middle line:84% And so the new behavioral functions 00:01:17.290 --> 00:01:22.000 align:middle line:84% here were the export function and the import function export. 00:01:22.000 --> 00:01:24.370 align:middle line:90% Is increasing in foreign output. 00:01:24.370 --> 00:01:26.740 align:middle line:84% More income abroad will lead to more imports 00:01:26.740 --> 00:01:30.490 align:middle line:84% by them, which means more export for home. 00:01:30.490 --> 00:01:34.717 align:middle line:84% And it's decreasing with respect to the exchange rate. 00:01:34.717 --> 00:01:36.550 align:middle line:84% Real exchange rate and nominal exchange rate 00:01:36.550 --> 00:01:39.350 align:middle line:84% will be the same here since we have fully sticky prices. 00:01:39.350 --> 00:01:43.570 align:middle line:84% But if the real exchange rate appreciates, 00:01:43.570 --> 00:01:45.850 align:middle line:84% that means domestic goods are more expensive. 00:01:45.850 --> 00:01:47.440 align:middle line:90% It means exports are less. 00:01:47.440 --> 00:01:49.780 align:middle line:84% Foreigners are going to buy less of our goods. 00:01:49.780 --> 00:01:53.290 align:middle line:84% Conversely for imports, it's like the exports 00:01:53.290 --> 00:01:57.460 align:middle line:84% of the other country, means that if domestic output goes up, then 00:01:57.460 --> 00:02:01.870 align:middle line:84% there will be more purchases of foreign goods. 00:02:01.870 --> 00:02:03.970 align:middle line:84% And if the exchange rate appreciate, 00:02:03.970 --> 00:02:06.310 align:middle line:84% means also that foreign goods are cheaper for us, 00:02:06.310 --> 00:02:08.090 align:middle line:90% and therefore we import more. 00:02:08.090 --> 00:02:08.590 align:middle line:90% OK. 00:02:08.590 --> 00:02:09.610 align:middle line:90% So positive. 00:02:09.610 --> 00:02:12.640 align:middle line:84% So those were the two new behavioral functions 00:02:12.640 --> 00:02:16.580 align:middle line:84% in the goods market expanded to include an open economy. 00:02:16.580 --> 00:02:18.830 align:middle line:84% And that had implications for the diagram 00:02:18.830 --> 00:02:23.090 align:middle line:84% that we had in lecture three or so to determine equilibrium 00:02:23.090 --> 00:02:25.010 align:middle line:90% output. 00:02:25.010 --> 00:02:28.400 align:middle line:84% We started from the same demand we had in closed economy. 00:02:28.400 --> 00:02:35.270 align:middle line:84% Then we had to subtract imports, and that shifts things down 00:02:35.270 --> 00:02:38.330 align:middle line:84% because now it's part of the domestic demand 00:02:38.330 --> 00:02:41.150 align:middle line:84% that is going to foreign goods, not to domestic goods. 00:02:41.150 --> 00:02:46.010 align:middle line:84% But it also rotates the curve because the higher 00:02:46.010 --> 00:02:48.890 align:middle line:84% is domestic income, the more the imports 00:02:48.890 --> 00:02:50.900 align:middle line:84% that we do from the rest of the world. 00:02:50.900 --> 00:02:54.590 align:middle line:84% Now to that we have to add the exports, which are not 00:02:54.590 --> 00:02:55.850 align:middle line:90% a function of domestic output. 00:02:55.850 --> 00:02:58.910 align:middle line:84% That's a parallel shift with respect to this curve. 00:02:58.910 --> 00:02:59.480 align:middle line:90% No. 00:02:59.480 --> 00:03:00.560 align:middle line:90% We go up. 00:03:00.560 --> 00:03:04.430 align:middle line:84% And that gives us the zz curve, which 00:03:04.430 --> 00:03:09.920 align:middle line:84% is what we call the demand for domestically-produced goods. 00:03:09.920 --> 00:03:12.440 align:middle line:84% Now notice that the distance between the demand 00:03:12.440 --> 00:03:16.220 align:middle line:84% for domestically-produced goods and the domestic demand 00:03:16.220 --> 00:03:21.320 align:middle line:84% for goods is the net export, so the distance between zz and dd 00:03:21.320 --> 00:03:22.830 align:middle line:90% is the net exports. 00:03:22.830 --> 00:03:28.310 align:middle line:84% So this point here, for example, the zz 00:03:28.310 --> 00:03:31.520 align:middle line:84% is higher than dd, which means that our exports are greater 00:03:31.520 --> 00:03:34.700 align:middle line:84% than our imports, and that's the reason you have a trade surplus. 00:03:34.700 --> 00:03:36.530 align:middle line:84% At this point they're the same, and that's 00:03:36.530 --> 00:03:39.200 align:middle line:84% the reason the trade account is balanced, 00:03:39.200 --> 00:03:41.468 align:middle line:84% but over here, imports exceed exports. 00:03:41.468 --> 00:03:43.385 align:middle line:84% And that's the reason we have a trade deficit. 00:03:43.385 --> 00:03:46.050 align:middle line:90% 00:03:46.050 --> 00:03:49.090 align:middle line:84% I'm going to go very quickly, so you're in charge of stopping me. 00:03:49.090 --> 00:03:50.040 align:middle line:84% I'm not going to ask you questions. 00:03:50.040 --> 00:03:51.415 align:middle line:84% Just stop me if there's something 00:03:51.415 --> 00:03:53.430 align:middle line:90% that you need clarification. 00:03:53.430 --> 00:03:56.460 align:middle line:84% OK, so that's what's the demand for domestically-produced goods. 00:03:56.460 --> 00:03:59.130 align:middle line:84% Now we're going to determine equilibrium output 00:03:59.130 --> 00:04:01.320 align:middle line:84% in this open economy context, and that 00:04:01.320 --> 00:04:03.900 align:middle line:84% means aggregate demand has to be equal-- 00:04:03.900 --> 00:04:06.120 align:middle line:84% aggregate demand for domestically-produced goods has 00:04:06.120 --> 00:04:09.720 align:middle line:84% to be equal to output, and that's what we do with 00:04:09.720 --> 00:04:11.620 align:middle line:90% the 45-degree line here. 00:04:11.620 --> 00:04:14.760 align:middle line:84% And so where the 45-degree line intersect with this zz curve, 00:04:14.760 --> 00:04:16.510 align:middle line:90% that's our equilibrium output. 00:04:16.510 --> 00:04:19.230 align:middle line:84% Now it happens that in this example, 00:04:19.230 --> 00:04:20.769 align:middle line:90% that leads to a trade deficit. 00:04:20.769 --> 00:04:24.000 align:middle line:84% But there is nothing here, so we still determine the equilibrium 00:04:24.000 --> 00:04:27.780 align:middle line:84% output up here, and then we read in this curve, bottom curve, 00:04:27.780 --> 00:04:33.370 align:middle line:84% what is the implication for the trade deficit or surplus. 00:04:33.370 --> 00:04:35.320 align:middle line:84% But the equilibrium condition, important 00:04:35.320 --> 00:04:37.840 align:middle line:84% is that domestically-produced output 00:04:37.840 --> 00:04:42.340 align:middle line:84% has to be equal to the demand for domestically-produced goods. 00:04:42.340 --> 00:04:43.315 align:middle line:90% Not for total demand. 00:04:43.315 --> 00:04:46.570 align:middle line:84% It's demand for domestically-produced goods. 00:04:46.570 --> 00:04:49.060 align:middle line:84% Because this is a Keynesian model in which output 00:04:49.060 --> 00:04:50.500 align:middle line:90% is aggregate demand determined. 00:04:50.500 --> 00:04:51.970 align:middle line:84% But it has to be aggregate demand 00:04:51.970 --> 00:04:53.560 align:middle line:84% for the things you're producing, not 00:04:53.560 --> 00:04:57.712 align:middle line:84% aggregate demand for all goods around the world. 00:04:57.712 --> 00:04:58.212 align:middle line:90% OK. 00:04:58.212 --> 00:04:59.060 align:middle line:90% Good. 00:04:59.060 --> 00:05:01.160 align:middle line:90% So then we did some experiments. 00:05:01.160 --> 00:05:04.340 align:middle line:84% We said, suppose what happens in this open economy context 00:05:04.340 --> 00:05:07.520 align:middle line:84% if we increase government expenditure. 00:05:07.520 --> 00:05:11.420 align:middle line:84% The curve will shift up in exactly the same way 00:05:11.420 --> 00:05:13.580 align:middle line:90% as in the closed economy. 00:05:13.580 --> 00:05:15.290 align:middle line:84% The difference will be in the multiplier 00:05:15.290 --> 00:05:18.440 align:middle line:84% though, because as output goes up 00:05:18.440 --> 00:05:21.500 align:middle line:84% as a result of the expansionary aggregate demand, that also 00:05:21.500 --> 00:05:24.480 align:middle line:84% means that domestic income will go up, 00:05:24.480 --> 00:05:26.630 align:middle line:84% and that means that imports will go up, 00:05:26.630 --> 00:05:28.760 align:middle line:84% and thus demand will go for foreign goods. 00:05:28.760 --> 00:05:32.090 align:middle line:84% And that's the reason this zz curve has a lower multiplier. 00:05:32.090 --> 00:05:35.720 align:middle line:90% It's flatter than the dd curve. 00:05:35.720 --> 00:05:38.600 align:middle line:84% Still if we start, for example, with a trade balance, 00:05:38.600 --> 00:05:40.130 align:middle line:84% since imports are going to increase 00:05:40.130 --> 00:05:42.590 align:middle line:84% as a result of this expansionary fiscal policy, 00:05:42.590 --> 00:05:45.680 align:middle line:84% we're going to end up with a trade deficit. 00:05:45.680 --> 00:05:48.080 align:middle line:84% And that's the reason the response of output 00:05:48.080 --> 00:05:50.330 align:middle line:84% is less than closed economies, because part of that 00:05:50.330 --> 00:05:51.770 align:middle line:90% goes to foreign goods. 00:05:51.770 --> 00:05:54.140 align:middle line:84% Conversely, if this other country 00:05:54.140 --> 00:05:57.060 align:middle line:84% that is doing an expansionary fiscal policy or something that 00:05:57.060 --> 00:05:59.610 align:middle line:84% leads to higher output abroad, y star, 00:05:59.610 --> 00:06:01.680 align:middle line:84% that's also expansionary for home 00:06:01.680 --> 00:06:04.800 align:middle line:84% because the export function goes up, 00:06:04.800 --> 00:06:08.160 align:middle line:84% and that leads to an increase in output, 00:06:08.160 --> 00:06:10.290 align:middle line:84% still with lower multiplier because part 00:06:10.290 --> 00:06:13.810 align:middle line:84% of that increase in domestic output will go to imports. 00:06:13.810 --> 00:06:17.310 align:middle line:84% But in this case, unlike the other ones, 00:06:17.310 --> 00:06:20.580 align:middle line:84% actually the trade balance improves because it's 00:06:20.580 --> 00:06:22.210 align:middle line:90% being pulled by exports. 00:06:22.210 --> 00:06:24.990 align:middle line:84% And so at impact we get a big increase 00:06:24.990 --> 00:06:27.510 align:middle line:84% in exports, which is the driver of increase 00:06:27.510 --> 00:06:29.610 align:middle line:84% for demand for domestically-produced goods. 00:06:29.610 --> 00:06:32.220 align:middle line:84% And then as income goes up, we do some of that, 00:06:32.220 --> 00:06:34.710 align:middle line:90% but you end up with higher-- 00:06:34.710 --> 00:06:39.930 align:middle line:84% better trade surpluses than in the case 00:06:39.930 --> 00:06:43.170 align:middle line:84% in which you induce the expansion in aggregate demand. 00:06:43.170 --> 00:06:46.530 align:middle line:90% 00:06:46.530 --> 00:06:50.160 align:middle line:84% Then the last step there was to look at the role of the exchange 00:06:50.160 --> 00:06:50.920 align:middle line:90% rate. 00:06:50.920 --> 00:06:54.990 align:middle line:84% And what we said is we're going to make some assumptions that I 00:06:54.990 --> 00:06:58.200 align:middle line:84% promise you, and I now read the quiz 00:06:58.200 --> 00:07:02.160 align:middle line:84% so I guarantee you all of this promise-- 00:07:02.160 --> 00:07:03.900 align:middle line:84% nothing weird will happen, meaning 00:07:03.900 --> 00:07:07.950 align:middle line:84% if our goods gets more expensive, that means 00:07:07.950 --> 00:07:10.060 align:middle line:90% that net exports will be worse. 00:07:10.060 --> 00:07:14.400 align:middle line:90% And for two reasons. 00:07:14.400 --> 00:07:16.410 align:middle line:84% For at least one reason, but it could be two. 00:07:16.410 --> 00:07:19.290 align:middle line:84% If the exchange rate goes up, then there 00:07:19.290 --> 00:07:21.030 align:middle line:84% is going to be less exports at any given 00:07:21.030 --> 00:07:22.920 align:middle line:90% level of foreign income. 00:07:22.920 --> 00:07:25.560 align:middle line:90% That will worsen the net export. 00:07:25.560 --> 00:07:28.620 align:middle line:84% And then we're going to tend to import more. 00:07:28.620 --> 00:07:30.570 align:middle line:84% Now that will be partially offset for the fact 00:07:30.570 --> 00:07:33.390 align:middle line:84% that you can buy more with the same amount of dollars, 00:07:33.390 --> 00:07:35.700 align:middle line:84% but we said we're going to impose conditions such 00:07:35.700 --> 00:07:38.310 align:middle line:84% that the positive-- the negative effect 00:07:38.310 --> 00:07:41.310 align:middle line:84% of an appreciation on net exports always dominates. 00:07:41.310 --> 00:07:42.960 align:middle line:84% And again, in your quiz you're going 00:07:42.960 --> 00:07:45.630 align:middle line:84% to have a situation like that, and that will be the case. 00:07:45.630 --> 00:07:48.180 align:middle line:90% 00:07:48.180 --> 00:07:51.620 align:middle line:84% So don't think that we're trying to trick you or anything. 00:07:51.620 --> 00:07:54.150 align:middle line:90% This will hold. 00:07:54.150 --> 00:08:03.350 align:middle line:84% The point of this being that depreciating your currency, 00:08:03.350 --> 00:08:09.200 align:middle line:84% making your goods less expensive will 00:08:09.200 --> 00:08:12.170 align:middle line:84% produce a response equivalent to what you get here 00:08:12.170 --> 00:08:14.960 align:middle line:90% out of an increase in y star. 00:08:14.960 --> 00:08:21.173 align:middle line:84% That's exports will go up, and you're 00:08:21.173 --> 00:08:22.340 align:middle line:90% going to get all this shift. 00:08:22.340 --> 00:08:24.360 align:middle line:90% Net export function will go up. 00:08:24.360 --> 00:08:26.608 align:middle line:84% That will increase aggregate demand and so on. 00:08:26.608 --> 00:08:28.400 align:middle line:84% So that's the kind of things that countries 00:08:28.400 --> 00:08:30.960 align:middle line:84% want to do typically when they're in a recession 00:08:30.960 --> 00:08:32.190 align:middle line:90% and so on. 00:08:32.190 --> 00:08:37.799 align:middle line:84% Then that was an introduction to the most important lecture 00:08:37.799 --> 00:08:41.370 align:middle line:84% in this part of the course, which 00:08:41.370 --> 00:08:43.679 align:middle line:90% is the Mundell-Fleming model. 00:08:43.679 --> 00:08:50.040 align:middle line:84% And I promise you that you would get 70% at least in the quiz, 00:08:50.040 --> 00:08:53.670 align:middle line:84% and I already read the quiz, so I tell you there is at least 70% 00:08:53.670 --> 00:08:55.720 align:middle line:84% of your points have to do with this model, 00:08:55.720 --> 00:08:57.990 align:middle line:84% so you better understand it very well. 00:08:57.990 --> 00:08:59.760 align:middle line:84% You do every single comparative statics 00:08:59.760 --> 00:09:01.380 align:middle line:84% that you can imagine with this model, 00:09:01.380 --> 00:09:03.870 align:middle line:84% and then you'll get 70% at least. 00:09:03.870 --> 00:09:09.180 align:middle line:84% I think you get 73% actually, but that's the-- 00:09:09.180 --> 00:09:11.880 align:middle line:90% so what's this? 00:09:11.880 --> 00:09:14.970 align:middle line:84% The Mundell-Fleming model is simply what I just showed you. 00:09:14.970 --> 00:09:17.970 align:middle line:84% It's the goods market equilibrium 00:09:17.970 --> 00:09:22.180 align:middle line:84% but with an endogenous exchange rate. 00:09:22.180 --> 00:09:27.270 align:middle line:84% And so we rewrote and said, since we're assuming completely 00:09:27.270 --> 00:09:29.445 align:middle line:84% sticky prices, we can replace the real exchange rate 00:09:29.445 --> 00:09:33.060 align:middle line:84% by the nominal exchange rate, but now we're 00:09:33.060 --> 00:09:35.070 align:middle line:84% going to endogenize the exchange rate. 00:09:35.070 --> 00:09:39.570 align:middle line:84% And for that we're going to use the uncovered interest parity 00:09:39.570 --> 00:09:40.110 align:middle line:90% condition. 00:09:40.110 --> 00:09:43.320 align:middle line:84% This is a condition you should understand very well as well. 00:09:43.320 --> 00:09:47.790 align:middle line:84% So that tells you essentially that the expected return 00:09:47.790 --> 00:09:49.890 align:middle line:84% of the two bonds, the bonds issued 00:09:49.890 --> 00:09:53.800 align:middle line:84% in foreign currency and domestic currency, have to be the same. 00:09:53.800 --> 00:09:56.130 align:middle line:84% The expected return have to be the same. 00:09:56.130 --> 00:09:59.110 align:middle line:84% And this condition ensures that, because if a country, 00:09:59.110 --> 00:10:01.590 align:middle line:84% for example, if the domestic interest 00:10:01.590 --> 00:10:04.470 align:middle line:84% rate is higher than the international interest rate, 00:10:04.470 --> 00:10:06.720 align:middle line:84% you need to expect a depreciation 00:10:06.720 --> 00:10:09.730 align:middle line:84% of the current currency, otherwise the expected return 00:10:09.730 --> 00:10:11.840 align:middle line:90% would not be the same. 00:10:11.840 --> 00:10:15.470 align:middle line:84% And that's the reason when we add the assumption 00:10:15.470 --> 00:10:19.520 align:middle line:84% that the expected exchange is fixed at least temporarily, 00:10:19.520 --> 00:10:22.053 align:middle line:84% then an increase in the interest rate 00:10:22.053 --> 00:10:23.970 align:middle line:84% leads to an appreciation of the exchange rate. 00:10:23.970 --> 00:10:24.470 align:middle line:90% Why? 00:10:24.470 --> 00:10:27.020 align:middle line:84% Because if the exchange rate appreciates 00:10:27.020 --> 00:10:29.030 align:middle line:84% but the expected exchange rate stays put, 00:10:29.030 --> 00:10:30.980 align:middle line:84% that means the expected appreciation will 00:10:30.980 --> 00:10:33.200 align:middle line:84% have to be undone, and that means 00:10:33.200 --> 00:10:35.540 align:middle line:84% that leads to an expected depreciation. 00:10:35.540 --> 00:10:37.290 align:middle line:90% So that's very important. 00:10:37.290 --> 00:10:39.140 align:middle line:84% So and here you have therefore you 00:10:39.140 --> 00:10:41.750 align:middle line:84% need to understand this, know that for a given 00:10:41.750 --> 00:10:44.220 align:middle line:84% expectation of the exchange rate, 00:10:44.220 --> 00:10:45.830 align:middle line:84% an increase in domestic interest rate 00:10:45.830 --> 00:10:48.170 align:middle line:84% appreciates the domestic currency, 00:10:48.170 --> 00:10:51.380 align:middle line:84% and an increase in the foreign interest rate without us 00:10:51.380 --> 00:10:53.810 align:middle line:84% matching it will lead to a depreciation 00:10:53.810 --> 00:10:57.410 align:middle line:90% of the domestic currency. 00:10:57.410 --> 00:10:58.790 align:middle line:90% So that's what you have there. 00:10:58.790 --> 00:10:59.810 align:middle line:90% That's important. 00:10:59.810 --> 00:11:02.480 align:middle line:90% 00:11:02.480 --> 00:11:07.000 align:middle line:84% Now notice that if the expected exchange rate goes up 00:11:07.000 --> 00:11:08.890 align:middle line:84% and the interest rates do not change, 00:11:08.890 --> 00:11:12.490 align:middle line:84% then the current exchange rate has to go up. 00:11:12.490 --> 00:11:15.910 align:middle line:84% Because if it didn't, then you would have an expected capital 00:11:15.910 --> 00:11:18.550 align:middle line:84% gain out of the currency and expected appreciation, 00:11:18.550 --> 00:11:20.830 align:middle line:84% and that would add to the expected return 00:11:20.830 --> 00:11:24.985 align:middle line:90% of owning domestic bonds. 00:11:24.985 --> 00:11:27.330 align:middle line:90% OK, good. 00:11:27.330 --> 00:11:31.390 align:middle line:84% So we characterize that interest parity condition as follows. 00:11:31.390 --> 00:11:35.080 align:middle line:84% We said, this here, we are plotting the domestic interest 00:11:35.080 --> 00:11:35.580 align:middle line:90% rate. 00:11:35.580 --> 00:11:38.050 align:middle line:84% Here we're plotting the current exchange rate. 00:11:38.050 --> 00:11:39.960 align:middle line:84% And we are marking in this picture-- 00:11:39.960 --> 00:11:42.930 align:middle line:84% this is a curve that traces the UIP 00:11:42.930 --> 00:11:44.550 align:middle line:90% and coverage by the condition. 00:11:44.550 --> 00:11:47.130 align:middle line:84% And naturally when the domestic interest rate 00:11:47.130 --> 00:11:49.200 align:middle line:84% is equal to the International interest rate, 00:11:49.200 --> 00:11:51.060 align:middle line:84% then it has to be the case that the exchange 00:11:51.060 --> 00:11:53.970 align:middle line:84% rate is at the same level as the expected exchange rate. 00:11:53.970 --> 00:11:57.280 align:middle line:84% If that is equal to that, so if we're here, 00:11:57.280 --> 00:11:59.460 align:middle line:84% then we know that the point in that curve 00:11:59.460 --> 00:12:03.090 align:middle line:84% is that in which the exchange rate is equal to the expected 00:12:03.090 --> 00:12:05.070 align:middle line:90% exchange rate. 00:12:05.070 --> 00:12:06.090 align:middle line:90% That's what we have. 00:12:06.090 --> 00:12:09.070 align:middle line:90% 00:12:09.070 --> 00:12:09.640 align:middle line:90% Good. 00:12:09.640 --> 00:12:13.120 align:middle line:84% So you should understand this curve and know what moves it. 00:12:13.120 --> 00:12:15.400 align:middle line:84% Here it's very clear what moves it, no? 00:12:15.400 --> 00:12:17.960 align:middle line:84% There are two things that can move this curve here. 00:12:17.960 --> 00:12:20.170 align:middle line:84% One is a change in i star, the other one 00:12:20.170 --> 00:12:23.760 align:middle line:84% is a change in expected exchange rate. 00:12:23.760 --> 00:12:28.360 align:middle line:84% What happens if the i star goes up? 00:12:28.360 --> 00:12:31.180 align:middle line:84% You know that the UIP will shift, 00:12:31.180 --> 00:12:37.052 align:middle line:84% but you do know that the point equivalent to that, that 00:12:37.052 --> 00:12:39.760 align:middle line:84% is one in which exchange rate is equal to expected exchange rate, 00:12:39.760 --> 00:12:43.120 align:middle line:84% will have to have a higher domestic interest rate. 00:12:43.120 --> 00:12:45.460 align:middle line:84% Because if I'm bringing this up and I 00:12:45.460 --> 00:12:47.365 align:middle line:84% want to still look at the point in which e 00:12:47.365 --> 00:12:48.990 align:middle line:84% is equal to the expected exchange rate, 00:12:48.990 --> 00:12:52.370 align:middle line:84% then I have to move i up by the same amount. 00:12:52.370 --> 00:12:55.780 align:middle line:84% And so I know that this curve, when i star goes up, this curve 00:12:55.780 --> 00:12:57.640 align:middle line:90% moves up or to the left. 00:12:57.640 --> 00:12:59.620 align:middle line:90% You pick which way you analyze. 00:12:59.620 --> 00:13:00.980 align:middle line:90% OK. 00:13:00.980 --> 00:13:03.210 align:middle line:84% Now what about the expected exchange rate? 00:13:03.210 --> 00:13:07.860 align:middle line:90% 00:13:07.860 --> 00:13:09.450 align:middle line:84% If the expected exchange rate goes up 00:13:09.450 --> 00:13:12.880 align:middle line:84% and the international interest rate hasn't gone up, 00:13:12.880 --> 00:13:15.690 align:middle line:84% so if the expected exchange rate moves 00:13:15.690 --> 00:13:22.470 align:middle line:84% to the right and the domestic interest doesn't go up, 00:13:22.470 --> 00:13:25.500 align:middle line:84% then that means that the current exchange 00:13:25.500 --> 00:13:28.680 align:middle line:90% rate will have to also go up. 00:13:28.680 --> 00:13:33.630 align:middle line:84% So that means if this goes up, then at an interest rate 00:13:33.630 --> 00:13:36.190 align:middle line:84% equal to the international interest rate, 00:13:36.190 --> 00:13:38.490 align:middle line:84% so let's look in this direction, then 00:13:38.490 --> 00:13:42.240 align:middle line:90% we have a point around here. 00:13:42.240 --> 00:13:44.892 align:middle line:84% If that wasn't the case, then you 00:13:44.892 --> 00:13:46.350 align:middle line:84% would be expecting an appreciation, 00:13:46.350 --> 00:13:52.520 align:middle line:84% and then again, it would be inconsistent with the UIP. 00:13:52.520 --> 00:13:54.060 align:middle line:90% Then we put things together. 00:13:54.060 --> 00:13:58.400 align:middle line:84% So what we did is we use the UIP to replace the exchange 00:13:58.400 --> 00:14:02.180 align:middle line:84% rate there, and now we get this expression in the net export 00:14:02.180 --> 00:14:02.960 align:middle line:90% function. 00:14:02.960 --> 00:14:07.810 align:middle line:84% Now the LM is exactly the same as before. 00:14:07.810 --> 00:14:11.150 align:middle line:84% The central bank sets the interest rate. 00:14:11.150 --> 00:14:14.120 align:middle line:84% Here I'm writing it in terms of the nominal interest rate. 00:14:14.120 --> 00:14:16.670 align:middle line:84% I think in the quiz we wrote it in terms of the real interest 00:14:16.670 --> 00:14:19.560 align:middle line:84% rate, but it's the same because prices are fixed, 00:14:19.560 --> 00:14:21.950 align:middle line:84% so real and nominal interest rates are exactly the same. 00:14:21.950 --> 00:14:23.790 align:middle line:90% Yeah. 00:14:23.790 --> 00:14:27.973 align:middle line:84% AUDIENCE: Is the x axis the expected exchange rate? 00:14:27.973 --> 00:14:28.890 align:middle line:90% RICARDO CABALLERO: No. 00:14:28.890 --> 00:14:30.240 align:middle line:90% It's the actual exchange rate. 00:14:30.240 --> 00:14:33.480 align:middle line:84% The expected exchange rate is in this curve here. 00:14:33.480 --> 00:14:35.620 align:middle line:90% That is a parameter. 00:14:35.620 --> 00:14:38.050 align:middle line:84% This happens to be a value of the current exchange 00:14:38.050 --> 00:14:39.800 align:middle line:84% equal to the expected exchange rate, which 00:14:39.800 --> 00:14:41.710 align:middle line:84% is convenient to plot because that's also 00:14:41.710 --> 00:14:44.483 align:middle line:84% when the domestic interest rate, which is what I'm putting here, 00:14:44.483 --> 00:14:46.150 align:middle line:84% is equal to international interest rate. 00:14:46.150 --> 00:14:47.200 align:middle line:90% That's all I'm saying. 00:14:47.200 --> 00:14:54.058 align:middle line:84% And then if you shift this to the right, exchange rate up, 00:14:54.058 --> 00:14:55.600 align:middle line:84% the expected exchange rate up, then I 00:14:55.600 --> 00:14:58.270 align:middle line:84% know that a new point in this curve 00:14:58.270 --> 00:15:01.070 align:middle line:84% has to have a higher current exchange rate. 00:15:01.070 --> 00:15:01.750 align:middle line:90% So that I know. 00:15:01.750 --> 00:15:03.565 align:middle line:84% I know that the equivalent to this point 00:15:03.565 --> 00:15:05.050 align:middle line:90% A is going to be to the right. 00:15:05.050 --> 00:15:08.590 align:middle line:84% If you lower the foreign interest rate, then what I know 00:15:08.590 --> 00:15:14.020 align:middle line:84% is that exactly, that the point at which exchange rate is 00:15:14.020 --> 00:15:15.790 align:middle line:84% equal to the expected exchange rate 00:15:15.790 --> 00:15:18.410 align:middle line:84% has to have a lower domestic interest rate. 00:15:18.410 --> 00:15:22.480 align:middle line:84% So that means that I know that this point 00:15:22.480 --> 00:15:25.660 align:middle line:84% A will be around here, which is like a shift to the right. 00:15:25.660 --> 00:15:30.940 align:middle line:90% 00:15:30.940 --> 00:15:36.400 align:middle line:84% Anyway, so as I was saying, nominal and real interest rates 00:15:36.400 --> 00:15:36.970 align:middle line:90% are the same. 00:15:36.970 --> 00:15:40.405 align:middle line:84% I think in the quiz we wrote r there, but it's the same. 00:15:40.405 --> 00:15:42.830 align:middle line:90% Same model. 00:15:42.830 --> 00:15:46.650 align:middle line:84% So now you see that interest rates have two effects. 00:15:46.650 --> 00:15:49.550 align:middle line:84% One is the traditional effect, affects investment, 00:15:49.550 --> 00:15:51.430 align:middle line:84% but it also affects the exchange rate. 00:15:51.430 --> 00:15:54.170 align:middle line:84% So an increase in the domestic interest rate 00:15:54.170 --> 00:15:56.990 align:middle line:84% now will be doubly contractionary in the sense 00:15:56.990 --> 00:15:58.880 align:middle line:84% that we lower domestic investment. 00:15:58.880 --> 00:16:00.380 align:middle line:90% That reduces aggregate demand. 00:16:00.380 --> 00:16:03.353 align:middle line:84% But at the same time, it will also 00:16:03.353 --> 00:16:05.270 align:middle line:84% appreciate the exchange rate, and therefore it 00:16:05.270 --> 00:16:06.740 align:middle line:90% will reduce net exports. 00:16:06.740 --> 00:16:08.990 align:middle line:84% We're going to import more and export less, 00:16:08.990 --> 00:16:12.890 align:middle line:84% and that's also going to reduce aggregate demand. 00:16:12.890 --> 00:16:15.620 align:middle line:90% So those are the two effects. 00:16:15.620 --> 00:16:18.220 align:middle line:84% So that's the contribution of all this exchange rate 00:16:18.220 --> 00:16:21.100 align:middle line:90% block to our IS-LM framework. 00:16:21.100 --> 00:16:26.560 align:middle line:84% Mundell-Fleming is simply IS-LM plus a UIP condition 00:16:26.560 --> 00:16:27.830 align:middle line:90% and a net export function. 00:16:27.830 --> 00:16:30.570 align:middle line:90% That's it. 00:16:30.570 --> 00:16:33.230 align:middle line:84% So we put out now the two things together, sort 00:16:33.230 --> 00:16:36.470 align:middle line:84% of a standard IS-LM, now with different slope 00:16:36.470 --> 00:16:38.600 align:middle line:84% and so on because we have this net export function 00:16:38.600 --> 00:16:42.620 align:middle line:84% and we have more parameter, we have y star, i star, and things 00:16:42.620 --> 00:16:45.350 align:middle line:84% like that, and then we have the UIP there. 00:16:45.350 --> 00:16:47.960 align:middle line:84% And then we did a few experiments. 00:16:47.960 --> 00:16:53.230 align:middle line:84% Said suppose that now you have an expansionary monetary policy. 00:16:53.230 --> 00:16:56.590 align:middle line:84% So an expansionary monetary policy 00:16:56.590 --> 00:16:59.287 align:middle line:84% as before with slightly different slopes 00:16:59.287 --> 00:17:01.120 align:middle line:84% and so on because of the net export function 00:17:01.120 --> 00:17:03.490 align:middle line:90% will lower equilibrium output. 00:17:03.490 --> 00:17:05.050 align:middle line:84% And it will lower it for two reasons. 00:17:05.050 --> 00:17:07.467 align:middle line:84% As I said before, it will lower it because investment will 00:17:07.467 --> 00:17:10.740 align:middle line:84% decline but also because higher interest rate 00:17:10.740 --> 00:17:12.490 align:middle line:84% means an appreciation of the exchange rate 00:17:12.490 --> 00:17:16.190 align:middle line:84% today because you have to expect a depreciation now 00:17:16.190 --> 00:17:18.020 align:middle line:90% in the next period. 00:17:18.020 --> 00:17:21.530 align:middle line:84% And that means also less net exports. 00:17:21.530 --> 00:17:23.630 align:middle line:84% So the interest rate is contractionary 00:17:23.630 --> 00:17:26.770 align:middle line:90% for two different reasons here. 00:17:26.770 --> 00:17:28.930 align:middle line:90% Is that clear? 00:17:28.930 --> 00:17:30.470 align:middle line:90% Yeah. 00:17:30.470 --> 00:17:31.345 align:middle line:90% Raised interest rate. 00:17:31.345 --> 00:17:34.318 align:middle line:90% 00:17:34.318 --> 00:17:36.360 align:middle line:84% Raised interest rates will lower aggregate demand 00:17:36.360 --> 00:17:38.620 align:middle line:84% for the standard reason, but on top of that, 00:17:38.620 --> 00:17:40.703 align:middle line:84% we're going to get an appreciation of the exchange 00:17:40.703 --> 00:17:42.570 align:middle line:84% rate, which also reduces net exports. 00:17:42.570 --> 00:17:45.960 align:middle line:90% 00:17:45.960 --> 00:17:49.860 align:middle line:84% What about an increase in government expenditure? 00:17:49.860 --> 00:17:52.380 align:middle line:84% It's the same as before, and nothing changes 00:17:52.380 --> 00:17:54.240 align:middle line:84% relative to before except for the fact 00:17:54.240 --> 00:17:55.740 align:middle line:90% that we have a lower multiplier. 00:17:55.740 --> 00:17:57.943 align:middle line:84% But it's still the case that it's expansionary, 00:17:57.943 --> 00:17:59.610 align:middle line:84% but it doesn't affect the interest rate, 00:17:59.610 --> 00:18:02.027 align:middle line:84% it doesn't affect the exchange rate or anything like that. 00:18:02.027 --> 00:18:05.040 align:middle line:84% Again, it's less expansionary than closed economy 00:18:05.040 --> 00:18:07.035 align:middle line:84% because part of that energy will go to imports. 00:18:07.035 --> 00:18:09.700 align:middle line:90% 00:18:09.700 --> 00:18:14.530 align:middle line:84% Then I went to this diagram, and I played with this diagram 00:18:14.530 --> 00:18:19.780 align:middle line:84% here and said, suppose that the expected exchange rate goes up, 00:18:19.780 --> 00:18:22.570 align:middle line:90% then which curves change? 00:18:22.570 --> 00:18:25.290 align:middle line:84% And the first one that changes is this one. 00:18:25.290 --> 00:18:28.290 align:middle line:84% This one moves to the right, so you get an appreciation today. 00:18:28.290 --> 00:18:30.870 align:middle line:84% And that also means that this curve here, that, yes, 00:18:30.870 --> 00:18:33.120 align:middle line:90% will shift to the left. 00:18:33.120 --> 00:18:35.820 align:middle line:84% If expected change goes up and you 00:18:35.820 --> 00:18:37.410 align:middle line:84% don't change monetary policy, that 00:18:37.410 --> 00:18:40.420 align:middle line:90% means interest rate will go up. 00:18:40.420 --> 00:18:40.920 align:middle line:90% Sorry. 00:18:40.920 --> 00:18:41.970 align:middle line:84% And you don't change monetary policy, 00:18:41.970 --> 00:18:44.178 align:middle line:84% that means the current exchange rate will appreciate. 00:18:44.178 --> 00:18:46.710 align:middle line:84% That will reduce net exports, and that's 00:18:46.710 --> 00:18:48.150 align:middle line:90% a shift in this space. 00:18:48.150 --> 00:18:51.410 align:middle line:84% That's a shift in the yes to the left. 00:18:51.410 --> 00:18:52.700 align:middle line:90% This is a parameter. 00:18:52.700 --> 00:18:57.020 align:middle line:84% These two things are parameters now in the IS-LM diagram. 00:18:57.020 --> 00:18:59.810 align:middle line:84% What about for an output going down? 00:18:59.810 --> 00:19:02.000 align:middle line:84% That doesn't affect the UIP condition, 00:19:02.000 --> 00:19:07.490 align:middle line:84% but it does affect net exports, so that moves IS to the left. 00:19:07.490 --> 00:19:12.410 align:middle line:84% And the last thing we did was an increase in i star. 00:19:12.410 --> 00:19:14.540 align:middle line:84% And an increase in i star, what it does 00:19:14.540 --> 00:19:17.762 align:middle line:84% is at the same interest rate, then 00:19:17.762 --> 00:19:19.970 align:middle line:84% you know that you need a depreciation of the currency 00:19:19.970 --> 00:19:23.150 align:middle line:84% today because that will lead to an expected appreciation, 00:19:23.150 --> 00:19:25.280 align:middle line:84% so that means that this UIP curve moves 00:19:25.280 --> 00:19:31.580 align:middle line:84% to the left and the IS curve moves to the right. 00:19:31.580 --> 00:19:35.440 align:middle line:84% And increasing the interest rate taken as given foreign output. 00:19:35.440 --> 00:19:37.340 align:middle line:84% If foreign output also changes, then you 00:19:37.340 --> 00:19:39.423 align:middle line:84% have to look at the combination of the two things. 00:19:39.423 --> 00:19:41.810 align:middle line:90% 00:19:41.810 --> 00:19:44.660 align:middle line:84% But taking foreign output as given, 00:19:44.660 --> 00:19:46.860 align:middle line:84% then this curve will shift to the left 00:19:46.860 --> 00:19:48.530 align:middle line:84% and that will move the IS to the right 00:19:48.530 --> 00:19:50.180 align:middle line:84% because the exchanges will depreciate. 00:19:50.180 --> 00:19:53.630 align:middle line:90% 00:19:53.630 --> 00:19:56.550 align:middle line:84% It said sometimes countries choose to fix exchange rates. 00:19:56.550 --> 00:19:58.160 align:middle line:84% And when you fix an exchange rate, 00:19:58.160 --> 00:20:00.050 align:middle line:84% and if it's a credible exchange rate, 00:20:00.050 --> 00:20:03.038 align:middle line:84% then the expected exchange is equal to the actual exchange 00:20:03.038 --> 00:20:04.580 align:middle line:84% rate and equal to some constant, then 00:20:04.580 --> 00:20:07.190 align:middle line:84% that implies immediately that the domestic interest 00:20:07.190 --> 00:20:10.370 align:middle line:84% rate has to be equal to the international interest rate. 00:20:10.370 --> 00:20:13.100 align:middle line:84% So if you fix your exchange rate to someone else, 00:20:13.100 --> 00:20:14.810 align:middle line:84% then you give up your monetary policy. 00:20:14.810 --> 00:20:16.893 align:middle line:84% The monetary policy is run by a different country. 00:20:16.893 --> 00:20:20.310 align:middle line:90% 00:20:20.310 --> 00:20:22.100 align:middle line:90% OK, good. 00:20:22.100 --> 00:20:23.780 align:middle line:84% So that's a very important lecture. 00:20:23.780 --> 00:20:25.940 align:middle line:90% Play with it, please. 00:20:25.940 --> 00:20:34.240 align:middle line:84% Then we look more carefully at different exchange rate regimes 00:20:34.240 --> 00:20:37.540 align:middle line:84% and the effectiveness of policy within each 00:20:37.540 --> 00:20:40.930 align:middle line:84% of these regimes, the flexible exchange rate system, which 00:20:40.930 --> 00:20:44.260 align:middle line:84% is the one we were discussing before, you get 00:20:44.260 --> 00:20:46.700 align:middle line:84% sort of-- if a country is in a recession, 00:20:46.700 --> 00:20:47.928 align:middle line:90% you can use fiscal policy. 00:20:47.928 --> 00:20:48.970 align:middle line:90% I showed you that before. 00:20:48.970 --> 00:20:50.660 align:middle line:90% It works well. 00:20:50.660 --> 00:20:53.480 align:middle line:84% And you can also use expansionary monetary policy, 00:20:53.480 --> 00:20:55.520 align:middle line:84% which will be very successful for two reasons. 00:20:55.520 --> 00:20:58.210 align:middle line:84% One, the traditional one, but the second reason 00:20:58.210 --> 00:21:01.090 align:middle line:84% is that it will depreciate your currency. 00:21:01.090 --> 00:21:03.060 align:middle line:90% OK, good. 00:21:03.060 --> 00:21:05.790 align:middle line:84% Now then suppose that you had a country that 00:21:05.790 --> 00:21:09.600 align:middle line:84% is also in a recession but you have a fixed exchange rate. 00:21:09.600 --> 00:21:11.790 align:middle line:84% Then you still can use fiscal policy. 00:21:11.790 --> 00:21:13.080 align:middle line:90% There is nothing against that. 00:21:13.080 --> 00:21:16.843 align:middle line:84% But you cannot use the expansionary monetary policy. 00:21:16.843 --> 00:21:18.760 align:middle line:84% So that's a limitation of fixed exchange rate, 00:21:18.760 --> 00:21:20.280 align:middle line:90% that you lose an important tool. 00:21:20.280 --> 00:21:22.980 align:middle line:90% 00:21:22.980 --> 00:21:27.690 align:middle line:84% Another problem that can arise with fixed exchange rates 00:21:27.690 --> 00:21:30.510 align:middle line:84% is speculative attacks on the currency. 00:21:30.510 --> 00:21:32.940 align:middle line:84% Sometimes the peg is not credible, 00:21:32.940 --> 00:21:37.230 align:middle line:84% and when the peg is not credible, you can imagine that-- 00:21:37.230 --> 00:21:43.020 align:middle line:84% suppose that people expect your currency to depreciate, 00:21:43.020 --> 00:21:47.040 align:middle line:84% so expect the exchange rate goes down, and suppose that you do 00:21:47.040 --> 00:21:50.520 align:middle line:84% want to keep your peg today, that's what typically happens. 00:21:50.520 --> 00:21:52.140 align:middle line:84% Somebody speculates against your peg, 00:21:52.140 --> 00:21:54.690 align:middle line:84% but the central bank resists that for a while. 00:21:54.690 --> 00:21:57.000 align:middle line:84% But the only way you can resist that, 00:21:57.000 --> 00:21:58.980 align:middle line:84% short of closing the capital account 00:21:58.980 --> 00:22:01.780 align:middle line:84% and doing all sorts of things there, 00:22:01.780 --> 00:22:05.280 align:middle line:84% but you haven't learned about those, so don't worry. 00:22:05.280 --> 00:22:08.100 align:middle line:84% The only tool you have here to defend the speculative attack 00:22:08.100 --> 00:22:10.140 align:middle line:84% on your currency that is for the exchanging note 00:22:10.140 --> 00:22:12.850 align:middle line:84% to depreciate today is by raising interest rates. 00:22:12.850 --> 00:22:17.230 align:middle line:84% So the defense of an exchange rate causes a recession at home. 00:22:17.230 --> 00:22:21.040 align:middle line:84% That's another problem that flexible exchange rate have. 00:22:21.040 --> 00:22:23.587 align:middle line:84% And the deal seems pretty obvious 00:22:23.587 --> 00:22:25.670 align:middle line:84% that you don't want to have a fixed exchange rate. 00:22:25.670 --> 00:22:29.080 align:middle line:84% And I said, be careful because flexible exchange 00:22:29.080 --> 00:22:30.430 align:middle line:90% rates are also not a panacea. 00:22:30.430 --> 00:22:32.680 align:middle line:84% You may get lots of volatility in the exchange rate 00:22:32.680 --> 00:22:38.570 align:middle line:84% because the role of expectations is very important. 00:22:38.570 --> 00:22:40.988 align:middle line:84% And anyways, this looks complicated, 00:22:40.988 --> 00:22:43.280 align:middle line:84% but it's essentially what we did later on when we price 00:22:43.280 --> 00:22:44.600 align:middle line:90% equity and things like that. 00:22:44.600 --> 00:22:48.740 align:middle line:84% We use the same sort of iterated substitutions and things. 00:22:48.740 --> 00:22:51.230 align:middle line:84% This was just meant to say that in a flexible exchange 00:22:51.230 --> 00:22:54.980 align:middle line:84% rate, once you endogenize expected exchange rate, 00:22:54.980 --> 00:22:56.480 align:middle line:84% you don't take it as a constant, it 00:22:56.480 --> 00:22:59.235 align:middle line:84% gets to be very complicated because effectively the exchange 00:22:59.235 --> 00:23:00.860 align:middle line:84% rate is pinned down by the expectations 00:23:00.860 --> 00:23:04.970 align:middle line:84% of infinite horizon of interest rate at home and abroad. 00:23:04.970 --> 00:23:07.490 align:middle line:84% So there's lots of space for creativity 00:23:07.490 --> 00:23:08.840 align:middle line:90% and moving things around. 00:23:08.840 --> 00:23:11.780 align:middle line:84% And that's the reason exchanges can be very volatile. 00:23:11.780 --> 00:23:15.100 align:middle line:90% 00:23:15.100 --> 00:23:15.970 align:middle line:90% OK, good. 00:23:15.970 --> 00:23:21.610 align:middle line:84% So anyways, so all that, that was it for Mundell-Fleming plus. 00:23:21.610 --> 00:23:22.630 align:middle line:90% Any question about that? 00:23:22.630 --> 00:23:25.760 align:middle line:84% Because now I'm going to move to the next part. 00:23:25.760 --> 00:23:30.400 align:middle line:84% OK, so then the next step was to look at asset prices 00:23:30.400 --> 00:23:35.380 align:middle line:84% really and/or valuations of assets in general that 00:23:35.380 --> 00:23:39.510 align:middle line:84% have cash flows in the future or an exchange 00:23:39.510 --> 00:23:42.310 align:middle line:84% that's a little bit like that, by the way. 00:23:42.310 --> 00:23:45.330 align:middle line:84% We talk a lot about current events. 00:23:45.330 --> 00:23:48.120 align:middle line:90% But the key thing was this. 00:23:48.120 --> 00:23:54.900 align:middle line:84% We said, OK, many things, many financial or real assets, 00:23:54.900 --> 00:23:59.580 align:middle line:84% actually, or even your human wealth, we'll discuss later on, 00:23:59.580 --> 00:24:02.183 align:middle line:84% you are receiving some income today, 00:24:02.183 --> 00:24:04.600 align:middle line:84% but you're also expecting to receive income in the future. 00:24:04.600 --> 00:24:08.195 align:middle line:84% And this part was about how do we value those things that we 00:24:08.195 --> 00:24:09.570 align:middle line:84% receive in the future, those cash 00:24:09.570 --> 00:24:11.380 align:middle line:90% flows that come in the future. 00:24:11.380 --> 00:24:16.090 align:middle line:84% And so we developed this concept of a expected present discounted 00:24:16.090 --> 00:24:16.590 align:middle line:90% value. 00:24:16.590 --> 00:24:20.100 align:middle line:84% And we said, very natural way of bringing dollars received 00:24:20.100 --> 00:24:23.700 align:middle line:84% in the future to the present is to discount them by the interest 00:24:23.700 --> 00:24:26.130 align:middle line:90% rate between now and then. 00:24:26.130 --> 00:24:28.170 align:middle line:84% And the reason, the logic behind that 00:24:28.170 --> 00:24:30.630 align:middle line:84% is because if you give me $1 today, 00:24:30.630 --> 00:24:34.080 align:middle line:84% I can do a lot more than if you give me $1 five years from now 00:24:34.080 --> 00:24:36.960 align:middle line:84% because I can invest the dollar today and earn the interest rate 00:24:36.960 --> 00:24:39.460 align:middle line:84% return up to five years from now. 00:24:39.460 --> 00:24:43.440 align:middle line:84% So $1 today is worth a lot more than $1 five years from now, 00:24:43.440 --> 00:24:47.120 align:middle line:84% therefore $1 five years from now is worth a lot less than $1 00:24:47.120 --> 00:24:47.620 align:middle line:90% today. 00:24:47.620 --> 00:24:48.580 align:middle line:90% How much less? 00:24:48.580 --> 00:24:52.090 align:middle line:84% 1 over 1 plus the interest rate over that period, which is-- 00:24:52.090 --> 00:24:53.990 align:middle line:90% OK. 00:24:53.990 --> 00:24:55.220 align:middle line:90% So that's what we did. 00:24:55.220 --> 00:24:59.000 align:middle line:84% Then I show you a general cash flow. 00:24:59.000 --> 00:25:01.820 align:middle line:84% This is an asset that gives a cash flow zt at the beginning 00:25:01.820 --> 00:25:02.990 align:middle line:90% of this period. 00:25:02.990 --> 00:25:05.540 align:middle line:84% zt plus 1 at the beginning of the next one 00:25:05.540 --> 00:25:08.270 align:middle line:84% or at the end of this one, something like that. 00:25:08.270 --> 00:25:09.770 align:middle line:84% This one you don't need to discount. 00:25:09.770 --> 00:25:12.080 align:middle line:84% That one you do need to discount because you're not receiving it 00:25:12.080 --> 00:25:13.940 align:middle line:84% now, you're receiving it a year from now. 00:25:13.940 --> 00:25:16.040 align:middle line:84% This one, it's two years from now. 00:25:16.040 --> 00:25:18.950 align:middle line:84% You need to discount it more because it's two years that you 00:25:18.950 --> 00:25:22.550 align:middle line:84% could be earning an interest rate and so on and so forth. 00:25:22.550 --> 00:25:24.521 align:middle line:84% This formula you need to understand. 00:25:24.521 --> 00:25:27.820 align:middle line:90% 00:25:27.820 --> 00:25:30.540 align:middle line:84% And I said, that's if you know the future. 00:25:30.540 --> 00:25:33.570 align:middle line:84% If you don't know the future, then you just replace the things 00:25:33.570 --> 00:25:35.347 align:middle line:84% you don't know for their expected value. 00:25:35.347 --> 00:25:36.180 align:middle line:90% That's what you say. 00:25:36.180 --> 00:25:37.440 align:middle line:90% And that's the approximation. 00:25:37.440 --> 00:25:40.350 align:middle line:84% In reality, if you were to do this formally, 00:25:40.350 --> 00:25:41.890 align:middle line:90% it's a little more complicated. 00:25:41.890 --> 00:25:44.340 align:middle line:84% But for this course, that's all that you do. 00:25:44.340 --> 00:25:46.940 align:middle line:90% 00:25:46.940 --> 00:25:48.830 align:middle line:84% And then I look at some particular cases. 00:25:48.830 --> 00:25:53.600 align:middle line:84% This is a case, the same case, but one in which the interest 00:25:53.600 --> 00:25:54.308 align:middle line:90% rate is constant. 00:25:54.308 --> 00:25:56.683 align:middle line:84% Suppose that you expect the interest rate to be constant, 00:25:56.683 --> 00:25:58.310 align:middle line:84% then it's a little simpler expression, 00:25:58.310 --> 00:26:00.980 align:middle line:84% because rather than getting this product of 1 00:26:00.980 --> 00:26:04.610 align:middle line:84% plus 1 the interest rates at different times, 00:26:04.610 --> 00:26:07.280 align:middle line:90% you get just powers of 1 plus i. 00:26:07.280 --> 00:26:09.320 align:middle line:84% Then another one that is simpler obviously 00:26:09.320 --> 00:26:11.300 align:middle line:84% is one in which all these expected payments 00:26:11.300 --> 00:26:13.620 align:middle line:90% are constant and so on. 00:26:13.620 --> 00:26:18.240 align:middle line:84% And then even simpler, if the interest rate is constant 00:26:18.240 --> 00:26:21.980 align:middle line:84% and the payment is constant, you get some simple formulas 00:26:21.980 --> 00:26:23.060 align:middle line:90% like that. 00:26:23.060 --> 00:26:24.560 align:middle line:90% Simpler formulas. 00:26:24.560 --> 00:26:26.990 align:middle line:84% And then cases in which asset lives forever 00:26:26.990 --> 00:26:29.600 align:middle line:84% of that kind and that's a value, if you 00:26:29.600 --> 00:26:32.490 align:middle line:84% don't pay for-- if you don't receive the first cash flow now 00:26:32.490 --> 00:26:34.490 align:middle line:84% but you receive it at the beginning of next year 00:26:34.490 --> 00:26:37.850 align:middle line:84% or at the end of this one, then it gets even simpler like that. 00:26:37.850 --> 00:26:41.810 align:middle line:84% And you are going to get a question of this kind in which 00:26:41.810 --> 00:26:43.310 align:middle line:84% you are going to be asked to compare 00:26:43.310 --> 00:26:49.040 align:middle line:84% two different assets that have different profiles of cash 00:26:49.040 --> 00:26:52.970 align:middle line:84% flows, and you're going to have to compare between those two. 00:26:52.970 --> 00:26:55.970 align:middle line:84% Then we talk about bonds and bond yields. 00:26:55.970 --> 00:26:59.480 align:middle line:84% And essentially we use expected present discounted value formula 00:26:59.480 --> 00:27:00.770 align:middle line:90% just for bonds. 00:27:00.770 --> 00:27:04.040 align:middle line:84% And bonds have a very particular form, profile of payment. 00:27:04.040 --> 00:27:07.287 align:middle line:84% Typically some coupons and some final payment, 00:27:07.287 --> 00:27:09.620 align:middle line:84% which we call it the face value of the bond or something 00:27:09.620 --> 00:27:10.880 align:middle line:90% like that. 00:27:10.880 --> 00:27:15.140 align:middle line:84% And we said a very important concept in bonds is maturity. 00:27:15.140 --> 00:27:18.890 align:middle line:84% And maturity is the date, the number of years 00:27:18.890 --> 00:27:21.763 align:middle line:84% till the last payment on that bond. 00:27:21.763 --> 00:27:23.180 align:middle line:84% Doesn't matter whether you receive 00:27:23.180 --> 00:27:24.990 align:middle line:84% lots of little coupons along the way. 00:27:24.990 --> 00:27:28.040 align:middle line:84% And one final payment, whether you receive no payment 00:27:28.040 --> 00:27:31.070 align:middle line:84% whatsoever until the last day, that doesn't matter. 00:27:31.070 --> 00:27:35.570 align:middle line:84% The maturity of a bond is the date, the number of years 00:27:35.570 --> 00:27:39.420 align:middle line:84% till the last time, your last payment. 00:27:39.420 --> 00:27:40.920 align:middle line:90% So we give some examples. 00:27:40.920 --> 00:27:43.700 align:middle line:84% There's a bond that pays nothing now but pays $100 one year 00:27:43.700 --> 00:27:45.800 align:middle line:90% from now. 00:27:45.800 --> 00:27:47.300 align:middle line:90% Has a price. 00:27:47.300 --> 00:27:51.110 align:middle line:84% It's a discounted value of $100 for one year divided 00:27:51.110 --> 00:27:53.510 align:middle line:84% by 1 plus the one year interest rate at time t. 00:27:53.510 --> 00:27:56.050 align:middle line:90% 00:27:56.050 --> 00:27:58.240 align:middle line:84% A bond that pays nothing up to two years 00:27:58.240 --> 00:28:02.650 align:middle line:84% and then after two years pays $100, 00:28:02.650 --> 00:28:05.080 align:middle line:84% then that's the value, the price of that bond. 00:28:05.080 --> 00:28:07.450 align:middle line:90% It's $100 discounted by that. 00:28:07.450 --> 00:28:10.020 align:middle line:90% 00:28:10.020 --> 00:28:12.080 align:middle line:84% And then we look at arbitrage, which 00:28:12.080 --> 00:28:16.910 align:middle line:84% says suppose you hold a bond that you're considering 00:28:16.910 --> 00:28:21.150 align:middle line:84% investing your money for one year, but you have two options. 00:28:21.150 --> 00:28:22.850 align:middle line:90% One is to buy a one-year bond. 00:28:22.850 --> 00:28:25.580 align:middle line:84% The alternative is to buy a two-year bond now and sell it 00:28:25.580 --> 00:28:26.790 align:middle line:90% at the end of the year. 00:28:26.790 --> 00:28:29.000 align:middle line:84% Those two strategies should give you more or less 00:28:29.000 --> 00:28:31.270 align:middle line:90% the same return. 00:28:31.270 --> 00:28:33.950 align:middle line:84% Well, if you buy a one-year bond, 00:28:33.950 --> 00:28:37.380 align:middle line:84% you're going to get 1 plus i1t at the end of the year. 00:28:37.380 --> 00:28:41.210 align:middle line:84% If you go through the two-year bond strategy, 00:28:41.210 --> 00:28:43.820 align:middle line:84% then you're going to pay this today 00:28:43.820 --> 00:28:51.050 align:middle line:84% but you expect to receive the price of a one-year bond one 00:28:51.050 --> 00:28:52.130 align:middle line:90% year from now. 00:28:52.130 --> 00:28:56.030 align:middle line:84% And we said these two things have to be equal. 00:28:56.030 --> 00:28:57.650 align:middle line:90% More or less equal. 00:28:57.650 --> 00:29:00.800 align:middle line:84% Again, we're not adding risk to these things. 00:29:00.800 --> 00:29:03.650 align:middle line:84% If there's no risk consideration of agents at risk neutral, 00:29:03.650 --> 00:29:06.080 align:middle line:84% then these two things have to be equal. 00:29:06.080 --> 00:29:09.800 align:middle line:84% That allows you to solve for the price of a two-year bond 00:29:09.800 --> 00:29:12.050 align:middle line:84% as expected price of a one-year bond one year 00:29:12.050 --> 00:29:14.120 align:middle line:84% from now divided by 1 plus the interest rate, 00:29:14.120 --> 00:29:17.690 align:middle line:84% but the expected price of a one-year bond one year from now 00:29:17.690 --> 00:29:21.990 align:middle line:84% is going to be like a one-year bond but one year from now, 00:29:21.990 --> 00:29:26.150 align:middle line:84% so it's 100 divided by 1 plus i1t plus 1 expected value. 00:29:26.150 --> 00:29:29.700 align:middle line:84% I can stick that in there, and I get exactly the same expression. 00:29:29.700 --> 00:29:34.850 align:middle line:84% So these are two different ways of pricing a bond 00:29:34.850 --> 00:29:39.450 align:middle line:90% or any other asset actually. 00:29:39.450 --> 00:29:42.040 align:middle line:84% And then we define the yield to maturity. 00:29:42.040 --> 00:29:44.310 align:middle line:90% So that's an important concept. 00:29:44.310 --> 00:29:59.170 align:middle line:84% Yield to maturity is a constant rate that gives you 00:29:59.170 --> 00:30:01.510 align:middle line:90% the current price of the bond. 00:30:01.510 --> 00:30:05.080 align:middle line:84% So we already determined the price of a two-year bond 00:30:05.080 --> 00:30:08.090 align:middle line:90% is that. 00:30:08.090 --> 00:30:10.930 align:middle line:84% And now I'm saying, suppose that-- let 00:30:10.930 --> 00:30:15.730 align:middle line:84% me look for a rate that is the same in both periods that 00:30:15.730 --> 00:30:17.050 align:middle line:90% gives me the same price. 00:30:17.050 --> 00:30:20.350 align:middle line:84% And that's the reason I have a subscript 2 here at time t. 00:30:20.350 --> 00:30:25.600 align:middle line:84% So what is the rate that, if I put a constant rate, so I have 00:30:25.600 --> 00:30:30.940 align:middle line:84% 1 plus i2t times 1 plus i2t gives me 00:30:30.940 --> 00:30:35.605 align:middle line:84% exactly the same price as the one we already determined. 00:30:35.605 --> 00:30:37.480 align:middle line:84% And that's what we call the yield to maturity 00:30:37.480 --> 00:30:39.760 align:middle line:90% or the yield or the end-- 00:30:39.760 --> 00:30:41.500 align:middle line:84% in this case, would be a two-year rate. 00:30:41.500 --> 00:30:46.230 align:middle line:84% If you hear, what is a two-year rate, it's that. 00:30:46.230 --> 00:30:51.080 align:middle line:84% And so we know what this price is, which is equal to that, 00:30:51.080 --> 00:30:52.710 align:middle line:90% thus this expression there. 00:30:52.710 --> 00:30:56.000 align:middle line:84% So the whole trick here is to find the two-year rate 00:30:56.000 --> 00:30:59.000 align:middle line:84% at time t that gives you exactly the same value. 00:30:59.000 --> 00:31:01.580 align:middle line:84% That means obviously since 100 is equal to 100, 00:31:01.580 --> 00:31:06.760 align:middle line:84% it means to find the i to t that gives you this equal to that. 00:31:06.760 --> 00:31:08.650 align:middle line:84% Would you say it's approximate, implies 00:31:08.650 --> 00:31:10.270 align:middle line:84% that approximately a two-year rate 00:31:10.270 --> 00:31:14.740 align:middle line:84% is like an average of the two one-year rates. 00:31:14.740 --> 00:31:19.070 align:middle line:84% But this concept, you should know what it is. 00:31:19.070 --> 00:31:21.950 align:middle line:84% I said there are two forms of risk in a bond. 00:31:21.950 --> 00:31:24.822 align:middle line:84% One type of risk is the full risk. 00:31:24.822 --> 00:31:26.780 align:middle line:84% What if the issuer of the bond doesn't pay you? 00:31:26.780 --> 00:31:30.380 align:middle line:84% Now there's a huge issue with the US debt ceiling, 00:31:30.380 --> 00:31:32.660 align:middle line:84% because if somehow they don't fix that, 00:31:32.660 --> 00:31:35.090 align:middle line:84% there will be a default on some treasury bonds. 00:31:35.090 --> 00:31:37.400 align:middle line:84% Let's hope that it doesn't happen. 00:31:37.400 --> 00:31:40.190 align:middle line:84% But that's default risk, is that whoever 00:31:40.190 --> 00:31:43.160 align:middle line:84% issued the debt, at the time in which it should be paying you 00:31:43.160 --> 00:31:48.110 align:middle line:84% a coupon or the principal, the face value, it doesn't pay you. 00:31:48.110 --> 00:31:49.790 align:middle line:90% That's default risk. 00:31:49.790 --> 00:31:54.870 align:middle line:84% And typically, US Treasury bonds don't have that risk, 00:31:54.870 --> 00:31:56.870 align:middle line:90% so nobody worries about that. 00:31:56.870 --> 00:32:00.200 align:middle line:84% At this moment, the default risk price 00:32:00.200 --> 00:32:04.580 align:middle line:84% in US bonds for one-month bonds is higher than that of Mexico 00:32:04.580 --> 00:32:07.370 align:middle line:84% and the bonds in Mexico or Brazil. 00:32:07.370 --> 00:32:10.200 align:middle line:84% That tells you the kind of things we have. 00:32:10.200 --> 00:32:15.530 align:middle line:84% But in any event, so this is a temporary default risk. 00:32:15.530 --> 00:32:17.780 align:middle line:84% Nobody expects in the US that this will not 00:32:17.780 --> 00:32:19.040 align:middle line:90% be eventually repaid. 00:32:19.040 --> 00:32:25.890 align:middle line:84% But you can cause a big mess by just delaying a coupon payment 00:32:25.890 --> 00:32:28.010 align:middle line:90% when these coupons are huge. 00:32:28.010 --> 00:32:32.270 align:middle line:84% And so that's what's leading to all this concern. 00:32:32.270 --> 00:32:35.453 align:middle line:84% But in any event, that's one type of risk. 00:32:35.453 --> 00:32:37.370 align:middle line:84% But we didn't look at that type of risk a lot. 00:32:37.370 --> 00:32:39.350 align:middle line:84% Corporate bonds have a lot of that risk, 00:32:39.350 --> 00:32:41.120 align:middle line:84% but we didn't look at that kind of risk. 00:32:41.120 --> 00:32:43.970 align:middle line:84% We looked at another kind of risk, which is price risk. 00:32:43.970 --> 00:32:48.290 align:middle line:84% If you invest in your one-year bond, there is no price risk, 00:32:48.290 --> 00:32:50.780 align:middle line:84% you're going to get your coupon, your face value of $100 00:32:50.780 --> 00:32:51.480 align:middle line:90% at the end of the year. 00:32:51.480 --> 00:32:52.070 align:middle line:90% That's it. 00:32:52.070 --> 00:32:53.875 align:middle line:84% If you go through a two-year strategy, 00:32:53.875 --> 00:32:55.250 align:middle line:84% there is a risk there because you 00:32:55.250 --> 00:32:57.740 align:middle line:84% don't know exactly what the price of the one-year bond 00:32:57.740 --> 00:33:00.830 align:middle line:84% will be one year from now, and that's a risk there. 00:33:00.830 --> 00:33:05.780 align:middle line:84% We are not looking at what risk-averse investors do and so 00:33:05.780 --> 00:33:09.020 align:middle line:84% on, but in reality, there is such a risk. 00:33:09.020 --> 00:33:12.320 align:middle line:84% And just the way we model that is we said, then 00:33:12.320 --> 00:33:15.980 align:middle line:84% if I'm going to go through the two-year bond 00:33:15.980 --> 00:33:18.680 align:middle line:84% route for a one-year investment, then I 00:33:18.680 --> 00:33:22.640 align:middle line:84% don't have to set this equal to the return 00:33:22.640 --> 00:33:25.140 align:middle line:84% I get in the short bond, the one-year bond. 00:33:25.140 --> 00:33:26.990 align:middle line:84% I have to add an extra risk premium. 00:33:26.990 --> 00:33:30.110 align:middle line:84% And then we write to this formula using the same steps. 00:33:30.110 --> 00:33:33.740 align:middle line:84% We said, well the two-year rate is really 00:33:33.740 --> 00:33:38.040 align:middle line:84% the average of the expected one-year rate plus a premium. 00:33:38.040 --> 00:33:41.320 align:middle line:84% And we call that actually the term premium. 00:33:41.320 --> 00:33:42.970 align:middle line:84% You're more likely to face a question 00:33:42.970 --> 00:33:45.440 align:middle line:84% about the top of the slide than the bottom of the slide, 00:33:45.440 --> 00:33:46.780 align:middle line:90% but I don't remember fully. 00:33:46.780 --> 00:33:51.370 align:middle line:90% 00:33:51.370 --> 00:33:52.970 align:middle line:90% Stock prices and present value. 00:33:52.970 --> 00:33:55.060 align:middle line:90% It's the same sort of idea. 00:33:55.060 --> 00:34:03.340 align:middle line:84% The only difference is that the equities do not have maturity. 00:34:03.340 --> 00:34:04.540 align:middle line:90% Stocks do not have maturity. 00:34:04.540 --> 00:34:07.220 align:middle line:84% In principle, a company would last forever. 00:34:07.220 --> 00:34:11.060 align:middle line:90% And so there is no maturity. 00:34:11.060 --> 00:34:14.530 align:middle line:84% And there is also the commitment of-- the coupons 00:34:14.530 --> 00:34:17.656 align:middle line:84% are a lot shakier in the sense that, yeah, the company is 00:34:17.656 --> 00:34:19.989 align:middle line:84% likely to give dividends, they may announce the dividend 00:34:19.989 --> 00:34:22.730 align:middle line:84% policy, but it's not a commitment. 00:34:22.730 --> 00:34:25.840 align:middle line:84% Regional banks now are not giving any dividend 00:34:25.840 --> 00:34:28.210 align:middle line:84% because they want to preserve the capital. 00:34:28.210 --> 00:34:30.969 align:middle line:84% They could, but they're not because they 00:34:30.969 --> 00:34:32.860 align:middle line:84% want to build capital just to be more 00:34:32.860 --> 00:34:37.150 align:middle line:84% resilient to any further bad news. 00:34:37.150 --> 00:34:40.060 align:middle line:84% But anyway, so equity, that means that you always 00:34:40.060 --> 00:34:42.100 align:middle line:84% have this future price floating around, 00:34:42.100 --> 00:34:45.790 align:middle line:84% and you can keep substituting this multiple times. 00:34:45.790 --> 00:34:48.460 align:middle line:84% And essentially, you get to an expression that says, look, 00:34:48.460 --> 00:34:52.989 align:middle line:84% the price of equity is really the expected present discounted 00:34:52.989 --> 00:34:56.973 align:middle line:84% value of the dividends, and that includes lots of uncertainty 00:34:56.973 --> 00:34:59.390 align:middle line:84% because you don't know exactly what the interest rate will 00:34:59.390 --> 00:35:00.840 align:middle line:90% be in that period and so on. 00:35:00.840 --> 00:35:05.060 align:middle line:84% And there is always a remaining term out there which 00:35:05.060 --> 00:35:06.530 align:middle line:90% also causes a lot of trouble. 00:35:06.530 --> 00:35:11.780 align:middle line:84% In practice, assets, equities move a lot more 00:35:11.780 --> 00:35:15.110 align:middle line:84% than what you can justify with respect to the present value 00:35:15.110 --> 00:35:17.270 align:middle line:90% of dividends. 00:35:17.270 --> 00:35:19.700 align:middle line:90% There's a lot of volatility. 00:35:19.700 --> 00:35:20.720 align:middle line:90% There are bubbles. 00:35:20.720 --> 00:35:22.130 align:middle line:90% There are all sorts of things. 00:35:22.130 --> 00:35:27.420 align:middle line:84% I told you the story of Newton and so on. 00:35:27.420 --> 00:35:31.220 align:middle line:84% So this formula for the bonds, those formulas are great. 00:35:31.220 --> 00:35:34.370 align:middle line:84% For equity you're going to be pretty far off on actual prices 00:35:34.370 --> 00:35:36.200 align:middle line:90% if you use this type of formula. 00:35:36.200 --> 00:35:39.230 align:middle line:84% Still people call this the fundamental value of equity. 00:35:39.230 --> 00:35:42.840 align:middle line:84% And then the rest is sort of more speculative. 00:35:42.840 --> 00:35:44.870 align:middle line:84% But the point is that the speculative component 00:35:44.870 --> 00:35:46.440 align:middle line:90% moves a lot. 00:35:46.440 --> 00:35:49.010 align:middle line:84% It's responsible for a very large share of the volatility 00:35:49.010 --> 00:35:50.547 align:middle line:90% in asset-- in equity prices. 00:35:50.547 --> 00:35:52.130 align:middle line:84% In any event, I'm not going to ask you 00:35:52.130 --> 00:35:53.820 align:middle line:90% about this kind of stuff. 00:35:53.820 --> 00:35:54.320 align:middle line:90% Yeah. 00:35:54.320 --> 00:35:54.890 align:middle line:90% 00:35:54.890 --> 00:35:57.080 align:middle line:84% AUDIENCE: So that final equation on the slide, 00:35:57.080 --> 00:36:00.172 align:middle line:90% there is no expression for qt. 00:36:00.172 --> 00:36:01.630 align:middle line:84% RICARDO CABALLERO: It's right here. 00:36:01.630 --> 00:36:02.338 align:middle line:90% AUDIENCE: Oh, OK. 00:36:02.338 --> 00:36:04.450 align:middle line:84% RICARDO CABALLERO: It keeps going forever. 00:36:04.450 --> 00:36:05.330 align:middle line:90% It doesn't stop. 00:36:05.330 --> 00:36:05.830 align:middle line:90% Yeah. 00:36:05.830 --> 00:36:08.230 align:middle line:84% It just discounted more and more and more, 00:36:08.230 --> 00:36:10.910 align:middle line:84% so you would expect it to be less and less important. 00:36:10.910 --> 00:36:15.310 align:middle line:84% But if the thing is blowing up, then it 00:36:15.310 --> 00:36:18.850 align:middle line:84% may dominate the heavier and heavier discounting 00:36:18.850 --> 00:36:21.440 align:middle line:84% because it's further out in the future. 00:36:21.440 --> 00:36:23.740 align:middle line:84% And that's the way you create theories of bubbles. 00:36:23.740 --> 00:36:26.360 align:middle line:84% You can even come up with rational bubbles in that way, 00:36:26.360 --> 00:36:30.280 align:middle line:84% but again, that's for a different course. 00:36:30.280 --> 00:36:31.893 align:middle line:90% What else? 00:36:31.893 --> 00:36:33.310 align:middle line:84% Then we look at what is the effect 00:36:33.310 --> 00:36:35.800 align:middle line:84% of an expansionary monetary policy on asset prices. 00:36:35.800 --> 00:36:37.522 align:middle line:84% And we said, obviously it's going to, 00:36:37.522 --> 00:36:38.980 align:middle line:84% if you lower interest rates, that's 00:36:38.980 --> 00:36:41.470 align:middle line:84% going to increase the value of any asset that 00:36:41.470 --> 00:36:43.310 align:middle line:90% pays in the future returns. 00:36:43.310 --> 00:36:46.510 align:middle line:84% And so it is typically the case that 00:36:46.510 --> 00:36:48.910 align:middle line:84% expansionary monetary policy will 00:36:48.910 --> 00:36:52.030 align:middle line:84% lead to an appreciation of all assets. 00:36:52.030 --> 00:36:55.830 align:middle line:84% Most assets, but certainly bonds will go up directly 00:36:55.830 --> 00:36:57.580 align:middle line:84% because that's where the interest rate has 00:36:57.580 --> 00:37:00.490 align:middle line:84% a maximum, the clearest effect, but it's also the case 00:37:00.490 --> 00:37:03.050 align:middle line:84% that it tends to be bullish for equity as well. 00:37:03.050 --> 00:37:05.800 align:middle line:90% It's got interest rate. 00:37:05.800 --> 00:37:08.980 align:middle line:84% A lot of the response of equity to news 00:37:08.980 --> 00:37:11.620 align:middle line:84% has to do with the expected behavior 00:37:11.620 --> 00:37:13.243 align:middle line:90% of the fed in the future. 00:37:13.243 --> 00:37:15.910 align:middle line:84% Do you think that this will lead them to increase interest rates 00:37:15.910 --> 00:37:18.560 align:middle line:84% or to lower interest rates and things of that kind. 00:37:18.560 --> 00:37:21.220 align:middle line:84% But again, I think that's a little too complicated for you 00:37:21.220 --> 00:37:22.750 align:middle line:90% for now. 00:37:22.750 --> 00:37:25.130 align:middle line:84% It said, what is the effect of an increase in consumer 00:37:25.130 --> 00:37:26.750 align:middle line:90% spending on asset prices? 00:37:26.750 --> 00:37:29.430 align:middle line:90% Well, that depends. 00:37:29.430 --> 00:37:32.690 align:middle line:84% It's clear that if consumers become more bullish, 00:37:32.690 --> 00:37:35.870 align:middle line:84% that's going to tend to lead to more cash flows for the firms, 00:37:35.870 --> 00:37:37.460 align:middle line:90% so equity at least will go up. 00:37:37.460 --> 00:37:40.490 align:middle line:84% Bonds no, because the coupon is set, fixed, 00:37:40.490 --> 00:37:42.410 align:middle line:84% doesn't depend on whether the economy 00:37:42.410 --> 00:37:43.940 align:middle line:90% is doing better or worse. 00:37:43.940 --> 00:37:46.700 align:middle line:84% I'm assuming there is no default risk. 00:37:46.700 --> 00:37:50.270 align:middle line:84% But it depends a lot of what you expect the fed to do. 00:37:50.270 --> 00:37:52.730 align:middle line:84% If you think that this is going to trigger a fed hike, 00:37:52.730 --> 00:37:56.600 align:middle line:84% then it's bad news for bonds because the bonds do not 00:37:56.600 --> 00:37:59.630 align:middle line:84% benefit from the extra economic activity, 00:37:59.630 --> 00:38:01.770 align:middle line:84% and they get hurt by higher interest rates. 00:38:01.770 --> 00:38:05.220 align:middle line:84% So it depends a lot on what you anticipate the fed to do or not. 00:38:05.220 --> 00:38:07.850 align:middle line:84% But again, I think this is a bit more complicated 00:38:07.850 --> 00:38:09.710 align:middle line:90% than what you need to know. 00:38:09.710 --> 00:38:15.200 align:middle line:84% OK, the last step was to bring expectations 00:38:15.200 --> 00:38:16.280 align:middle line:90% into the IS-LM model. 00:38:16.280 --> 00:38:19.970 align:middle line:84% I said the model we discussed through the course on the IS-LM 00:38:19.970 --> 00:38:23.090 align:middle line:84% except for the part where we put the exchange rate, where 00:38:23.090 --> 00:38:26.690 align:middle line:84% we had to think about the future exchange rates 00:38:26.690 --> 00:38:27.920 align:middle line:90% and things like that. 00:38:27.920 --> 00:38:30.350 align:middle line:84% It really overweighed the present. 00:38:30.350 --> 00:38:34.220 align:middle line:84% In reality, expectations matter a lot for consumers' decisions, 00:38:34.220 --> 00:38:36.302 align:middle line:90% for firms' decisions, and so on. 00:38:36.302 --> 00:38:38.885 align:middle line:84% Probably matters even more than the future-- than the present. 00:38:38.885 --> 00:38:41.770 align:middle line:90% 00:38:41.770 --> 00:38:48.180 align:middle line:84% And so what we did is we expanded the IS-LM to include 00:38:48.180 --> 00:38:51.780 align:middle line:84% expectations, which is where consumers not only worry about 00:38:51.780 --> 00:38:53.710 align:middle line:90% disposable income-- 00:38:53.710 --> 00:38:55.420 align:middle line:84% this part will show up in your test, 00:38:55.420 --> 00:38:58.680 align:middle line:84% so you should understand what the IS-LM model is 00:38:58.680 --> 00:39:03.100 align:middle line:84% and do the comparative statics that corresponds to this model. 00:39:03.100 --> 00:39:06.090 align:middle line:84% So what we did here, it says, consumers not only 00:39:06.090 --> 00:39:08.820 align:middle line:84% worry about the current disposable income, 00:39:08.820 --> 00:39:12.390 align:middle line:84% they also worry about the income they receive in the future 00:39:12.390 --> 00:39:14.670 align:middle line:84% through financial assets, financial wealth, 00:39:14.670 --> 00:39:16.590 align:middle line:84% or through their future labor income. 00:39:16.590 --> 00:39:18.180 align:middle line:84% That's what we call human wealth. 00:39:18.180 --> 00:39:20.340 align:middle line:84% But the point is that expectations 00:39:20.340 --> 00:39:22.740 align:middle line:84% about the future matter for consumption. 00:39:22.740 --> 00:39:26.790 align:middle line:84% In the first part of the course we summarize all that 00:39:26.790 --> 00:39:28.590 align:middle line:90% in that little parameter c0. 00:39:28.590 --> 00:39:30.960 align:middle line:84% We said consumers can be bullish or not. 00:39:30.960 --> 00:39:32.550 align:middle line:84% A lot of what happens here is what 00:39:32.550 --> 00:39:36.180 align:middle line:84% shifts c0 in the first part of the course. 00:39:36.180 --> 00:39:38.860 align:middle line:84% And this also highlights an important concept, 00:39:38.860 --> 00:39:41.970 align:middle line:84% which is typically if you expect something 00:39:41.970 --> 00:39:44.730 align:middle line:84% to have only a temporary transitory consequence, 00:39:44.730 --> 00:39:48.100 align:middle line:84% it will move consumption little relative to when you expect 00:39:48.100 --> 00:39:49.310 align:middle line:90% that change to be permanent. 00:39:49.310 --> 00:39:52.000 align:middle line:84% So you expect current income to be up, 00:39:52.000 --> 00:39:54.370 align:middle line:84% but future income to go back to a lower 00:39:54.370 --> 00:39:55.990 align:middle line:84% level, that's not going to change 00:39:55.990 --> 00:39:57.410 align:middle line:90% current consumption a lot. 00:39:57.410 --> 00:39:59.243 align:middle line:84% However, if you think there is a change that 00:39:59.243 --> 00:40:01.870 align:middle line:84% will increase consumers income permanently up, 00:40:01.870 --> 00:40:05.140 align:middle line:84% well that will increase not only this but also human wealth, 00:40:05.140 --> 00:40:09.840 align:middle line:84% and that will lead to a much larger response of consumption. 00:40:09.840 --> 00:40:12.150 align:middle line:84% We did more or less the same for investment. 00:40:12.150 --> 00:40:16.240 align:middle line:84% Obviously what matters for investment is future cash flows. 00:40:16.240 --> 00:40:19.150 align:middle line:84% And there we talk about the concept of depreciation. 00:40:19.150 --> 00:40:21.750 align:middle line:84% But really was this expected present discounted 00:40:21.750 --> 00:40:26.690 align:middle line:84% value of the cash flow generated by an extra unit of capital. 00:40:26.690 --> 00:40:31.520 align:middle line:84% So expected present discounted value formula. 00:40:31.520 --> 00:40:35.210 align:middle line:84% So in the first part of the course, 00:40:35.210 --> 00:40:38.285 align:middle line:84% we just look at an investment function that has output here, 00:40:38.285 --> 00:40:39.910 align:middle line:84% and then we have an interest rate here, 00:40:39.910 --> 00:40:42.118 align:middle line:84% where now we have something that is more complicated. 00:40:42.118 --> 00:40:45.370 align:middle line:84% It has future output, which as a proxy for future cash flows 00:40:45.370 --> 00:40:47.650 align:middle line:84% but also current and future interest 00:40:47.650 --> 00:40:50.890 align:middle line:84% rates because those affect the value of those future cash 00:40:50.890 --> 00:40:54.720 align:middle line:84% flows in terms of today's dollars. 00:40:54.720 --> 00:40:58.260 align:middle line:84% And we put all of this together, and we ended up 00:40:58.260 --> 00:41:04.260 align:middle line:84% with an expanded aggregate demand in which we 00:41:04.260 --> 00:41:07.080 align:middle line:84% had the same parameters as we had 00:41:07.080 --> 00:41:12.120 align:middle line:84% when we did the static model without expectations, 00:41:12.120 --> 00:41:14.370 align:middle line:84% but now we get sort of the same things 00:41:14.370 --> 00:41:18.630 align:middle line:84% repeated here one year ahead because it matters 00:41:18.630 --> 00:41:20.220 align:middle line:84% not only for aggregate demand, not 00:41:20.220 --> 00:41:23.370 align:middle line:84% only the income that consumers are receiving today 00:41:23.370 --> 00:41:25.560 align:middle line:84% or the sales that firms are making today, 00:41:25.560 --> 00:41:28.440 align:middle line:84% but also what they expect to have next year. 00:41:28.440 --> 00:41:30.810 align:middle line:84% It matters what the taxes they are paying today 00:41:30.810 --> 00:41:33.150 align:middle line:84% but also what they expect to pay in the future. 00:41:33.150 --> 00:41:35.648 align:middle line:84% The interest rate matters not only today 00:41:35.648 --> 00:41:37.440 align:middle line:84% but also what they expect the interest rate 00:41:37.440 --> 00:41:39.480 align:middle line:90% to be in the future and so on. 00:41:39.480 --> 00:41:45.810 align:middle line:84% So the bottom line is that if we now look at the IS-LM model, now 00:41:45.810 --> 00:41:47.490 align:middle line:90% we have lots of more parameters. 00:41:47.490 --> 00:41:51.670 align:middle line:84% All these things that happen in the future are new parameters. 00:41:51.670 --> 00:41:57.670 align:middle line:84% I said notice that also this curve now is a lot steeper. 00:41:57.670 --> 00:41:58.437 align:middle line:90% Why is that? 00:41:58.437 --> 00:42:00.520 align:middle line:84% Well because if you change the interest rate today 00:42:00.520 --> 00:42:03.860 align:middle line:84% without changing the interest rate in the future, 00:42:03.860 --> 00:42:06.610 align:middle line:90% then that has a small effect. 00:42:06.610 --> 00:42:10.930 align:middle line:84% And so I said now this IS becomes very steep, 00:42:10.930 --> 00:42:13.360 align:middle line:84% but the equivalent to what we did in the static model 00:42:13.360 --> 00:42:16.690 align:middle line:84% is a situation where you cut the interest rate today-- say 00:42:16.690 --> 00:42:18.970 align:middle line:84% the central bank cuts the interest rate today, 00:42:18.970 --> 00:42:22.030 align:middle line:84% but it also convinces the public that it will also 00:42:22.030 --> 00:42:24.010 align:middle line:84% keep the interest rate low in the next period. 00:42:24.010 --> 00:42:27.220 align:middle line:84% That is not only you move along these [INAUDIBLE],, 00:42:27.220 --> 00:42:30.400 align:middle line:84% but you also persuade the public that the interest 00:42:30.400 --> 00:42:32.230 align:middle line:84% rate will be lower in the future, that 00:42:32.230 --> 00:42:34.570 align:middle line:90% will shift IS to the right. 00:42:34.570 --> 00:42:37.270 align:middle line:84% And then therefore you're going to get a much larger kick out 00:42:37.270 --> 00:42:38.440 align:middle line:90% of monetary policy. 00:42:38.440 --> 00:42:42.010 align:middle line:84% And monetary policy is a lot about forward guidance. 00:42:42.010 --> 00:42:45.040 align:middle line:84% It's that you cut interest rates today, but you're also telling, 00:42:45.040 --> 00:42:47.950 align:middle line:84% there is always a speech after they take the policy action 00:42:47.950 --> 00:42:51.160 align:middle line:84% which they talk about how they see interest rates going 00:42:51.160 --> 00:42:52.930 align:middle line:90% in the future and that. 00:42:52.930 --> 00:42:56.490 align:middle line:84% That's because you want to have maximum power. 00:42:56.490 --> 00:42:58.013 align:middle line:84% If you just tell the markets, I'm 00:42:58.013 --> 00:43:00.430 align:middle line:84% going to change the interest rate for now and then nothing 00:43:00.430 --> 00:43:03.100 align:middle line:84% else, that's going to have a very limited impact. 00:43:03.100 --> 00:43:06.070 align:middle line:84% To have a large impact out of monetary policy, 00:43:06.070 --> 00:43:08.110 align:middle line:84% you have to convince them that you will also 00:43:08.110 --> 00:43:11.820 align:middle line:84% affect the interest rate path in the future. 00:43:11.820 --> 00:43:13.620 align:middle line:90% Same sort of situation here. 00:43:13.620 --> 00:43:16.800 align:middle line:84% The other parameters is what happens if, for example, you 00:43:16.800 --> 00:43:20.550 align:middle line:90% expect future output to go up. 00:43:20.550 --> 00:43:22.320 align:middle line:84% That's going to shift IS to the right. 00:43:22.320 --> 00:43:24.990 align:middle line:84% That's yet another reason why convincing people that you're 00:43:24.990 --> 00:43:27.120 align:middle line:84% going to cut interest rates in the future 00:43:27.120 --> 00:43:28.745 align:middle line:84% as well, that you're going to keep them 00:43:28.745 --> 00:43:31.077 align:middle line:84% low in the future shift IS even more, 00:43:31.077 --> 00:43:32.910 align:middle line:84% because if you're going to keep the interest 00:43:32.910 --> 00:43:34.710 align:middle line:84% rate low in the future, that means probably 00:43:34.710 --> 00:43:36.600 align:middle line:84% that future output will be higher. 00:43:36.600 --> 00:43:38.220 align:middle line:84% And since future output is higher, 00:43:38.220 --> 00:43:40.320 align:middle line:84% that increases human wealth, and that means 00:43:40.320 --> 00:43:42.870 align:middle line:90% consumption will tend to go up. 00:43:42.870 --> 00:43:44.920 align:middle line:90% But do play with this. 00:43:44.920 --> 00:43:48.150 align:middle line:84% And again, it's important to have 00:43:48.150 --> 00:43:51.330 align:middle line:84% this distinction between the impact of temporary things, 00:43:51.330 --> 00:43:54.750 align:middle line:84% which is much smaller, and the impact 00:43:54.750 --> 00:43:56.430 align:middle line:84% of permanent things, which is bigger 00:43:56.430 --> 00:43:58.005 align:middle line:90% because it affects wealth. 00:43:58.005 --> 00:44:02.710 align:middle line:90% 00:44:02.710 --> 00:44:04.000 align:middle line:90% Oh, that's an example. 00:44:04.000 --> 00:44:07.810 align:middle line:84% So monetary policy, again, that's 00:44:07.810 --> 00:44:09.400 align:middle line:84% just if you don't persuade the public 00:44:09.400 --> 00:44:11.900 align:middle line:84% that you're going to change the interest rate in the future, 00:44:11.900 --> 00:44:15.520 align:middle line:84% then it just a movement along, but if you also convince them 00:44:15.520 --> 00:44:21.130 align:middle line:84% that you remain sort of loose monetary conditions next year, 00:44:21.130 --> 00:44:24.970 align:middle line:84% then that effectively shifts the IS to the right for a variety 00:44:24.970 --> 00:44:26.740 align:middle line:84% of reasons, for two reasons at least, 00:44:26.740 --> 00:44:30.800 align:middle line:84% and that's much more expansionary. 00:44:30.800 --> 00:44:32.950 align:middle line:84% The last thing we need is fiscal policy. 00:44:32.950 --> 00:44:36.140 align:middle line:84% I said fiscal policy today is contractionary. 00:44:36.140 --> 00:44:38.780 align:middle line:90% There is no doubt of that. 00:44:38.780 --> 00:44:40.820 align:middle line:84% But there are episodes, and I show you 00:44:40.820 --> 00:44:43.880 align:middle line:84% the Irish episode, in which actually may end up 00:44:43.880 --> 00:44:46.070 align:middle line:84% going the other way around, in which you 00:44:46.070 --> 00:44:48.290 align:middle line:84% cut expenditure today, which is contractionary, 00:44:48.290 --> 00:44:50.480 align:middle line:84% but you end up actually having an expansion. 00:44:50.480 --> 00:44:53.120 align:middle line:84% But for that, the only way that can happen 00:44:53.120 --> 00:44:55.610 align:middle line:84% is that if somehow you affect expectations 00:44:55.610 --> 00:44:57.180 align:middle line:90% in a very significant way. 00:44:57.180 --> 00:44:58.260 align:middle line:90% So that's what I said. 00:44:58.260 --> 00:45:03.140 align:middle line:84% If you ever get sort of a strange correlate response 00:45:03.140 --> 00:45:05.660 align:middle line:84% to a policy announcement, it's probably 00:45:05.660 --> 00:45:08.000 align:middle line:84% because there has been a big effect on expectations. 00:45:08.000 --> 00:45:10.250 align:middle line:84% So I showed you the case of Ireland 00:45:10.250 --> 00:45:12.290 align:middle line:84% because there's a case that was famous in which 00:45:12.290 --> 00:45:15.080 align:middle line:84% all the people talk about there was a fiscal deficit-- that it's 00:45:15.080 --> 00:45:17.660 align:middle line:84% a big drag in the economy, that it was going 00:45:17.660 --> 00:45:21.570 align:middle line:84% to be a big day of reckoning and that, and so on and so forth. 00:45:21.570 --> 00:45:24.230 align:middle line:84% So once they dealt with it, sort of expectations, 00:45:24.230 --> 00:45:26.480 align:middle line:84% they realized that they could cut interest rates then, 00:45:26.480 --> 00:45:31.470 align:middle line:84% they could realize that also that this malaise in the economy 00:45:31.470 --> 00:45:33.690 align:middle line:84% was going to go away, so people became optimistic 00:45:33.690 --> 00:45:37.620 align:middle line:84% about the future and so on, and they end up with an expansion. 00:45:37.620 --> 00:45:40.860 align:middle line:84% That shows you how important expectations are. 00:45:40.860 --> 00:45:45.870 align:middle line:84% So economic policy in general, the direct immediate effect 00:45:45.870 --> 00:45:48.460 align:middle line:84% is what we have been discussing throughout the course, 00:45:48.460 --> 00:45:53.400 align:middle line:84% but a lot of its power and even the sort of perverse or good 00:45:53.400 --> 00:45:55.080 align:middle line:84% synergies that you get out of them 00:45:55.080 --> 00:45:57.840 align:middle line:84% has to do with what you do with expectations. 00:45:57.840 --> 00:45:59.930 align:middle line:90% OK, good. 00:45:59.930 --> 00:46:12.000 align:middle line:90%