WEBVTT 00:00:00.000 --> 00:00:01.980 align:middle line:90% [SQUEAKING] 00:00:01.980 --> 00:00:03.465 align:middle line:90% [RUSTLING] 00:00:03.465 --> 00:00:07.425 align:middle line:90% [CLICKING] 00:00:07.425 --> 00:00:16.360 align:middle line:90% 00:00:16.360 --> 00:00:20.020 align:middle line:84% RICHARDO CABALLERO: And so we started with something 00:00:20.020 --> 00:00:22.390 align:middle line:84% a little boring, basic definitions. 00:00:22.390 --> 00:00:24.340 align:middle line:84% And the first thing we had to do is 00:00:24.340 --> 00:00:27.220 align:middle line:84% to understand how do we measure output at the aggregate level. 00:00:27.220 --> 00:00:28.660 align:middle line:84% It's very easy to understand what 00:00:28.660 --> 00:00:31.000 align:middle line:84% output is at the level of an individual factory, 00:00:31.000 --> 00:00:33.740 align:middle line:84% but at the aggregate level, it's a little tricky. 00:00:33.740 --> 00:00:38.110 align:middle line:84% And so we had an example of a very simple economy 00:00:38.110 --> 00:00:41.320 align:middle line:84% with two companies, one that produces steel 00:00:41.320 --> 00:00:43.750 align:middle line:84% and the other one that produces cars. 00:00:43.750 --> 00:00:46.780 align:middle line:84% And in this particular example, the steel company 00:00:46.780 --> 00:00:48.910 align:middle line:84% doesn't sell anything to the final consumers, 00:00:48.910 --> 00:00:52.240 align:middle line:84% it sells all its production to the car company. 00:00:52.240 --> 00:00:56.140 align:middle line:84% And we ask the question, what is the GDP of this economy? 00:00:56.140 --> 00:00:59.690 align:middle line:84% The simplest answer would have been, well, 300. 00:00:59.690 --> 00:01:03.070 align:middle line:84% I summed the output of the two companies 00:01:03.070 --> 00:01:05.050 align:middle line:90% and that could be one answer. 00:01:05.050 --> 00:01:08.220 align:middle line:84% But then I show you the three different methods 00:01:08.220 --> 00:01:10.270 align:middle line:90% that that's the wrong answer. 00:01:10.270 --> 00:01:15.060 align:middle line:90% And method 1 was-- 00:01:15.060 --> 00:01:21.790 align:middle line:84% a definition is GDP is the value of final goods only. 00:01:21.790 --> 00:01:24.790 align:middle line:84% And final goods in this simple example 00:01:24.790 --> 00:01:27.400 align:middle line:84% is, well, this company is not producing anything 00:01:27.400 --> 00:01:31.660 align:middle line:84% as a final good because all its sales are going to-- as an input 00:01:31.660 --> 00:01:34.010 align:middle line:84% into other companies' production. 00:01:34.010 --> 00:01:36.100 align:middle line:84% And so this one doesn't count at all 00:01:36.100 --> 00:01:38.290 align:middle line:84% in our simple example, this one counts, 00:01:38.290 --> 00:01:40.840 align:middle line:90% and then the answer is $200. 00:01:40.840 --> 00:01:43.300 align:middle line:90% Not 300, but $200. 00:01:43.300 --> 00:01:48.430 align:middle line:84% Method 2 was to count only the value added in each company. 00:01:48.430 --> 00:01:49.840 align:middle line:84% And value added is the difference 00:01:49.840 --> 00:01:52.840 align:middle line:90% between the final output-- 00:01:52.840 --> 00:01:57.100 align:middle line:84% that is, the revenue from sales, minus whatever that company 00:01:57.100 --> 00:01:59.230 align:middle line:90% spends on intermediate inputs. 00:01:59.230 --> 00:02:01.630 align:middle line:84% In this simple example, this company-- 00:02:01.630 --> 00:02:03.550 align:middle line:84% the steel company is not spending anything 00:02:03.550 --> 00:02:04.690 align:middle line:90% on intermediate inputs-- 00:02:04.690 --> 00:02:06.880 align:middle line:84% it's a strange production of steel, but anyways, 00:02:06.880 --> 00:02:08.780 align:middle line:90% it is quite a decent example. 00:02:08.780 --> 00:02:13.360 align:middle line:84% And so this $100 is value-added, completely value-added. 00:02:13.360 --> 00:02:16.180 align:middle line:84% There is no expenses on intermediate inputs. 00:02:16.180 --> 00:02:20.300 align:middle line:84% For the car company, however, the revenue from sales is 200, 00:02:20.300 --> 00:02:23.240 align:middle line:84% but the company spends 100 on intermediate inputs. 00:02:23.240 --> 00:02:25.190 align:middle line:84% Therefore, the value added of this company 00:02:25.190 --> 00:02:27.980 align:middle line:84% is 200 negative 100, so you get 100 value added 00:02:27.980 --> 00:02:30.650 align:middle line:84% from this one, 100 of value added from that one, 00:02:30.650 --> 00:02:32.780 align:middle line:90% total value added, 200. 00:02:32.780 --> 00:02:33.800 align:middle line:90% So same answer. 00:02:33.800 --> 00:02:35.280 align:middle line:90% And the third method-- 00:02:35.280 --> 00:02:37.580 align:middle line:84% these are-- the two methods that I just described 00:02:37.580 --> 00:02:38.990 align:middle line:90% are production methods. 00:02:38.990 --> 00:02:40.730 align:middle line:84% You're measuring the production side. 00:02:40.730 --> 00:02:44.840 align:middle line:84% The alternative is to look at the income side. 00:02:44.840 --> 00:02:48.560 align:middle line:84% And the income side says just-- let's sum all the incomes 00:02:48.560 --> 00:02:49.400 align:middle line:90% in the economy. 00:02:49.400 --> 00:02:52.460 align:middle line:84% And the incomes are income to workers, wages, and income 00:02:52.460 --> 00:02:55.920 align:middle line:84% to the owners of capital, profits. 00:02:55.920 --> 00:03:00.870 align:middle line:84% Income to workers is $80 plus 70, is 150. 00:03:00.870 --> 00:03:04.620 align:middle line:84% Income to owners of capital is 20 plus 30, that's 50. 00:03:04.620 --> 00:03:07.230 align:middle line:90% So 150 plus 50 is, again, 200. 00:03:07.230 --> 00:03:12.510 align:middle line:84% So these are three equivalent ways of measuring output. 00:03:12.510 --> 00:03:21.270 align:middle line:84% And I said-- one of the features I show you of this method 00:03:21.270 --> 00:03:25.790 align:middle line:84% is that they are immune to organizational structure 00:03:25.790 --> 00:03:26.650 align:middle line:90% within the economy. 00:03:26.650 --> 00:03:29.670 align:middle line:84% So for example, if these two companies were to merge, 00:03:29.670 --> 00:03:32.560 align:middle line:84% clearly the sum of incomes would not change. 00:03:32.560 --> 00:03:34.500 align:middle line:90% It would still be 100-- 00:03:34.500 --> 00:03:37.320 align:middle line:90% it would be 200. 00:03:37.320 --> 00:03:40.500 align:middle line:84% This one would not change because if they were to merge, 00:03:40.500 --> 00:03:44.040 align:middle line:84% then the whole production of the revenues from sales of the car 00:03:44.040 --> 00:03:46.377 align:middle line:90% company would be value-added. 00:03:46.377 --> 00:03:47.960 align:middle line:84% Everything would be produced in-house, 00:03:47.960 --> 00:03:49.880 align:middle line:84% and still, the answer would be 200, 00:03:49.880 --> 00:03:51.950 align:middle line:84% then, because this company would disappear, 00:03:51.950 --> 00:03:56.060 align:middle line:84% it would emerge inside here, and you would get still get 200. 00:03:56.060 --> 00:04:00.680 align:middle line:84% And the same happened with method 1 because still, 00:04:00.680 --> 00:04:04.240 align:middle line:84% the sales of final goods is only 200. 00:04:04.240 --> 00:04:07.120 align:middle line:84% The naive approach of just summing output 00:04:07.120 --> 00:04:10.570 align:middle line:84% would be terrible because once you merge it, 00:04:10.570 --> 00:04:13.360 align:middle line:84% output would collapse from 300 to 200. 00:04:13.360 --> 00:04:16.570 align:middle line:84% That tells you that's not the right way of doing things. 00:04:16.570 --> 00:04:21.640 align:middle line:84% So while the three methods we propose do work, 00:04:21.640 --> 00:04:23.710 align:middle line:84% are immune to this organization-- changes 00:04:23.710 --> 00:04:25.090 align:middle line:90% in the organization structure. 00:04:25.090 --> 00:04:30.040 align:middle line:84% The next step was to highlight that when we say output, 00:04:30.040 --> 00:04:32.720 align:middle line:90% we're really after real output. 00:04:32.720 --> 00:04:34.780 align:middle line:84% And there is a distinction between nominal output 00:04:34.780 --> 00:04:35.890 align:middle line:90% and real output. 00:04:35.890 --> 00:04:39.190 align:middle line:84% Nominal output is simply the quantity 00:04:39.190 --> 00:04:42.160 align:middle line:84% of final goods measured at current prices, 00:04:42.160 --> 00:04:47.770 align:middle line:84% while real output is measured at some fixed set of prices of one 00:04:47.770 --> 00:04:48.730 align:middle line:90% fixed year. 00:04:48.730 --> 00:04:51.620 align:middle line:84% And I think I gave you an example. 00:04:51.620 --> 00:04:54.190 align:middle line:84% This is an example I gave you, and then in the P-sets, 00:04:54.190 --> 00:04:56.860 align:middle line:84% you had more complicated examples with multiple goods. 00:04:56.860 --> 00:05:00.970 align:middle line:84% Here, you have an economy that produces only one good, cars, 00:05:00.970 --> 00:05:05.450 align:middle line:84% and that produces 10 cars here, 12 cars, 13 cars here. 00:05:05.450 --> 00:05:09.020 align:middle line:84% The price of the cars is rising, so the nominal GDP 00:05:09.020 --> 00:05:12.330 align:middle line:84% is rising a lot while the real GDP is rising less. 00:05:12.330 --> 00:05:14.150 align:middle line:90% How do we measure real GDP here? 00:05:14.150 --> 00:05:17.950 align:middle line:84% We use-- in this particular example, we use the prices here, 00:05:17.950 --> 00:05:18.450 align:middle line:90% 12-- 00:05:18.450 --> 00:05:24.650 align:middle line:84% 10 times the price of the car in 2012 is 24,000, that's 240. 00:05:24.650 --> 00:05:27.470 align:middle line:84% Obviously for the base year, nominal GDP 00:05:27.470 --> 00:05:29.210 align:middle line:90% is the same as real GDP. 00:05:29.210 --> 00:05:31.550 align:middle line:90% And then for 2013 is 13-- 00:05:31.550 --> 00:05:35.180 align:middle line:84% not times 26,000, but times 24,000 and we get that. 00:05:35.180 --> 00:05:40.130 align:middle line:84% Now in this particular example of only one good, 00:05:40.130 --> 00:05:42.530 align:middle line:84% you can pick any base year and you'll 00:05:42.530 --> 00:05:45.440 align:middle line:84% get exactly the same rate of growth of real output. 00:05:45.440 --> 00:05:47.360 align:middle line:84% If you have multiple goods, that's not true 00:05:47.360 --> 00:05:50.540 align:middle line:84% because the relative prices of goods are moving over time, 00:05:50.540 --> 00:05:53.070 align:middle line:90% but that's the basic idea. 00:05:53.070 --> 00:05:56.988 align:middle line:84% So-- I mean, again, you should know these things-- 00:05:56.988 --> 00:05:59.280 align:middle line:84% I'm not going to be tremendously important in the quiz, 00:05:59.280 --> 00:06:00.755 align:middle line:84% but they will show up in your quiz. 00:06:00.755 --> 00:06:05.400 align:middle line:90% 00:06:05.400 --> 00:06:07.810 align:middle line:84% Then we went through some definitions. 00:06:07.810 --> 00:06:10.980 align:middle line:84% The unemployment rate being the number 00:06:10.980 --> 00:06:13.830 align:middle line:84% of unemployed over the labor force, not population, 00:06:13.830 --> 00:06:16.260 align:middle line:90% that's important. 00:06:16.260 --> 00:06:19.815 align:middle line:84% We talked about the inflation rate as well. 00:06:19.815 --> 00:06:21.703 align:middle line:84% And that's the rate of change of prices, 00:06:21.703 --> 00:06:23.620 align:middle line:84% and there are different prices in the economy. 00:06:23.620 --> 00:06:25.370 align:middle line:84% One of them is the deflator, the other one 00:06:25.370 --> 00:06:27.570 align:middle line:90% is CPI, and so on and so forth. 00:06:27.570 --> 00:06:28.260 align:middle line:90% That's it. 00:06:28.260 --> 00:06:32.513 align:middle line:84% So that was the first lecture relevant for the quiz. 00:06:32.513 --> 00:06:33.555 align:middle line:90% Any questions about that? 00:06:33.555 --> 00:06:36.080 align:middle line:90% 00:06:36.080 --> 00:06:36.590 align:middle line:90% Good. 00:06:36.590 --> 00:06:37.090 align:middle line:90% Keep moving. 00:06:37.090 --> 00:06:40.200 align:middle line:90% 00:06:40.200 --> 00:06:41.550 align:middle line:90% OK, then we move to-- 00:06:41.550 --> 00:06:43.380 align:middle line:84% then we began to really get serious 00:06:43.380 --> 00:06:48.755 align:middle line:84% because we began to construct a foundation for the IS-LM model. 00:06:48.755 --> 00:06:51.255 align:middle line:84% And the first thing we did is we looked at the goods market. 00:06:51.255 --> 00:06:56.680 align:middle line:90% 00:06:56.680 --> 00:06:57.180 align:middle line:90% No. 00:06:57.180 --> 00:06:59.580 align:middle line:84% And what we did here is we said-- 00:06:59.580 --> 00:07:03.270 align:middle line:84% we describe the different components of aggregate demand, 00:07:03.270 --> 00:07:06.793 align:middle line:84% and we said, in this economy-- for now, at least, 00:07:06.793 --> 00:07:08.460 align:middle line:84% we're going to make this economy closed, 00:07:08.460 --> 00:07:11.460 align:middle line:84% so we remove exports and imports, and for your quiz, 00:07:11.460 --> 00:07:13.290 align:middle line:84% absolutely you're not going to see anything 00:07:13.290 --> 00:07:15.420 align:middle line:90% about exports or imports. 00:07:15.420 --> 00:07:18.150 align:middle line:84% So this is your aggregate demand. 00:07:18.150 --> 00:07:20.710 align:middle line:84% We wanted to build a little more, 00:07:20.710 --> 00:07:23.250 align:middle line:84% so we had to have some behavioral assumptions. 00:07:23.250 --> 00:07:25.150 align:middle line:84% We made it initially very simple. 00:07:25.150 --> 00:07:28.640 align:middle line:84% We assume this was exogenous, that government expenditure was 00:07:28.640 --> 00:07:29.420 align:middle line:90% exogenous. 00:07:29.420 --> 00:07:32.690 align:middle line:90% Taxes were also exogenous. 00:07:32.690 --> 00:07:34.970 align:middle line:84% And the only behavioral equation we had 00:07:34.970 --> 00:07:36.650 align:middle line:84% was this consumption function, and we 00:07:36.650 --> 00:07:40.220 align:middle line:84% said consumption is increasing disposable income. 00:07:40.220 --> 00:07:43.670 align:middle line:84% So we assume something linear like this. 00:07:43.670 --> 00:07:46.980 align:middle line:84% Disposable income is just income minus taxes. 00:07:46.980 --> 00:07:51.290 align:middle line:84% And remember, income-- remember from the alternative ways 00:07:51.290 --> 00:07:54.810 align:middle line:84% of measuring GDP, income is the same as output. 00:07:54.810 --> 00:07:57.157 align:middle line:84% So when I say income, because that's what 00:07:57.157 --> 00:07:59.240 align:middle line:84% is relevant for the consumption-- consumers world, 00:07:59.240 --> 00:08:01.710 align:middle line:90% but it's the same as output. 00:08:01.710 --> 00:08:04.220 align:middle line:84% So that was our consumption function. 00:08:04.220 --> 00:08:06.242 align:middle line:84% it had an upward-sloping-- it was 00:08:06.242 --> 00:08:08.450 align:middle line:84% upward-sloping because there is a marginal propensity 00:08:08.450 --> 00:08:11.030 align:middle line:90% to consume, c1. 00:08:11.030 --> 00:08:15.840 align:middle line:84% And then a key assumption of this part of the course 00:08:15.840 --> 00:08:19.620 align:middle line:84% is that output is aggregate demand-determined. 00:08:19.620 --> 00:08:23.400 align:middle line:84% Prices were completely fixed, and we said, well, 00:08:23.400 --> 00:08:27.480 align:middle line:84% but output is whatever demand wants, that's what output is. 00:08:27.480 --> 00:08:31.620 align:middle line:84% So this is an equilibrium condition. 00:08:31.620 --> 00:08:34.080 align:middle line:84% This is the aggregate demand, this is an equilibrium 00:08:34.080 --> 00:08:36.360 align:middle line:84% condition, so we can solve out because I 00:08:36.360 --> 00:08:39.600 align:middle line:84% can say in equilibrium, z is equal to y, 00:08:39.600 --> 00:08:42.809 align:middle line:84% and I can solve for equilibrium output from that equation. 00:08:42.809 --> 00:08:44.820 align:middle line:84% And that's exactly what we did in this slide, 00:08:44.820 --> 00:08:47.870 align:middle line:84% and you got to an expression like this. 00:08:47.870 --> 00:08:50.750 align:middle line:84% Knowing how to do that is very important for you. 00:08:50.750 --> 00:08:54.500 align:middle line:84% So you better be sure that how to find equilibrium output 00:08:54.500 --> 00:08:57.595 align:middle line:90% in this model. 00:08:57.595 --> 00:08:59.720 align:middle line:84% I mean, it's going to be very difficult to do IS-LM 00:08:59.720 --> 00:09:04.160 align:middle line:84% if you don't know these steps, so you better know this stuff. 00:09:04.160 --> 00:09:07.340 align:middle line:84% And remember something-- we call this guy 00:09:07.340 --> 00:09:09.680 align:middle line:84% here in the simple economy the multiplier. 00:09:09.680 --> 00:09:11.000 align:middle line:90% Why the multiplier? 00:09:11.000 --> 00:09:13.010 align:middle line:84% Well, because given certain something 00:09:13.010 --> 00:09:19.700 align:middle line:84% we call exogenous expenditure, the 1 minus c1 multiplies that. 00:09:19.700 --> 00:09:22.565 align:middle line:84% If the marginal propensity to consume is very high-- 00:09:22.565 --> 00:09:26.420 align:middle line:84% say it's close to 1, then the multiplier is very, very high. 00:09:26.420 --> 00:09:29.750 align:middle line:84% If the marginal propensity to consume, say, is 0.5, then 00:09:29.750 --> 00:09:31.010 align:middle line:90% how much is the multiplier? 00:09:31.010 --> 00:09:34.550 align:middle line:90% 00:09:34.550 --> 00:09:35.270 align:middle line:90% 2. 00:09:35.270 --> 00:09:36.170 align:middle line:90% OK, good. 00:09:36.170 --> 00:09:38.780 align:middle line:90% So the multiplier is 2. 00:09:38.780 --> 00:09:39.860 align:middle line:90% Good. 00:09:39.860 --> 00:09:42.020 align:middle line:90% And that was our equilibrium. 00:09:42.020 --> 00:09:43.370 align:middle line:90% We had the aggregate demand. 00:09:43.370 --> 00:09:46.250 align:middle line:84% The slope was less than the 45-degree line because c1 is 00:09:46.250 --> 00:09:49.620 align:middle line:84% a number less than 1, and so you have some equilibrium output 00:09:49.620 --> 00:09:50.120 align:middle line:90% there. 00:09:50.120 --> 00:09:51.370 align:middle line:90% That's the equilibrium output. 00:09:51.370 --> 00:09:54.530 align:middle line:84% At this point, aggregate demand is equal to-- 00:09:54.530 --> 00:09:57.440 align:middle line:84% well, aggregate demand is equal to aggregate supply, that's 00:09:57.440 --> 00:10:00.380 align:middle line:84% always true, but that's consistent also 00:10:00.380 --> 00:10:02.030 align:middle line:90% with aggregate demand-- 00:10:02.030 --> 00:10:04.730 align:middle line:84% with the function of aggregate demand. 00:10:04.730 --> 00:10:08.570 align:middle line:84% And important for this equilibrium output 00:10:08.570 --> 00:10:11.390 align:middle line:84% is that the equilibrium output is a function of a lot of things 00:10:11.390 --> 00:10:14.600 align:middle line:84% that we took as parameters in this aggregate demand curve. 00:10:14.600 --> 00:10:17.673 align:middle line:84% What did we take as parameters in the aggregate demand curve? 00:10:17.673 --> 00:10:18.590 align:middle line:90% Just give me examples. 00:10:18.590 --> 00:10:23.380 align:middle line:90% 00:10:23.380 --> 00:10:28.450 align:middle line:84% Well, investment, government expenditure, and taxes 00:10:28.450 --> 00:10:29.440 align:middle line:90% at the very least. 00:10:29.440 --> 00:10:33.190 align:middle line:84% Also, parameters like autonomous consumption, that c0 we're 00:10:33.190 --> 00:10:34.030 align:middle line:90% taking as given. 00:10:34.030 --> 00:10:37.080 align:middle line:84% Anything-- if any of those things move, 00:10:37.080 --> 00:10:42.110 align:middle line:84% the position of the aggregate demand curve will shift around. 00:10:42.110 --> 00:10:43.670 align:middle line:90% And that was one example. 00:10:43.670 --> 00:10:46.430 align:middle line:84% Suppose autonomous consumption c0 goes up. 00:10:46.430 --> 00:10:49.730 align:middle line:84% So suddenly consumers decide to spend more. 00:10:49.730 --> 00:10:54.080 align:middle line:84% Well, then what we have is that aggregate demand shift up 00:10:54.080 --> 00:10:56.390 align:middle line:84% and equilibrium output ends up changing 00:10:56.390 --> 00:10:59.000 align:middle line:84% by more than the initial change in c0. 00:10:59.000 --> 00:11:00.590 align:middle line:90% Why is that? 00:11:00.590 --> 00:11:07.400 align:middle line:84% So this is the change in c0, but the change in output-- 00:11:07.400 --> 00:11:09.930 align:middle line:84% and so the initial change c0 leads 00:11:09.930 --> 00:11:13.270 align:middle line:84% to an initial change in output, which is equal to c0. 00:11:13.270 --> 00:11:14.500 align:middle line:90% That's up to here. 00:11:14.500 --> 00:11:17.860 align:middle line:84% But then we end up with a final equilibrium output is higher 00:11:17.860 --> 00:11:19.810 align:middle line:90% than the initial response. 00:11:19.810 --> 00:11:22.570 align:middle line:84% All this happens infinitely fast in this model. 00:11:22.570 --> 00:11:27.330 align:middle line:84% Why is this change greater than c0? 00:11:27.330 --> 00:11:28.890 align:middle line:90% There is a multiplier in front. 00:11:28.890 --> 00:11:29.790 align:middle line:90% Exactly. 00:11:29.790 --> 00:11:33.810 align:middle line:84% We change c0 by 1, but then you have to multiply it by 1 over 1 00:11:33.810 --> 00:11:34.470 align:middle line:90% minus c1. 00:11:34.470 --> 00:11:37.710 align:middle line:84% And that's what we illustrated in this picture there. 00:11:37.710 --> 00:11:39.330 align:middle line:90% OK, good. 00:11:39.330 --> 00:11:41.860 align:middle line:84% And so you should move everything-- 00:11:41.860 --> 00:11:43.200 align:middle line:90% you can move here around. 00:11:43.200 --> 00:11:48.420 align:middle line:84% Move G up, D up, and stuff like that and see what happens. 00:11:48.420 --> 00:11:51.150 align:middle line:90% 00:11:51.150 --> 00:11:52.670 align:middle line:84% The last thing I did in this section 00:11:52.670 --> 00:11:56.600 align:middle line:84% is I showed you an alternative way-- entirely equivalent way 00:11:56.600 --> 00:11:59.510 align:middle line:84% of illustrating equilibrium, which 00:11:59.510 --> 00:12:03.110 align:middle line:90% was saving equal to investment. 00:12:03.110 --> 00:12:07.730 align:middle line:84% Remember, I derived this, and I go to an expression like that. 00:12:07.730 --> 00:12:09.560 align:middle line:84% That's exactly the same as aggregate demand 00:12:09.560 --> 00:12:11.630 align:middle line:90% equal to aggregate supply. 00:12:11.630 --> 00:12:15.080 align:middle line:84% An investment, which, in this particular basic model, 00:12:15.080 --> 00:12:18.400 align:middle line:84% is fixed, is equal to saving by the government, which is also, 00:12:18.400 --> 00:12:20.150 align:middle line:84% in this basic model, is fixed because it's 00:12:20.150 --> 00:12:23.280 align:middle line:90% G minus T, which is fixed. 00:12:23.280 --> 00:12:26.330 align:middle line:84% Sorry, it's T minus G, which is fixed. 00:12:26.330 --> 00:12:28.190 align:middle line:90% And then private saving. 00:12:28.190 --> 00:12:32.700 align:middle line:84% And then I show you an interesting result, 00:12:32.700 --> 00:12:34.740 align:middle line:84% which is called-- known the paradox of savings, 00:12:34.740 --> 00:12:36.050 align:middle line:90% which says the following. 00:12:36.050 --> 00:12:39.770 align:middle line:84% If, for whatever reason, consumers decide to save more, 00:12:39.770 --> 00:12:43.640 align:middle line:84% say, for example, because c0 now comes down. 00:12:43.640 --> 00:12:46.040 align:middle line:90% So now they have certain income. 00:12:46.040 --> 00:12:49.100 align:middle line:84% Out of that same income, they want to save more. 00:12:49.100 --> 00:12:51.390 align:middle line:84% Then from this very simple equation, 00:12:51.390 --> 00:12:53.330 align:middle line:84% I know that-- what happens to output? 00:12:53.330 --> 00:13:02.310 align:middle line:90% 00:13:02.310 --> 00:13:03.466 align:middle line:90% Why? 00:13:03.466 --> 00:13:06.410 align:middle line:84% AUDIENCE: Because savings go up, consumer demand goes down. 00:13:06.410 --> 00:13:09.410 align:middle line:84% And then also, investments will also go down. 00:13:09.410 --> 00:13:09.910 align:middle line:90% And then-- 00:13:09.910 --> 00:13:10.868 align:middle line:90% RICHARDO CABALLERO: No. 00:13:10.868 --> 00:13:13.040 align:middle line:84% Investment doesn't go down here because it's fixed. 00:13:13.040 --> 00:13:16.300 align:middle line:84% In this basic example, not IS-LM. 00:13:16.300 --> 00:13:17.680 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:13:17.680 --> 00:13:19.870 align:middle line:84% RICHARDO CABALLERO: Yes, but that's 00:13:19.870 --> 00:13:22.120 align:middle line:84% an explanation, which is the right explanation, 00:13:22.120 --> 00:13:29.440 align:middle line:84% but the explanation in the outer space, output and the income. 00:13:29.440 --> 00:13:32.450 align:middle line:84% I wanted in the space of saving and investment. 00:13:32.450 --> 00:13:34.220 align:middle line:84% So let me give it to you very quickly. 00:13:34.220 --> 00:13:36.932 align:middle line:84% But your answer is correct, but it's not 00:13:36.932 --> 00:13:38.890 align:middle line:84% what I wanted here because what I wanted to say 00:13:38.890 --> 00:13:39.770 align:middle line:90% is the following. 00:13:39.770 --> 00:13:42.880 align:middle line:84% If, for whatever reason, for any given level of income, 00:13:42.880 --> 00:13:45.700 align:middle line:84% savings go up, then we have an imbalance. 00:13:45.700 --> 00:13:48.280 align:middle line:84% Total saving is greater than investment. 00:13:48.280 --> 00:13:50.680 align:middle line:84% The only variable that can adjust here-- 00:13:50.680 --> 00:13:53.470 align:middle line:84% so we restore equilibrium, investment equal to savings, 00:13:53.470 --> 00:13:56.590 align:middle line:84% is for the output to come down because if output comes down, 00:13:56.590 --> 00:14:00.100 align:middle line:84% savings come down, and that's the way you restore equilibrium. 00:14:00.100 --> 00:14:01.930 align:middle line:84% I told you, this way of looking at things 00:14:01.930 --> 00:14:04.150 align:middle line:84% is entirely equivalent as we have already done. 00:14:04.150 --> 00:14:06.500 align:middle line:84% So I can also do what you wanted to do, 00:14:06.500 --> 00:14:10.120 align:middle line:84% which is represent that in the space of output and-- 00:14:10.120 --> 00:14:13.510 align:middle line:84% aggregate demand and aggregate-- and output or income. 00:14:13.510 --> 00:14:17.680 align:middle line:90% And an increase in c0-- 00:14:17.680 --> 00:14:21.970 align:middle line:84% a reduction in c0 would lead to a decline in aggregate demand 00:14:21.970 --> 00:14:24.440 align:middle line:84% and then through the multiplier larger increase in output. 00:14:24.440 --> 00:14:25.982 align:middle line:84% So this is the way we characterize it 00:14:25.982 --> 00:14:29.890 align:middle line:84% before, this is a slightly different way of characterizing 00:14:29.890 --> 00:14:33.032 align:middle line:84% which is what gives rise to what is called the paradox of savings 00:14:33.032 --> 00:14:34.740 align:middle line:84% because suddenly you decide to save more, 00:14:34.740 --> 00:14:36.100 align:middle line:90% supposedly that should be good. 00:14:36.100 --> 00:14:37.990 align:middle line:84% Well, in the short-run it's not really good, 00:14:37.990 --> 00:14:40.420 align:middle line:90% it causes a recession. 00:14:40.420 --> 00:14:42.100 align:middle line:90% Anyways. 00:14:42.100 --> 00:14:44.150 align:middle line:84% It's cute, but it may show up in your future, 00:14:44.150 --> 00:14:45.850 align:middle line:90% so I wanted to remind you. 00:14:45.850 --> 00:15:01.580 align:middle line:90% 00:15:01.580 --> 00:15:03.700 align:middle line:84% So that was the goods market side. 00:15:03.700 --> 00:15:05.800 align:middle line:90% Oops. 00:15:05.800 --> 00:15:07.630 align:middle line:84% Then we look at financial markets 00:15:07.630 --> 00:15:09.850 align:middle line:84% and we trivialize financial markets, really. 00:15:09.850 --> 00:15:12.520 align:middle line:84% We said let's assume the financial markets are very, very 00:15:12.520 --> 00:15:13.270 align:middle line:90% simple. 00:15:13.270 --> 00:15:14.960 align:middle line:90% Money and bonds. 00:15:14.960 --> 00:15:15.970 align:middle line:90% That's it. 00:15:15.970 --> 00:15:16.690 align:middle line:90% Nothing else. 00:15:16.690 --> 00:15:20.820 align:middle line:90% 00:15:20.820 --> 00:15:23.520 align:middle line:90% And the first behavior-- 00:15:23.520 --> 00:15:25.800 align:middle line:84% the only behavioral equation we really had here 00:15:25.800 --> 00:15:27.450 align:middle line:84% was money demand, and we said, well, 00:15:27.450 --> 00:15:29.680 align:middle line:84% money demand is increasing in nominal GDP 00:15:29.680 --> 00:15:31.620 align:middle line:84% because if nominal GDP is larger, 00:15:31.620 --> 00:15:33.300 align:middle line:84% then you need to do more transactions, 00:15:33.300 --> 00:15:36.480 align:middle line:90% you need more money, more cash. 00:15:36.480 --> 00:15:40.350 align:middle line:84% Cash of deposit, but here, we're looking only at cash. 00:15:40.350 --> 00:15:42.273 align:middle line:84% But it's decreasing in the interest rate. 00:15:42.273 --> 00:15:44.190 align:middle line:84% Money-- the money is decreasing in-- why is it 00:15:44.190 --> 00:15:45.360 align:middle line:90% decreasing in interest rate? 00:15:45.360 --> 00:15:49.123 align:middle line:84% Interest rate is the return on the bonds. 00:15:49.123 --> 00:15:51.290 align:middle line:84% Why is money demand decreasing in the interest rate? 00:15:51.290 --> 00:15:55.850 align:middle line:90% 00:15:55.850 --> 00:15:56.480 align:middle line:90% Yes. 00:15:56.480 --> 00:15:59.420 align:middle line:84% The opportunity cost of holding cash in your pocket is higher. 00:15:59.420 --> 00:16:05.270 align:middle line:84% You didn't care about this stuff a year ago. 00:16:05.270 --> 00:16:09.170 align:middle line:84% But now, it costs you 5% to hold cash. 00:16:09.170 --> 00:16:14.840 align:middle line:84% That's what you get in 1-year certificate bond. 00:16:14.840 --> 00:16:16.860 align:middle line:90% US Treasury bond at this moment. 00:16:16.860 --> 00:16:18.470 align:middle line:90% So it's more significant. 00:16:18.470 --> 00:16:21.020 align:middle line:84% Maybe it's not that relevant for you, but corporation, 00:16:21.020 --> 00:16:22.893 align:middle line:84% makes a big difference, I guarantee you. 00:16:22.893 --> 00:16:24.810 align:middle line:84% I'm keeping the thing in the checking account, 00:16:24.810 --> 00:16:27.590 align:middle line:84% now they're really buying short-term Treasuries and stuff 00:16:27.590 --> 00:16:30.030 align:middle line:90% like that. 00:16:30.030 --> 00:16:30.660 align:middle line:90% Good. 00:16:30.660 --> 00:16:35.060 align:middle line:84% So that's the reason this is downward-sloping. 00:16:35.060 --> 00:16:39.710 align:middle line:90% And that's the concept here. 00:16:39.710 --> 00:16:43.910 align:middle line:84% So then what the central bank controls is money. 00:16:43.910 --> 00:16:47.750 align:middle line:84% How much money it injects in the economy, that is how much-- 00:16:47.750 --> 00:16:48.640 align:middle line:90% OK. 00:16:48.640 --> 00:16:52.960 align:middle line:84% How much money it injects into the economy, how does-- 00:16:52.960 --> 00:16:54.590 align:middle line:90% let me say just that for now. 00:16:54.590 --> 00:16:56.780 align:middle line:90% And so that's the money supply. 00:16:56.780 --> 00:16:59.980 align:middle line:84% So the equilibrium interest rate is simply 00:16:59.980 --> 00:17:03.640 align:middle line:84% the point in which money demand is equal to the money exogenous 00:17:03.640 --> 00:17:04.599 align:middle line:90% money supply. 00:17:04.599 --> 00:17:08.630 align:middle line:84% And I said in the modern world, the central banks don't tell you 00:17:08.630 --> 00:17:11.170 align:middle line:84% M S. They tell you this is the interest rate we want, 00:17:11.170 --> 00:17:14.560 align:middle line:84% and then they provide whatever M they need in order 00:17:14.560 --> 00:17:19.810 align:middle line:84% to get the interest rate they have told you they want to have. 00:17:19.810 --> 00:17:22.900 align:middle line:84% So that's the case of an expansionary monetary policy. 00:17:22.900 --> 00:17:25.569 align:middle line:84% Suppose the Fed wants to lower the interest rate from here 00:17:25.569 --> 00:17:26.390 align:middle line:90% to here. 00:17:26.390 --> 00:17:29.950 align:middle line:84% Well, what it needs to do is increase money. 00:17:29.950 --> 00:17:34.210 align:middle line:84% And increase money means it goes out there, an open market 00:17:34.210 --> 00:17:39.830 align:middle line:84% operation, and buys bonds from the private sector. 00:17:39.830 --> 00:17:44.230 align:middle line:84% Buys bonds, takes bonds in, and gives them cash. 00:17:44.230 --> 00:17:45.730 align:middle line:90% Money. 00:17:45.730 --> 00:17:47.692 align:middle line:84% That's an expansionary monetary policy, 00:17:47.692 --> 00:17:49.150 align:middle line:84% and an expansionary monetary policy 00:17:49.150 --> 00:17:50.950 align:middle line:90% will lower the interest rate. 00:17:50.950 --> 00:17:54.250 align:middle line:90% 00:17:54.250 --> 00:17:55.730 align:middle line:90% That's an open market operation. 00:17:55.730 --> 00:17:58.570 align:middle line:84% So that's what we just saw, was exactly that. 00:17:58.570 --> 00:18:00.640 align:middle line:84% The Fed wants to lower the interest rate. 00:18:00.640 --> 00:18:02.560 align:middle line:84% What it does is it goes out there, 00:18:02.560 --> 00:18:04.550 align:middle line:84% it buys bonds from the private sector 00:18:04.550 --> 00:18:07.840 align:middle line:84% so it's balance sheet on the asset side has more bonds now, 00:18:07.840 --> 00:18:10.660 align:middle line:84% but it has more liabilities because it gives cash to people 00:18:10.660 --> 00:18:13.180 align:middle line:84% and that's a liability of the central banks. 00:18:13.180 --> 00:18:15.490 align:middle line:84% So that's an open market operation. 00:18:15.490 --> 00:18:18.010 align:middle line:84% That's an expansionary open market operation 00:18:18.010 --> 00:18:20.080 align:middle line:84% which is designed to lower the interest rate. 00:18:20.080 --> 00:18:23.180 align:middle line:90% 00:18:23.180 --> 00:18:25.010 align:middle line:84% Then I talked about the relationship 00:18:25.010 --> 00:18:28.370 align:middle line:84% between the interest rate and the price of the bond. 00:18:28.370 --> 00:18:31.040 align:middle line:90% And that's the return on a bond. 00:18:31.040 --> 00:18:34.520 align:middle line:84% It's the face value of the bond, what 00:18:34.520 --> 00:18:37.250 align:middle line:90% you get when the bond matures. 00:18:37.250 --> 00:18:40.070 align:middle line:84% Say it's 100, it's a bond for 100, minus 00:18:40.070 --> 00:18:42.410 align:middle line:84% whatever you pay divided by whatever you pay. 00:18:42.410 --> 00:18:46.640 align:middle line:84% So say if you pay today $95 for a bond 00:18:46.640 --> 00:18:49.505 align:middle line:84% that will pay you $100 a year from now, that's approximately-- 00:18:49.505 --> 00:18:51.530 align:middle line:90% it's 5% interest rate. 00:18:51.530 --> 00:18:57.320 align:middle line:84% It's a little more, but that's about it. 00:18:57.320 --> 00:19:00.560 align:middle line:84% Which also helps you understand a little bit what 00:19:00.560 --> 00:19:02.540 align:middle line:84% happens during an open market operation. 00:19:02.540 --> 00:19:05.610 align:middle line:84% In an open market operation, an expansionary monetary policy, 00:19:05.610 --> 00:19:08.910 align:middle line:84% the central bank goes out there and buys bonds. 00:19:08.910 --> 00:19:12.540 align:middle line:84% What typically happens to a price of a good 00:19:12.540 --> 00:19:17.230 align:middle line:84% or an asset that is being bought by somebody big? 00:19:17.230 --> 00:19:18.333 align:middle line:90% Goes up or down? 00:19:18.333 --> 00:19:20.750 align:middle line:84% Now we have a big buyer out there that goes and buys bond. 00:19:20.750 --> 00:19:24.740 align:middle line:84% Do you think the price of bonds will go up or down? 00:19:24.740 --> 00:19:25.820 align:middle line:90% Up. 00:19:25.820 --> 00:19:29.420 align:middle line:84% Big buyer got into the market to buy bonds, the price of bonds 00:19:29.420 --> 00:19:30.180 align:middle line:90% go up. 00:19:30.180 --> 00:19:32.490 align:middle line:84% But if the price of bonds goes up, 00:19:32.490 --> 00:19:35.580 align:middle line:84% that means the interest rate goes down. 00:19:35.580 --> 00:19:37.670 align:middle line:84% So that's an intuitive way of understanding 00:19:37.670 --> 00:19:39.470 align:middle line:84% how monetary policy lowers interest rates. 00:19:39.470 --> 00:19:42.920 align:middle line:84% It's a big buyer buying bonds, the price of bonds will go up, 00:19:42.920 --> 00:19:45.200 align:middle line:84% but the interest rate and the price of the bond 00:19:45.200 --> 00:19:46.190 align:middle line:90% are inversely related. 00:19:46.190 --> 00:19:49.440 align:middle line:90% 00:19:49.440 --> 00:19:50.620 align:middle line:90% You can see that. 00:19:50.620 --> 00:19:53.550 align:middle line:84% Now suppose that the initial price of the bond was 95, 00:19:53.550 --> 00:19:56.010 align:middle line:84% and now the price of the bond goes to 100, 00:19:56.010 --> 00:20:00.540 align:middle line:84% the interest rate goes from a little more than 5% to 0%. 00:20:00.540 --> 00:20:02.760 align:middle line:90% Good. 00:20:02.760 --> 00:20:05.730 align:middle line:84% Then we talked about intermediaries. 00:20:05.730 --> 00:20:06.870 align:middle line:90% Forget it for now. 00:20:06.870 --> 00:20:10.040 align:middle line:90% 00:20:10.040 --> 00:20:12.490 align:middle line:84% So then we got into two lectures about IS-LM-- 00:20:12.490 --> 00:20:14.980 align:middle line:84% about the basic IS-LM model, and then 00:20:14.980 --> 00:20:18.340 align:middle line:84% we did one more on the extended IS-LM model. 00:20:18.340 --> 00:20:21.160 align:middle line:84% And I told you that at least two-thirds of your quiz 00:20:21.160 --> 00:20:22.250 align:middle line:90% will be about this. 00:20:22.250 --> 00:20:26.500 align:middle line:84% So-- and I already know what is in the quiz and I cannot tell 00:20:26.500 --> 00:20:30.400 align:middle line:90% you, that I honor my commitment. 00:20:30.400 --> 00:20:34.970 align:middle line:84% So you better understand the IS-LM model very, very well. 00:20:34.970 --> 00:20:36.910 align:middle line:84% Now understanding the IS-LM model also 00:20:36.910 --> 00:20:38.650 align:middle line:84% means understanding the previous two 00:20:38.650 --> 00:20:41.300 align:middle line:84% lectures because we're building the IS-LM model there. 00:20:41.300 --> 00:20:47.370 align:middle line:90% 00:20:47.370 --> 00:20:49.080 align:middle line:84% So the first thing we did here is 00:20:49.080 --> 00:20:51.038 align:middle line:84% we said, well, to make this stuff a little more 00:20:51.038 --> 00:20:53.070 align:middle line:84% interesting-- we already had a model in which we 00:20:53.070 --> 00:20:54.320 align:middle line:90% could find equilibrium output. 00:20:54.320 --> 00:20:59.190 align:middle line:84% But remember, that was in lecture 3, we had that. 00:20:59.190 --> 00:21:02.640 align:middle line:84% But we said-- but we took many things as exogenous there 00:21:02.640 --> 00:21:04.530 align:middle line:84% that are really not exogenous in practice. 00:21:04.530 --> 00:21:06.390 align:middle line:84% In particular, private investment. 00:21:06.390 --> 00:21:08.280 align:middle line:84% Private investment is certainly something 00:21:08.280 --> 00:21:11.010 align:middle line:84% that responds to aggregate activity 00:21:11.010 --> 00:21:13.870 align:middle line:84% and to the cost of borrowing and things of that nature. 00:21:13.870 --> 00:21:15.810 align:middle line:84% So what we did-- the first thing we did here 00:21:15.810 --> 00:21:18.450 align:middle line:84% is we changed the investment function 00:21:18.450 --> 00:21:21.810 align:middle line:84% for some constant for something that was a function of output 00:21:21.810 --> 00:21:23.580 align:middle line:90% and the interest rate. 00:21:23.580 --> 00:21:26.970 align:middle line:84% That component here, the fact that it was increasing in output 00:21:26.970 --> 00:21:29.910 align:middle line:84% just increase the multiplier, but it didn't change anything 00:21:29.910 --> 00:21:32.860 align:middle line:90% qualitatively in the analysis. 00:21:32.860 --> 00:21:35.130 align:middle line:84% But the fact that it depends on the interest rate 00:21:35.130 --> 00:21:40.710 align:middle line:84% is important because now we have as a parameter in the goods-- 00:21:40.710 --> 00:21:44.190 align:middle line:84% in the aggregate demand curve the interest rate. 00:21:44.190 --> 00:21:45.802 align:middle line:84% When you solve out the whole thing, 00:21:45.802 --> 00:21:47.760 align:middle line:84% the interest rate is one of the things that can 00:21:47.760 --> 00:21:49.410 align:middle line:90% move aggregate demand around. 00:21:49.410 --> 00:21:51.657 align:middle line:84% And that's important because now you 00:21:51.657 --> 00:21:53.490 align:middle line:84% can begin to see the connection between what 00:21:53.490 --> 00:21:57.000 align:middle line:84% the central bank does and how it affects aggregate activity 00:21:57.000 --> 00:21:58.530 align:middle line:84% because what the central bank does 00:21:58.530 --> 00:22:00.010 align:middle line:90% is affect the interest rate. 00:22:00.010 --> 00:22:02.700 align:middle line:84% The central bank cannot go out there and buy hamburgers as I 00:22:02.700 --> 00:22:03.370 align:middle line:90% said. 00:22:03.370 --> 00:22:05.580 align:middle line:84% It can go out there and buy bonds, 00:22:05.580 --> 00:22:07.500 align:middle line:84% and with that, it affects the interest rate. 00:22:07.500 --> 00:22:10.200 align:middle line:84% And for that to matter for the economy, 00:22:10.200 --> 00:22:12.465 align:middle line:84% not only to bondholders, it better 00:22:12.465 --> 00:22:15.090 align:middle line:84% be the case that that interest rate matters for the equilibrium 00:22:15.090 --> 00:22:16.080 align:middle line:90% level of output. 00:22:16.080 --> 00:22:20.160 align:middle line:84% And it does so by affecting real investment. 00:22:20.160 --> 00:22:23.550 align:middle line:84% So that's the mechanism through which monetary policy affects 00:22:23.550 --> 00:22:24.540 align:middle line:90% real activity. 00:22:24.540 --> 00:22:28.260 align:middle line:84% Is through the cost of borrowing. 00:22:28.260 --> 00:22:30.480 align:middle line:84% We simply-- in reality, consumers 00:22:30.480 --> 00:22:33.190 align:middle line:84% are also affected by that, by the interest rate and so on, 00:22:33.190 --> 00:22:37.560 align:middle line:84% but let's keep things simple and have only investment 00:22:37.560 --> 00:22:39.330 align:middle line:84% as a function of the interest rate. 00:22:39.330 --> 00:22:42.330 align:middle line:84% And very importantly, it's a decreasing function 00:22:42.330 --> 00:22:43.330 align:middle line:90% of the interest rate. 00:22:43.330 --> 00:22:45.010 align:middle line:84% The higher interest rates, the lower 00:22:45.010 --> 00:22:46.900 align:middle line:84% its investment for any given level of output 00:22:46.900 --> 00:22:50.540 align:middle line:84% because it's more costly to borrow to fund that investment. 00:22:50.540 --> 00:22:52.960 align:middle line:84% So that gives us our curve, which 00:22:52.960 --> 00:22:56.708 align:middle line:84% is a combination of output and interest rate 00:22:56.708 --> 00:22:58.750 align:middle line:84% that are consistent with equilibrium in the goods 00:22:58.750 --> 00:23:03.680 align:middle line:84% market-- that is, when output is equal to aggregate demand. 00:23:03.680 --> 00:23:06.080 align:middle line:84% So that's the IS So that point belongs 00:23:06.080 --> 00:23:09.095 align:middle line:84% to one IS for one interest rate here. 00:23:09.095 --> 00:23:11.880 align:middle line:90% 00:23:11.880 --> 00:23:14.070 align:middle line:90% So how do we construct the IS? 00:23:14.070 --> 00:23:17.320 align:middle line:84% Well, we start moving the interest rate. 00:23:17.320 --> 00:23:21.240 align:middle line:84% So suppose we start from this one point in the IS, 00:23:21.240 --> 00:23:22.710 align:middle line:90% the point I just showed you. 00:23:22.710 --> 00:23:25.950 align:middle line:84% Supposing that now-- we increase the interest rate, 00:23:25.950 --> 00:23:27.930 align:middle line:84% we look at the new equilibrium output. 00:23:27.930 --> 00:23:30.238 align:middle line:84% Well, that also belongs to this IS. 00:23:30.238 --> 00:23:32.280 align:middle line:84% And you can keep moving the interest rate around. 00:23:32.280 --> 00:23:34.860 align:middle line:84% So you move z around only by moving the interest rate. 00:23:34.860 --> 00:23:36.960 align:middle line:84% Don't move G, T, or anything else. 00:23:36.960 --> 00:23:38.970 align:middle line:84% Only by moving the interest rate, and then 00:23:38.970 --> 00:23:42.490 align:middle line:90% you can trace an IS curve. 00:23:42.490 --> 00:23:45.170 align:middle line:84% If you move other parameters than the interest rate, 00:23:45.170 --> 00:23:47.030 align:middle line:84% then it's a shift in the IS curve, 00:23:47.030 --> 00:23:48.710 align:middle line:84% it's not a movement along the IS curve. 00:23:48.710 --> 00:23:52.135 align:middle line:84% So if, for example, if I increase G, what happens? 00:23:52.135 --> 00:23:55.110 align:middle line:90% 00:23:55.110 --> 00:23:58.060 align:middle line:90% With this IS curve? 00:23:58.060 --> 00:24:00.880 align:middle line:84% The IS curve shift to the right because-- 00:24:00.880 --> 00:24:03.910 align:middle line:84% now for any given level of interest rate, 00:24:03.910 --> 00:24:06.980 align:middle line:84% output will be higher because aggregate demand moves up. 00:24:06.980 --> 00:24:10.500 align:middle line:84% And so that's a shift to the right of the IS curve. 00:24:10.500 --> 00:24:12.090 align:middle line:90% Good. 00:24:12.090 --> 00:24:13.740 align:middle line:84% That's an example of the opposite. 00:24:13.740 --> 00:24:17.235 align:middle line:84% An increase in taxes, well, it will shift IS to the left. 00:24:17.235 --> 00:24:21.950 align:middle line:90% 00:24:21.950 --> 00:24:24.410 align:middle line:84% The LM relationship is already described. 00:24:24.410 --> 00:24:26.780 align:middle line:84% It is no equilibrium in financial markets, 00:24:26.780 --> 00:24:30.260 align:middle line:84% but we said the way monetary policy is conducted 00:24:30.260 --> 00:24:32.960 align:middle line:84% is the Fed sets the interest rate and the money 00:24:32.960 --> 00:24:36.020 align:middle line:84% is whatever the market needs in order for that to be 00:24:36.020 --> 00:24:37.500 align:middle line:90% the equilibrium interest rate. 00:24:37.500 --> 00:24:42.890 align:middle line:84% So the model in LM, if you will, is horizontal just like that. 00:24:42.890 --> 00:24:45.260 align:middle line:84% So now we're set, because once the Fed decides 00:24:45.260 --> 00:24:47.120 align:middle line:84% to set this interest rate, we can 00:24:47.120 --> 00:24:49.825 align:middle line:84% find not only the equilibrium combinations of interest rate 00:24:49.825 --> 00:24:51.950 align:middle line:84% and output that are consistent with the equilibrium 00:24:51.950 --> 00:24:55.400 align:middle line:84% in the goods market, but the particular equilibrium 00:24:55.400 --> 00:24:58.190 align:middle line:84% level of output that is consistent with that interest 00:24:58.190 --> 00:24:59.210 align:middle line:90% rate. 00:24:59.210 --> 00:25:01.850 align:middle line:84% And that's exactly equilibrium output. 00:25:01.850 --> 00:25:07.010 align:middle line:84% So given the LLM, now I looked at it intersection with my IS, 00:25:07.010 --> 00:25:08.660 align:middle line:84% and that gives me equilibrium output 00:25:08.660 --> 00:25:10.130 align:middle line:84% for that level of the interest rate, which 00:25:10.130 --> 00:25:11.165 align:middle line:90% has been set by the Fed. 00:25:11.165 --> 00:25:15.747 align:middle line:90% 00:25:15.747 --> 00:25:17.080 align:middle line:90% And then you can use this model. 00:25:17.080 --> 00:25:19.020 align:middle line:84% This is a very powerful little model 00:25:19.020 --> 00:25:21.940 align:middle line:84% because now you can do lots of things with it. 00:25:21.940 --> 00:25:25.500 align:middle line:84% For example, that's a contractionary fiscal policy. 00:25:25.500 --> 00:25:27.630 align:middle line:84% That's what happens when you reduce G 00:25:27.630 --> 00:25:36.420 align:middle line:84% or when you increase T. What happens if you reduce 00:25:36.420 --> 00:25:40.445 align:middle line:90% G and T by the same amount? 00:25:40.445 --> 00:25:46.010 align:middle line:90% 00:25:46.010 --> 00:25:47.120 align:middle line:90% You see what I'm doing. 00:25:47.120 --> 00:25:49.457 align:middle line:84% Maybe if you-- that's often done. 00:25:49.457 --> 00:25:51.290 align:middle line:84% OK, you can increase government expenditure, 00:25:51.290 --> 00:25:52.873 align:middle line:84% but then you find a source of revenue, 00:25:52.873 --> 00:25:55.310 align:middle line:84% or reduce government expenditure, 00:25:55.310 --> 00:25:59.370 align:middle line:84% but then you don't need to generate a fiscal surplus, 00:25:59.370 --> 00:25:59.880 align:middle line:90% and so on. 00:25:59.880 --> 00:26:04.160 align:middle line:84% So what I'm saying, this is a balanced budget fiscal policy. 00:26:04.160 --> 00:26:05.450 align:middle line:90% That's what it's called. 00:26:05.450 --> 00:26:08.120 align:middle line:84% What if I move G and T by the same amount? 00:26:08.120 --> 00:26:09.530 align:middle line:90% Does that curve move? 00:26:09.530 --> 00:26:14.970 align:middle line:90% 00:26:14.970 --> 00:26:16.937 align:middle line:90% Yeah. 00:26:16.937 --> 00:26:19.020 align:middle line:84% AUDIENCE: It does because the multiplier next to T 00:26:19.020 --> 00:26:22.170 align:middle line:84% is c0 in the equation-- original equation. 00:26:22.170 --> 00:26:23.898 align:middle line:90% RICHARDO CABALLERO: c0? 00:26:23.898 --> 00:26:24.440 align:middle line:90% AUDIENCE: c1. 00:26:24.440 --> 00:26:26.130 align:middle line:90% RICHARDO CABALLERO: Yeah, OK. 00:26:26.130 --> 00:26:27.120 align:middle line:90% Perfect. 00:26:27.120 --> 00:26:27.830 align:middle line:90% Yeah. 00:26:27.830 --> 00:26:28.530 align:middle line:90% Yeah. 00:26:28.530 --> 00:26:30.340 align:middle line:84% So, in which direction does it move? 00:26:30.340 --> 00:26:37.090 align:middle line:84% So if I reduce G and reduce T by the same amount, 00:26:37.090 --> 00:26:38.190 align:middle line:90% what happens to IS? 00:26:38.190 --> 00:26:41.870 align:middle line:84% Moves to the left or to the right? 00:26:41.870 --> 00:26:43.640 align:middle line:90% Yeah, it moves to the left. 00:26:43.640 --> 00:26:44.810 align:middle line:90% Because why is that? 00:26:44.810 --> 00:26:48.350 align:middle line:84% I can always go back to my basic goods market equilibrium model. 00:26:48.350 --> 00:26:52.115 align:middle line:84% If I reduce G by 1, that reduces aggregate demand one by 1. 00:26:52.115 --> 00:26:53.060 align:middle line:90% One for one. 00:26:53.060 --> 00:26:55.490 align:middle line:84% And then the multiplier kicks in. 00:26:55.490 --> 00:26:59.570 align:middle line:84% If I-- but the initial change shift down is 1. 00:26:59.570 --> 00:27:05.930 align:middle line:84% If I reduce taxes, I increase aggregate demand, 00:27:05.930 --> 00:27:10.450 align:middle line:90% but by c1 times 1. 00:27:10.450 --> 00:27:13.510 align:middle line:84% And so I had a reduction in aggregate demand of 1 00:27:13.510 --> 00:27:17.080 align:middle line:84% and I had an increase in aggregate demand of c1. 00:27:17.080 --> 00:27:19.310 align:middle line:90% 1 minus c1 is greater than 0. 00:27:19.310 --> 00:27:22.330 align:middle line:84% That's the reason you have, on net, a reduction 00:27:22.330 --> 00:27:23.890 align:middle line:90% in aggregate demand. 00:27:23.890 --> 00:27:29.150 align:middle line:90% 00:27:29.150 --> 00:27:32.730 align:middle line:84% Hint, this is not a random thought I had, 00:27:32.730 --> 00:27:35.120 align:middle line:90% so do understand it. 00:27:35.120 --> 00:27:35.765 align:middle line:90% OK, good. 00:27:35.765 --> 00:27:39.670 align:middle line:90% 00:27:39.670 --> 00:27:40.170 align:middle line:90% OK. 00:27:40.170 --> 00:27:44.830 align:middle line:90% 00:27:44.830 --> 00:27:48.440 align:middle line:90% Thus, monetary policy. 00:27:48.440 --> 00:27:52.900 align:middle line:84% So that's an expansionary monetary policy. 00:27:52.900 --> 00:27:56.090 align:middle line:84% And in equilibrium, why it's expansionary? 00:27:56.090 --> 00:27:58.090 align:middle line:84% So cutting interest rate, because it will 00:27:58.090 --> 00:27:59.720 align:middle line:90% increase equilibrium output. 00:27:59.720 --> 00:28:02.830 align:middle line:84% That's the case in which the Fed probably 00:28:02.830 --> 00:28:04.540 align:middle line:84% is unhappy with this low level of output, 00:28:04.540 --> 00:28:05.690 align:middle line:90% maybe it's a recession. 00:28:05.690 --> 00:28:08.710 align:middle line:84% So one of the main policy tools we have to fight a recession 00:28:08.710 --> 00:28:10.065 align:middle line:90% is to lower the interest rate. 00:28:10.065 --> 00:28:12.190 align:middle line:84% And you can see here how lowering the interest rate 00:28:12.190 --> 00:28:14.110 align:middle line:84% will increase equilibrium output. 00:28:14.110 --> 00:28:16.130 align:middle line:90% How does it happen? 00:28:16.130 --> 00:28:17.400 align:middle line:90% Why is it that this happened? 00:28:17.400 --> 00:28:19.233 align:middle line:84% Why is it that the equilibrium output rises? 00:28:19.233 --> 00:28:23.460 align:middle line:90% 00:28:23.460 --> 00:28:24.582 align:middle line:90% Exactly. 00:28:24.582 --> 00:28:26.040 align:middle line:84% Because it's increasing investment. 00:28:26.040 --> 00:28:27.720 align:middle line:90% That gives us the first kick. 00:28:27.720 --> 00:28:30.330 align:middle line:84% And once equilibrium starts rising, 00:28:30.330 --> 00:28:33.060 align:middle line:84% then consumption rises and we get the whole multiplier. 00:28:33.060 --> 00:28:35.730 align:middle line:84% But the initial impulse is exactly 00:28:35.730 --> 00:28:40.540 align:middle line:84% because this increase in investment. 00:28:40.540 --> 00:28:42.990 align:middle line:90% And how does it implement that? 00:28:42.990 --> 00:28:44.350 align:middle line:90% Open market operation. 00:28:44.350 --> 00:28:47.017 align:middle line:84% So what the Fed will do is if it wants to cut the interest rate, 00:28:47.017 --> 00:28:50.550 align:middle line:84% it goes out there, buys bonds from the public, 00:28:50.550 --> 00:28:53.730 align:middle line:84% and gives them money in exchange, 00:28:53.730 --> 00:28:57.390 align:middle line:90% and that's what happens here. 00:28:57.390 --> 00:28:59.870 align:middle line:84% And then I talk about different policy mixes. 00:28:59.870 --> 00:29:03.290 align:middle line:84% This is what typically when an economy is deep into recession, 00:29:03.290 --> 00:29:05.660 align:middle line:84% you're going to see both policies that 00:29:05.660 --> 00:29:07.610 align:middle line:84% work at the same time that's very powerful. 00:29:07.610 --> 00:29:13.790 align:middle line:84% That's the case in which we have a very-- we cut-- 00:29:13.790 --> 00:29:16.640 align:middle line:84% we have an expansionary monetary policy that shifts down 00:29:16.640 --> 00:29:18.680 align:middle line:84% and an expansionary fiscal policy. 00:29:18.680 --> 00:29:23.030 align:middle line:84% And that's definitely what we did during COVID, was massive. 00:29:23.030 --> 00:29:24.930 align:middle line:84% And during the Global Financial Crisis-- 00:29:24.930 --> 00:29:27.890 align:middle line:84% so typically big recessions will lead to-- 00:29:27.890 --> 00:29:30.020 align:middle line:84% any recession will lead to something like that. 00:29:30.020 --> 00:29:31.520 align:middle line:84% Obviously if it is big, you're going 00:29:31.520 --> 00:29:35.930 align:middle line:84% to have a bigger combination of this kind of stuff. 00:29:35.930 --> 00:29:38.840 align:middle line:84% Some problems that monetary policy may face 00:29:38.840 --> 00:29:41.960 align:middle line:84% is that sometimes you hit a zero lower bound. 00:29:41.960 --> 00:29:43.727 align:middle line:84% And then when you hit a zero lower bound, 00:29:43.727 --> 00:29:45.560 align:middle line:84% you just can't lower the interest rate more, 00:29:45.560 --> 00:29:48.630 align:middle line:84% you lose monetary policy, you need to do other stuff, 00:29:48.630 --> 00:29:53.460 align:middle line:84% and typically fiscal policy then becomes very, very active. 00:29:53.460 --> 00:29:56.540 align:middle line:84% And this is not just a theoretical curiosity. 00:29:56.540 --> 00:29:59.530 align:middle line:84% I mean, we have been against the zero lower bound 00:29:59.530 --> 00:30:04.120 align:middle line:84% for a sustained amount of time during the last 20 years or so. 00:30:04.120 --> 00:30:07.186 align:middle line:90% 00:30:07.186 --> 00:30:11.320 align:middle line:84% Oh, that's another policy mix as well that-- 00:30:11.320 --> 00:30:13.810 align:middle line:84% suppose that you need to do a fiscal adjustment, I said. 00:30:13.810 --> 00:30:17.920 align:middle line:84% So you want to reduce the deficit, reduce G, 00:30:17.920 --> 00:30:21.190 align:middle line:84% but you don't want to have a recession as a result of that. 00:30:21.190 --> 00:30:25.810 align:middle line:84% One way you can do that is by-- you have a contraction in G 00:30:25.810 --> 00:30:27.290 align:middle line:90% or increase in taxes. 00:30:27.290 --> 00:30:29.650 align:middle line:84% That's contractionary, but you can offset it 00:30:29.650 --> 00:30:31.420 align:middle line:84% with an expansionary monetary policy. 00:30:31.420 --> 00:30:33.890 align:middle line:84% I think in the quiz somewhere you have a question-- 00:30:33.890 --> 00:30:36.478 align:middle line:84% I don't think that is specific to this, but you could 00:30:36.478 --> 00:30:38.770 align:middle line:84% you're asked to compensate for something with something 00:30:38.770 --> 00:30:40.060 align:middle line:90% and something like that. 00:30:40.060 --> 00:30:42.490 align:middle line:84% So some curve move, and then you're 00:30:42.490 --> 00:30:47.270 align:middle line:84% asked to offset that effect on output. 00:30:47.270 --> 00:30:49.340 align:middle line:84% So you should understand this kind of things. 00:30:49.340 --> 00:30:54.050 align:middle line:84% The next step was to extend a little bit our IS-LM model. 00:30:54.050 --> 00:30:57.550 align:middle line:84% And by extension we said, well, look, 00:30:57.550 --> 00:31:01.000 align:middle line:90% at this moment we have only-- 00:31:01.000 --> 00:31:05.570 align:middle line:84% prices are completely fixed, but in reality we have inflation. 00:31:05.570 --> 00:31:08.868 align:middle line:84% And so the nominal interest rate is not really the effective cost 00:31:08.868 --> 00:31:09.910 align:middle line:90% of capital for a company. 00:31:09.910 --> 00:31:12.730 align:middle line:84% A company that wants to fund the real investment 00:31:12.730 --> 00:31:15.090 align:middle line:84% is more concerned with the real interest rate in Spain, 00:31:15.090 --> 00:31:16.340 align:middle line:90% not the nominal interest rate. 00:31:16.340 --> 00:31:18.430 align:middle line:84% So with prices that are constant, 00:31:18.430 --> 00:31:21.430 align:middle line:84% there is no distinction, but if you have positive inflation, 00:31:21.430 --> 00:31:24.725 align:middle line:84% then the distinction makes a difference. 00:31:24.725 --> 00:31:26.600 align:middle line:84% That's the reason we want to talk about that. 00:31:26.600 --> 00:31:29.620 align:middle line:84% And the second thing is that the same firms 00:31:29.620 --> 00:31:32.980 align:middle line:84% are very unlikely to pay the same that the Treasury pays 00:31:32.980 --> 00:31:34.030 align:middle line:90% for borrowing. 00:31:34.030 --> 00:31:35.080 align:middle line:90% It's going to pay-- 00:31:35.080 --> 00:31:36.940 align:middle line:84% it's a riskier proposition to invest 00:31:36.940 --> 00:31:38.500 align:middle line:84% in bonds issued by a corporation, 00:31:38.500 --> 00:31:40.000 align:middle line:84% and therefore, they're going to have 00:31:40.000 --> 00:31:42.220 align:middle line:90% to pay a risk premium for that. 00:31:42.220 --> 00:31:44.860 align:middle line:84% And so the importance of these two things 00:31:44.860 --> 00:31:52.860 align:middle line:84% is that a we ended up with an IS-LM model that 00:31:52.860 --> 00:31:54.750 align:middle line:84% now had something a little more complicated 00:31:54.750 --> 00:31:57.750 align:middle line:84% here because it didn't have only the nominal interest rate, 00:31:57.750 --> 00:32:00.390 align:middle line:90% but also had expected inflation. 00:32:00.390 --> 00:32:02.880 align:middle line:84% If, for any given nominal interest 00:32:02.880 --> 00:32:06.840 align:middle line:84% rate, if we expect a higher inflation, 00:32:06.840 --> 00:32:09.240 align:middle line:84% that means a lower real interest rate. 00:32:09.240 --> 00:32:12.630 align:middle line:84% So for any given nominal interest 00:32:12.630 --> 00:32:14.580 align:middle line:84% rate, if expected inflation goes up, 00:32:14.580 --> 00:32:17.040 align:middle line:84% that's expansionary, really, for firms. 00:32:17.040 --> 00:32:20.370 align:middle line:84% It's like it's cheaper, in a sense, to borrow. 00:32:20.370 --> 00:32:23.220 align:middle line:84% Conversely, if x goes up, the credit spread 00:32:23.220 --> 00:32:26.310 align:middle line:84% goes up, that's contractionary because it's now 00:32:26.310 --> 00:32:27.990 align:middle line:84% more expensive for the firms to borrow 00:32:27.990 --> 00:32:30.300 align:middle line:84% for any given real interest rate. 00:32:30.300 --> 00:32:35.290 align:middle line:90% 00:32:35.290 --> 00:32:40.990 align:middle line:84% So we can-- this is called extended IS-LM model simply 00:32:40.990 --> 00:32:43.510 align:middle line:84% because it has been extended to incorporate 00:32:43.510 --> 00:32:45.760 align:middle line:90% these additional factors. 00:32:45.760 --> 00:32:48.400 align:middle line:84% And now, you have two more parameters 00:32:48.400 --> 00:32:50.920 align:middle line:84% in your model, which is expected inflation 00:32:50.920 --> 00:32:52.870 align:middle line:90% and the credit spreads. 00:32:52.870 --> 00:32:57.740 align:middle line:84% So if you move either of these, you're 00:32:57.740 --> 00:32:59.480 align:middle line:84% going to move your aggregate demand 00:32:59.480 --> 00:33:01.980 align:middle line:90% curve in the goods market. 00:33:01.980 --> 00:33:04.560 align:middle line:84% And it's going to move for exactly the same reasons 00:33:04.560 --> 00:33:08.250 align:middle line:84% that that aggregate demand moved when you move the interest rate. 00:33:08.250 --> 00:33:09.900 align:middle line:90% It enters symmetrically. 00:33:09.900 --> 00:33:13.950 align:middle line:84% In this model, these guys here enter completely symmetrically 00:33:13.950 --> 00:33:15.280 align:middle line:90% with the interest rate. 00:33:15.280 --> 00:33:18.180 align:middle line:84% So whatever was the comparative statics 00:33:18.180 --> 00:33:20.280 align:middle line:84% you had with respect to the nominal interest rate 00:33:20.280 --> 00:33:26.590 align:middle line:84% before, they applied to x minus pi. 00:33:26.590 --> 00:33:29.760 align:middle line:84% What I'm trying to say is if you know 00:33:29.760 --> 00:33:32.320 align:middle line:84% what is the change in equilibrium 00:33:32.320 --> 00:33:35.590 align:middle line:84% output as a response-- as a result of an increase in 100 00:33:35.590 --> 00:33:37.690 align:middle line:84% basis points on the nominal interest rate, 00:33:37.690 --> 00:33:40.570 align:middle line:84% then you know what is the response of equilibrium output 00:33:40.570 --> 00:33:43.660 align:middle line:84% to an increase in credit spreads of 100 basis points, 00:33:43.660 --> 00:33:47.260 align:middle line:84% or to a reduction-- or to a reduction in expected 00:33:47.260 --> 00:33:49.170 align:middle line:90% inflation of 100 basis points. 00:33:49.170 --> 00:33:51.910 align:middle line:90% Entirely symmetric. 00:33:51.910 --> 00:33:53.890 align:middle line:90% Because that's a channel. 00:33:53.890 --> 00:33:59.510 align:middle line:84% It's the real-- it's the cost of capital channel for the firm. 00:33:59.510 --> 00:34:03.010 align:middle line:84% That's they're all entering exactly through the same place. 00:34:03.010 --> 00:34:06.400 align:middle line:84% But the Fed doesn't control this guy, 00:34:06.400 --> 00:34:10.000 align:middle line:84% it controls only the nominal interest rate. 00:34:10.000 --> 00:34:10.780 align:middle line:90% So anyways. 00:34:10.780 --> 00:34:12.350 align:middle line:84% So these are new parameters here. 00:34:12.350 --> 00:34:15.179 align:middle line:90% So this is an example here. 00:34:15.179 --> 00:34:18.380 align:middle line:84% That's an example in which credit spreads 00:34:18.380 --> 00:34:21.760 align:middle line:90% or expected inflation went up. 00:34:21.760 --> 00:34:22.260 align:middle line:90% Sorry. 00:34:22.260 --> 00:34:29.389 align:middle line:84% Where credit spreads went down or expected inflation went up. 00:34:29.389 --> 00:34:30.469 align:middle line:90% And that's expansionary. 00:34:30.469 --> 00:34:32.330 align:middle line:84% That will increase aggregate demand 00:34:32.330 --> 00:34:34.889 align:middle line:84% because for any given level of output, 00:34:34.889 --> 00:34:38.730 align:middle line:84% now there will be more investment. 00:34:38.730 --> 00:34:41.880 align:middle line:84% Credit spreads are lower or expected inflation is higher 00:34:41.880 --> 00:34:43.380 align:middle line:84% mean the real interest rate is lower 00:34:43.380 --> 00:34:45.100 align:middle line:84% for any given nominal interest rate. 00:34:45.100 --> 00:34:47.976 align:middle line:84% So if the Fed doesn't react to that, 00:34:47.976 --> 00:34:49.934 align:middle line:84% that's going to lead to an expansion in output. 00:34:49.934 --> 00:34:53.690 align:middle line:90% 00:34:53.690 --> 00:34:55.639 align:middle line:84% Of course, the Fed could react to that. 00:34:55.639 --> 00:34:58.580 align:middle line:84% Suppose the Fed is OK with the level of output we have. 00:34:58.580 --> 00:35:01.140 align:middle line:90% 00:35:01.140 --> 00:35:02.580 align:middle line:90% Suppose it's a low output. 00:35:02.580 --> 00:35:05.550 align:middle line:84% And the Fed's seeing credit spreads falling, 00:35:05.550 --> 00:35:06.923 align:middle line:90% so output is expanding. 00:35:06.923 --> 00:35:09.090 align:middle line:84% But the Fed says, no, no, no, the level of output Y0 00:35:09.090 --> 00:35:10.230 align:middle line:90% wasn't what I needed. 00:35:10.230 --> 00:35:11.640 align:middle line:90% I don't want Y1. 00:35:11.640 --> 00:35:14.810 align:middle line:90% What would the Fed do? 00:35:14.810 --> 00:35:16.130 align:middle line:90% Increase the interest rate. 00:35:16.130 --> 00:35:17.030 align:middle line:90% Exactly. 00:35:17.030 --> 00:35:19.550 align:middle line:84% And it's very easy to see in this picture here 00:35:19.550 --> 00:35:23.690 align:middle line:84% that if you don't want this guy, the total sum to move, then 00:35:23.690 --> 00:35:25.520 align:middle line:90% if this guy moves down-- 00:35:25.520 --> 00:35:30.380 align:middle line:84% or this guy moves up, then I need to move i exactly 00:35:30.380 --> 00:35:31.850 align:middle line:90% to offset that, and that's it. 00:35:31.850 --> 00:35:33.017 align:middle line:90% It's very easy to calculate. 00:35:33.017 --> 00:35:35.180 align:middle line:84% I don't need to solve my whole model, actually. 00:35:35.180 --> 00:35:38.635 align:middle line:84% You tell me this thing in net went down by 100 basis points, 00:35:38.635 --> 00:35:40.010 align:middle line:84% if I don't want to change output, 00:35:40.010 --> 00:35:42.260 align:middle line:84% then I need to increase the interest rate by 100 basis 00:35:42.260 --> 00:35:44.960 align:middle line:84% points so I don't change the cost of borrowing-- 00:35:44.960 --> 00:35:47.270 align:middle line:84% the effective cost of borrowing for corporations. 00:35:47.270 --> 00:35:50.450 align:middle line:90% 00:35:50.450 --> 00:35:53.090 align:middle line:84% In fact, this is exactly what is going on right now 00:35:53.090 --> 00:35:55.200 align:middle line:90% in the US economy. 00:35:55.200 --> 00:35:57.770 align:middle line:84% Every time Marcus gets very excited, 00:35:57.770 --> 00:36:00.110 align:middle line:84% credit spreads are compressed, the stock market goes up, 00:36:00.110 --> 00:36:01.860 align:middle line:84% the Fed comes out and says, come on, guys. 00:36:01.860 --> 00:36:03.650 align:middle line:84% I mean, we have inflation problem, 00:36:03.650 --> 00:36:08.360 align:middle line:84% I'm going to need to keep hiking interest rates because I 00:36:08.360 --> 00:36:10.678 align:middle line:90% need to offset your enthusiasm. 00:36:10.678 --> 00:36:13.220 align:middle line:84% They don't use those words, but that's exactly what happened. 00:36:13.220 --> 00:36:16.550 align:middle line:84% I mean, Chairman Powell was testifying in Congress 00:36:16.550 --> 00:36:18.980 align:middle line:84% yesterday and today, and that's what he said. 00:36:18.980 --> 00:36:21.680 align:middle line:84% I'm just giving you a summary of what he said. 00:36:21.680 --> 00:36:24.840 align:middle line:90% 00:36:24.840 --> 00:36:31.000 align:middle line:84% Now a problem that the central bank may face, 00:36:31.000 --> 00:36:32.860 align:middle line:84% suppose you have the opposite situation, 00:36:32.860 --> 00:36:36.130 align:middle line:84% is that one in which credit spreads are going up a lot 00:36:36.130 --> 00:36:38.590 align:middle line:84% and expected inflation is declining a lot. 00:36:38.590 --> 00:36:40.840 align:middle line:84% And the Fed doesn't want output to decline 00:36:40.840 --> 00:36:43.820 align:middle line:84% because that combination will lead to a reduction in output. 00:36:43.820 --> 00:36:45.640 align:middle line:84% So the Fed wants to cut interest rate. 00:36:45.640 --> 00:36:46.795 align:middle line:90% What problem may it face? 00:36:46.795 --> 00:36:50.490 align:middle line:90% 00:36:50.490 --> 00:36:51.390 align:middle line:90% The zero lower bound. 00:36:51.390 --> 00:36:54.270 align:middle line:84% It may not be able to bring interest rates as much as-- 00:36:54.270 --> 00:36:59.580 align:middle line:84% Because suppose that the interest rate today is 50 basis 00:36:59.580 --> 00:37:00.240 align:middle line:90% point. 00:37:00.240 --> 00:37:03.240 align:middle line:84% It's not the case today, but it was two years ago, 00:37:03.240 --> 00:37:07.890 align:middle line:84% 50 basis points, or 25 basis points, and credit spreads 00:37:07.890 --> 00:37:10.285 align:middle line:90% go up by 200 basis points. 00:37:10.285 --> 00:37:11.910 align:middle line:84% Well, there's no way the Fed can offset 00:37:11.910 --> 00:37:16.740 align:middle line:84% that because it has maximum 25 basis points to lower and credit 00:37:16.740 --> 00:37:18.480 align:middle line:84% spreads went up by 100 basis points. 00:37:18.480 --> 00:37:21.300 align:middle line:84% And that's when you start seeing all these more exotic policies-- 00:37:21.300 --> 00:37:23.400 align:middle line:84% quantitative easing and other things-- 00:37:23.400 --> 00:37:27.030 align:middle line:84% to offset the negative impact of the increase in the credit 00:37:27.030 --> 00:37:30.040 align:middle line:90% spreads in the economy. 00:37:30.040 --> 00:37:36.700 align:middle line:84% And the last thing we did was to begin our transition 00:37:36.700 --> 00:37:40.450 align:middle line:84% to wear medium running shoes, and the whole thing 00:37:40.450 --> 00:37:41.830 align:middle line:90% began from the labor market. 00:37:41.830 --> 00:37:44.270 align:middle line:84% Now you're going to get a little bit in the quiz of that, 00:37:44.270 --> 00:37:46.270 align:middle line:84% but it's not going to be as important as what I just 00:37:46.270 --> 00:37:46.870 align:middle line:90% described. 00:37:46.870 --> 00:37:49.560 align:middle line:84% A little bit you're going to have. 00:37:49.560 --> 00:37:53.100 align:middle line:84% And the basic-- well, definitions, you 00:37:53.100 --> 00:37:55.930 align:middle line:84% should know the basic definitions. 00:37:55.930 --> 00:37:59.010 align:middle line:84% Well, this was the first important equation. 00:37:59.010 --> 00:38:00.990 align:middle line:84% We had that wage-setting equation 00:38:00.990 --> 00:38:04.020 align:middle line:84% that said essentially that wages are 00:38:04.020 --> 00:38:05.293 align:middle line:90% increasing in expected prices. 00:38:05.293 --> 00:38:07.710 align:middle line:84% Obviously the nominal wage the workers are going to demand 00:38:07.710 --> 00:38:10.350 align:middle line:84% is going to be higher if they expect the price level to be 00:38:10.350 --> 00:38:12.090 align:middle line:90% higher in the future. 00:38:12.090 --> 00:38:15.930 align:middle line:84% But importantly, it's decreasing and unemployment and increasing 00:38:15.930 --> 00:38:19.890 align:middle line:84% in this variable that represents their bargaining power and so 00:38:19.890 --> 00:38:22.400 align:middle line:90% on. 00:38:22.400 --> 00:38:25.970 align:middle line:84% Then we look at what happened on the price-setting side, 00:38:25.970 --> 00:38:27.280 align:middle line:90% meaning what firms do. 00:38:27.280 --> 00:38:29.780 align:middle line:84% And for that, we have to start with the production function. 00:38:29.780 --> 00:38:31.490 align:middle line:84% We had a very simple production function 00:38:31.490 --> 00:38:32.865 align:middle line:84% which said if you want to produce 00:38:32.865 --> 00:38:35.990 align:middle line:84% one more unit of the good, you need to hire one more worker. 00:38:35.990 --> 00:38:39.090 align:middle line:84% That means that the marginal cost of production is the wage. 00:38:39.090 --> 00:38:40.100 align:middle line:90% So it's very simple. 00:38:40.100 --> 00:38:41.600 align:middle line:84% And then we said we're going to have 00:38:41.600 --> 00:38:45.020 align:middle line:84% a very simple model in which the firms charge 00:38:45.020 --> 00:38:48.080 align:middle line:84% their marginal cost, which is the wage times the markup 1 00:38:48.080 --> 00:38:48.800 align:middle line:90% plus m. 00:38:48.800 --> 00:38:51.530 align:middle line:90% So m is a number like, say, 0.2. 00:38:51.530 --> 00:38:56.750 align:middle line:84% So the wage is 100, the markup is 20%, they want the price of-- 00:38:56.750 --> 00:38:58.940 align:middle line:84% they're going to charge a price of $120. 00:38:58.940 --> 00:39:02.000 align:middle line:84% We can rearrange this in terms of wages, 00:39:02.000 --> 00:39:03.770 align:middle line:84% and you can say, well, the firm-- 00:39:03.770 --> 00:39:07.370 align:middle line:84% the maximum real wage that firms collectively are willing to pay 00:39:07.370 --> 00:39:10.190 align:middle line:84% is really 1 over 1 plus the markup. 00:39:10.190 --> 00:39:12.320 align:middle line:90% That's just from that. 00:39:12.320 --> 00:39:16.660 align:middle line:84% So then we look at a concept that is important, 00:39:16.660 --> 00:39:18.410 align:middle line:84% which is the natural rate of unemployment, 00:39:18.410 --> 00:39:20.540 align:middle line:84% and we said the natural rate of unemployment 00:39:20.540 --> 00:39:22.520 align:middle line:90% has nothing of natural. 00:39:22.520 --> 00:39:26.990 align:middle line:84% It just means that is the level of unemployment when 00:39:26.990 --> 00:39:28.940 align:middle line:84% the price is equal to expected price, 00:39:28.940 --> 00:39:32.210 align:middle line:84% or expected price equal to the price, you pick. 00:39:32.210 --> 00:39:34.670 align:middle line:84% So all that we did was to replace 00:39:34.670 --> 00:39:36.830 align:middle line:84% the wage-setting equation the expected price 00:39:36.830 --> 00:39:39.590 align:middle line:84% for the actual price, and then we divided both sides. 00:39:39.590 --> 00:39:43.580 align:middle line:84% And now we have this real wage demand by workers, 00:39:43.580 --> 00:39:45.840 align:middle line:84% when the price is equal to expected price, 00:39:45.840 --> 00:39:47.990 align:middle line:84% and we also had a price-setting equation. 00:39:47.990 --> 00:39:51.890 align:middle line:84% We can-- and I said when we replace P e for P, 00:39:51.890 --> 00:39:54.320 align:middle line:84% then I get the right to put an n-- 00:39:54.320 --> 00:39:55.653 align:middle line:90% superscript n there. 00:39:55.653 --> 00:39:57.320 align:middle line:84% That's the natural rate of unemployment. 00:39:57.320 --> 00:39:58.880 align:middle line:84% Because that's my definition of the natural rate 00:39:58.880 --> 00:39:59.547 align:middle line:90% of unemployment. 00:39:59.547 --> 00:40:01.520 align:middle line:84% It's what happens when I can replace 00:40:01.520 --> 00:40:06.650 align:middle line:84% in the wage-setting equation the expected price for the price. 00:40:06.650 --> 00:40:09.360 align:middle line:84% And we look at the natural rate of unemployment, 00:40:09.360 --> 00:40:12.020 align:middle line:84% which is the equilibrium here of the price-setting equation. 00:40:12.020 --> 00:40:15.600 align:middle line:84% It has an implied real wage of 1 over 1 plus m. 00:40:15.600 --> 00:40:18.962 align:middle line:84% And that's the wage-setting equation, which is obviously 00:40:18.962 --> 00:40:21.420 align:middle line:84% decreasing unemployment because the higher is unemployment, 00:40:21.420 --> 00:40:23.730 align:middle line:84% the lower the wage demand by the workers. 00:40:23.730 --> 00:40:26.670 align:middle line:84% And that's one natural rate of unemployment. 00:40:26.670 --> 00:40:29.070 align:middle line:84% Again, nothing natural, it's a function of parameters. 00:40:29.070 --> 00:40:30.150 align:middle line:90% Which parameters? 00:40:30.150 --> 00:40:32.280 align:middle line:84% Well, it's a function of that markup parameter, 00:40:32.280 --> 00:40:34.470 align:middle line:84% it's a function of this institutional variable 00:40:34.470 --> 00:40:37.470 align:middle line:90% z, for example. 00:40:37.470 --> 00:40:39.840 align:middle line:90% So that's an equation. 00:40:39.840 --> 00:40:43.810 align:middle line:84% That's an example in which z goes up. 00:40:43.810 --> 00:40:47.365 align:middle line:84% So suppose that somehow unions go up 00:40:47.365 --> 00:40:49.240 align:middle line:84% or something like that, unionization goes up, 00:40:49.240 --> 00:40:50.520 align:middle line:90% something of that kind. 00:40:50.520 --> 00:40:53.310 align:middle line:84% Or unemployment benefits go up, something 00:40:53.310 --> 00:40:55.380 align:middle line:84% of that kind, which, in principle, is 00:40:55.380 --> 00:40:56.370 align:middle line:90% supportive of workers. 00:40:56.370 --> 00:40:58.890 align:middle line:84% Well, in this model, that will immediately 00:40:58.890 --> 00:41:01.530 align:middle line:84% lead to an increase in wage demand-- 00:41:01.530 --> 00:41:03.900 align:middle line:84% at this level of unemployment, there 00:41:03.900 --> 00:41:08.040 align:middle line:84% are going to be a higher demand of-- a higher real wage 00:41:08.040 --> 00:41:10.690 align:middle line:84% demand by the workers because they have more bargaining power 00:41:10.690 --> 00:41:11.460 align:middle line:90% now. 00:41:11.460 --> 00:41:15.870 align:middle line:84% In this particular model, that cannot happen because the real 00:41:15.870 --> 00:41:19.860 align:middle line:84% wage that firms are willing to pay is only this, 1, 1 plus m. 00:41:19.860 --> 00:41:21.930 align:middle line:84% So in order to restore equilibrium 00:41:21.930 --> 00:41:24.480 align:middle line:84% in the labor market, what has to happen 00:41:24.480 --> 00:41:27.420 align:middle line:84% is unemployment-- natural rate of unemployment will go up, 00:41:27.420 --> 00:41:30.000 align:middle line:84% and that will restore equilibrium here 00:41:30.000 --> 00:41:33.930 align:middle line:84% because, well, the workers-- the bargaining power workers gain 00:41:33.930 --> 00:41:36.480 align:middle line:84% through those benefits in z they end up 00:41:36.480 --> 00:41:39.990 align:middle line:84% losing by an increase in the equilibrium 00:41:39.990 --> 00:41:41.550 align:middle line:90% level of unemployment. 00:41:41.550 --> 00:41:45.600 align:middle line:84% So that's the reason here this stuff backfire in a sense-- 00:41:45.600 --> 00:41:47.550 align:middle line:84% to the workers because you end up 00:41:47.550 --> 00:41:49.750 align:middle line:84% with higher natural rate of unemployment. 00:41:49.750 --> 00:41:52.590 align:middle line:84% So Europe, for example, has much higher labor protection 00:41:52.590 --> 00:41:53.280 align:middle line:90% than the US. 00:41:53.280 --> 00:41:56.400 align:middle line:84% Well, they typically have a much higher unemployment rate 00:41:56.400 --> 00:41:57.540 align:middle line:90% than the US. 00:41:57.540 --> 00:42:00.930 align:middle line:84% So that trade-offs, all these things. 00:42:00.930 --> 00:42:03.030 align:middle line:84% That's the case of increasing the markup, 00:42:03.030 --> 00:42:05.310 align:middle line:84% and increasing the markup means effectively 00:42:05.310 --> 00:42:09.570 align:middle line:84% that the firms are going offering a lower real wage. 00:42:09.570 --> 00:42:11.280 align:middle line:84% Well, at this level of unemployment, 00:42:11.280 --> 00:42:13.870 align:middle line:84% workers are not going to take that lower real wage. 00:42:13.870 --> 00:42:15.690 align:middle line:84% So what will have to happen for workers 00:42:15.690 --> 00:42:19.673 align:middle line:84% to take that lower real wage is for unemployment to rise. 00:42:19.673 --> 00:42:22.215 align:middle line:84% So those are the two canonical experiments you can have here. 00:42:22.215 --> 00:42:24.780 align:middle line:84% It's what happens when markups go up. 00:42:24.780 --> 00:42:27.580 align:middle line:84% And that can go-- they can go up for the wrong reasons. 00:42:27.580 --> 00:42:31.170 align:middle line:84% It could be for oil shocks and stuff like that. 00:42:31.170 --> 00:42:33.990 align:middle line:84% It could be because the market becomes less competitive 00:42:33.990 --> 00:42:35.920 align:middle line:84% or it will be used to [INAUDIBLE] and so on. 00:42:35.920 --> 00:42:39.210 align:middle line:84% But the final outcome here is that we end up with a higher 00:42:39.210 --> 00:42:41.250 align:middle line:84% natural rate of unemployment, which, again, 00:42:41.250 --> 00:42:44.310 align:middle line:84% highlights the idea that this is not a God-given unemployment 00:42:44.310 --> 00:42:45.600 align:middle line:90% rate, so it's not-- 00:42:45.600 --> 00:42:47.790 align:middle line:84% it's not good in any sense, it's just 00:42:47.790 --> 00:42:49.401 align:middle line:90% whatever it is the equilibrium. 00:42:49.401 --> 00:42:52.230 align:middle line:90% 00:42:52.230 --> 00:42:53.500 align:middle line:90% OK. 00:42:53.500 --> 00:42:54.000 align:middle line:90% Anyway. 00:42:54.000 --> 00:42:56.580 align:middle line:84% So you should understand well what these two type of shocks 00:42:56.580 --> 00:43:00.040 align:middle line:84% do to the natural rate of unemployment. 00:43:00.040 --> 00:43:01.360 align:middle line:90% And I think that's-- 00:43:01.360 --> 00:43:04.630 align:middle line:84% because lecture 9 is not for this quiz. 00:43:04.630 --> 00:43:07.440 align:middle line:90% 00:43:07.440 --> 00:43:08.730 align:middle line:90% That's all I want to say. 00:43:08.730 --> 00:43:09.780 align:middle line:90% Any questions? 00:43:09.780 --> 00:43:13.910 align:middle line:90% 00:43:13.910 --> 00:43:15.050 align:middle line:90% No? 00:43:15.050 --> 00:43:16.595 align:middle line:90% So-- oh, yeah. 00:43:16.595 --> 00:43:19.310 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:43:19.310 --> 00:43:21.918 align:middle line:90% 00:43:21.918 --> 00:43:22.960 align:middle line:90% RICHARDO CABALLERO: Yeah. 00:43:22.960 --> 00:43:25.730 align:middle line:90% 00:43:25.730 --> 00:43:26.955 align:middle line:90% This? 00:43:26.955 --> 00:43:27.830 align:middle line:90% AUDIENCE: I think so. 00:43:27.830 --> 00:43:30.478 align:middle line:84% I think-- is that the same x as next to the-- 00:43:30.478 --> 00:43:31.520 align:middle line:90% RICHARDO CABALLERO: Yeah. 00:43:31.520 --> 00:43:32.603 align:middle line:90% This is the credit spread. 00:43:32.603 --> 00:43:34.400 align:middle line:90% AUDIENCE: All right. 00:43:34.400 --> 00:43:36.490 align:middle line:84% RICHARDO CABALLERO: You want me to explain this-- 00:43:36.490 --> 00:43:38.400 align:middle line:84% AUDIENCE: I just want to make sure it's credit spread. 00:43:38.400 --> 00:43:40.567 align:middle line:84% RICHARDO CABALLERO: Yeah, this is the credit spread. 00:43:40.567 --> 00:43:42.810 align:middle line:84% I said-- that's the way you calculate this credit 00:43:42.810 --> 00:43:43.840 align:middle line:90% spread here. 00:43:43.840 --> 00:43:46.548 align:middle line:84% It's-- remember, there are two reasons why-- 00:43:46.548 --> 00:43:52.430 align:middle line:90% 00:43:52.430 --> 00:43:55.480 align:middle line:90% you really want to know? 00:43:55.480 --> 00:43:58.600 align:middle line:90% In any event, let me say. 00:43:58.600 --> 00:44:02.150 align:middle line:84% So there are two reasons why the credit spreads really happened. 00:44:02.150 --> 00:44:04.540 align:middle line:84% One is the actual probability of default 00:44:04.540 --> 00:44:07.810 align:middle line:84% of a bond, which the Treasury has a very low probability 00:44:07.810 --> 00:44:09.940 align:middle line:84% to default. Corporations, depending on the ratings, 00:44:09.940 --> 00:44:11.470 align:middle line:90% they may have a high or low. 00:44:11.470 --> 00:44:13.690 align:middle line:84% And the other one, which is very significant, 00:44:13.690 --> 00:44:16.120 align:middle line:84% is how risk-averse investors are. 00:44:16.120 --> 00:44:20.410 align:middle line:84% And that risk aversion changes a lot over the business cycle. 00:44:20.410 --> 00:44:23.960 align:middle line:84% We capture everything through just that x spread, which 00:44:23.960 --> 00:44:26.090 align:middle line:84% we capture through this probability of default. 00:44:26.090 --> 00:44:28.090 align:middle line:84% But you can think of that probability of default 00:44:28.090 --> 00:44:30.023 align:middle line:84% as being the perceived probability of default. 00:44:30.023 --> 00:44:32.440 align:middle line:84% When you're very scared, you perceive that terrible things 00:44:32.440 --> 00:44:33.670 align:middle line:90% can happen. 00:44:33.670 --> 00:44:37.400 align:middle line:84% So it's a subjective probability of default. 00:44:37.400 --> 00:44:40.300 align:middle line:84% So when that probability of default is different from 0, 00:44:40.300 --> 00:44:43.740 align:middle line:84% then you start getting a positive spread. 00:44:43.740 --> 00:44:45.690 align:middle line:84% AUDIENCE: How impactful is the actual default? 00:44:45.690 --> 00:44:49.170 align:middle line:84% I know there were some recent defaults in at least the 00:44:49.170 --> 00:44:50.800 align:middle line:90% European real estate markets. 00:44:50.800 --> 00:44:51.900 align:middle line:90% RICHARDO CABALLERO: Yeah. 00:44:51.900 --> 00:44:52.733 align:middle line:90% AUDIENCE: Like how-- 00:44:52.733 --> 00:44:56.295 align:middle line:84% I guess, is there a difference between a fear of a default 00:44:56.295 --> 00:44:58.420 align:middle line:84% and like an actual default, like the implications-- 00:44:58.420 --> 00:44:59.378 align:middle line:90% RICHARDO CABALLERO: Oh. 00:44:59.378 --> 00:45:01.270 align:middle line:84% This is all about perceived risk. 00:45:01.270 --> 00:45:04.980 align:middle line:84% So because this determines the borrowing 00:45:04.980 --> 00:45:07.740 align:middle line:84% that firms can do-- the cost for firms of borrowing. 00:45:07.740 --> 00:45:10.680 align:middle line:84% If you already defaulted, you cannot borrow, so that's over. 00:45:10.680 --> 00:45:12.390 align:middle line:90% That has other consequences. 00:45:12.390 --> 00:45:14.760 align:middle line:84% It may have impact on the balance sheets of the banks, 00:45:14.760 --> 00:45:18.162 align:middle line:84% it's destruction of wealth, it may lead to other problems. 00:45:18.162 --> 00:45:20.370 align:middle line:84% But the problem we're highlighting here in this model 00:45:20.370 --> 00:45:21.900 align:middle line:84% is the cost of borrowing, and that 00:45:21.900 --> 00:45:28.650 align:middle line:84% is something that happens only before you default. 00:45:28.650 --> 00:45:29.220 align:middle line:90% Yeah. 00:45:29.220 --> 00:45:32.670 align:middle line:84% I mean, actual defaults, especially typically 00:45:32.670 --> 00:45:34.140 align:middle line:84% in developers and stuff like that, 00:45:34.140 --> 00:45:37.390 align:middle line:84% can-- and that's what happened in the Great Recession, 00:45:37.390 --> 00:45:39.510 align:middle line:84% it can have consequences, especially 00:45:39.510 --> 00:45:43.170 align:middle line:84% for the banks that typically lend to these developers 00:45:43.170 --> 00:45:44.020 align:middle line:90% and so on. 00:45:44.020 --> 00:45:47.430 align:middle line:84% But I may do something about financial crisis, 00:45:47.430 --> 00:45:50.280 align:middle line:84% but much later in the course at the end. 00:45:50.280 --> 00:45:50.970 align:middle line:90% OK. 00:45:50.970 --> 00:45:51.700 align:middle line:90% Well, good luck. 00:45:51.700 --> 00:45:52.200 align:middle line:90% Enjoy it. 00:45:52.200 --> 00:45:57.110 align:middle line:84% If you understood what I said today, you're in good shape. 00:45:57.110 --> 00:46:09.000 align:middle line:90%