WEBVTT 00:00:00.000 --> 00:00:01.458 align:middle line:90% [SQUEAKING] 00:00:01.458 --> 00:00:02.916 align:middle line:90% [RUSTLING] 00:00:02.916 --> 00:00:04.860 align:middle line:90% [CLICKING] 00:00:04.860 --> 00:00:15.188 align:middle line:90% 00:00:15.188 --> 00:00:16.730 align:middle line:84% RICARDO J. CABALLERO: So today, we're 00:00:16.730 --> 00:00:21.050 align:middle line:84% going to talk about perhaps the most important model 00:00:21.050 --> 00:00:23.870 align:middle line:84% in this class, the IS-LM-PC model, which 00:00:23.870 --> 00:00:26.670 align:middle line:84% puts together all that we have done up to now. 00:00:26.670 --> 00:00:30.860 align:middle line:84% But before we do that, let's talk a little bit 00:00:30.860 --> 00:00:33.760 align:middle line:90% about current events. 00:00:33.760 --> 00:00:35.227 align:middle line:90% Who knows what that is? 00:00:35.227 --> 00:00:37.909 align:middle line:90% 00:00:37.909 --> 00:00:40.160 align:middle line:90% Is this exam week or what? 00:00:40.160 --> 00:00:42.008 align:middle line:90% [LAUGHS] 00:00:42.008 --> 00:00:43.860 align:middle line:90% AUDIENCE: Silicon Valley Bank. 00:00:43.860 --> 00:00:46.330 align:middle line:84% RICARDO J. CABALLERO: Silicon Valley Bank, exactly. 00:00:46.330 --> 00:00:51.780 align:middle line:84% So Silicon Valley Bank, the 16th bank in size, asset size, 00:00:51.780 --> 00:00:57.450 align:middle line:84% in the US went, essentially, under last Friday. 00:00:57.450 --> 00:01:02.380 align:middle line:84% It was shut down by the FDIC last Friday. 00:01:02.380 --> 00:01:04.980 align:middle line:84% So that's the decline in the stock 00:01:04.980 --> 00:01:08.630 align:middle line:90% value during Thursday, Friday. 00:01:08.630 --> 00:01:11.340 align:middle line:84% And then it was shut down, and you 00:01:11.340 --> 00:01:15.360 align:middle line:84% see that it's not been traded anymore. 00:01:15.360 --> 00:01:17.400 align:middle line:84% So that's a pretty significant event. 00:01:17.400 --> 00:01:20.460 align:middle line:84% And the weekend was pretty stressful for anyone 00:01:20.460 --> 00:01:23.070 align:middle line:90% involved in this event-- 00:01:23.070 --> 00:01:29.200 align:middle line:84% the Treasury, the FDIC, the Federal Reserve, and so on. 00:01:29.200 --> 00:01:32.130 align:middle line:84% And it's first-- it was a large-- 00:01:32.130 --> 00:01:35.380 align:middle line:84% I mean, it's not one of the big systemic banks, if you will. 00:01:35.380 --> 00:01:40.410 align:middle line:84% It's not JP Morgan, Citi, Bank of America, one of those banks, 00:01:40.410 --> 00:01:43.350 align:middle line:84% which are regulated even differently from these banks. 00:01:43.350 --> 00:01:46.980 align:middle line:84% But it still is a pretty large bank, as you see, by asset size, 00:01:46.980 --> 00:01:52.525 align:middle line:84% $209 billion, which is comparable to Washington 00:01:52.525 --> 00:01:54.150 align:middle line:84% Mutual, which was the largest bank that 00:01:54.150 --> 00:01:56.400 align:middle line:84% went under during the global financial crisis. 00:01:56.400 --> 00:01:57.420 align:middle line:90% Great Recession. 00:01:57.420 --> 00:02:01.740 align:middle line:84% At that time, there were lots of other banks that went under. 00:02:01.740 --> 00:02:04.680 align:middle line:84% But the largest was comparable to this one. 00:02:04.680 --> 00:02:07.350 align:middle line:84% And in fact, all the things that were done over the weekend 00:02:07.350 --> 00:02:09.000 align:middle line:84% and are still being done today is 00:02:09.000 --> 00:02:12.540 align:middle line:84% to prevent something like this happening here as well. 00:02:12.540 --> 00:02:17.670 align:middle line:84% And so it was a pretty significant event. 00:02:17.670 --> 00:02:22.920 align:middle line:84% Now, what happened to Silicon Valley Bank? 00:02:22.920 --> 00:02:27.060 align:middle line:84% Well, in the immediate cost of the failure 00:02:27.060 --> 00:02:30.330 align:middle line:84% is what always kills a bank, which is a run on its-- 00:02:30.330 --> 00:02:32.400 align:middle line:90% by these depositors. 00:02:32.400 --> 00:02:34.810 align:middle line:84% And what you see here is the following. 00:02:34.810 --> 00:02:37.170 align:middle line:84% This is-- this bank actually grew 00:02:37.170 --> 00:02:39.450 align:middle line:84% enormously over the last two, three years, 00:02:39.450 --> 00:02:41.505 align:middle line:84% essentially doubled its asset size. 00:02:41.505 --> 00:02:44.160 align:middle line:90% 00:02:44.160 --> 00:02:46.860 align:middle line:84% But it began to have sort of outflow-- 00:02:46.860 --> 00:02:50.940 align:middle line:84% net outflows of deposits during 2022. 00:02:50.940 --> 00:02:53.940 align:middle line:84% And the reason for that is not because the business 00:02:53.940 --> 00:02:55.980 align:middle line:90% was doing poorly or anything. 00:02:55.980 --> 00:02:59.700 align:middle line:84% It was simply because this is a bank that serves primarily 00:02:59.700 --> 00:03:01.960 align:middle line:90% sort of the tech sector-- 00:03:01.960 --> 00:03:04.310 align:middle line:84% startups, companies, and things like that. 00:03:04.310 --> 00:03:06.910 align:middle line:84% And those sectors were having a hard time 00:03:06.910 --> 00:03:09.190 align:middle line:84% raising new capital in an environment that 00:03:09.190 --> 00:03:13.390 align:middle line:84% was not very friendly towards the tech sector. 00:03:13.390 --> 00:03:15.970 align:middle line:84% So they began to withdraw on their deposits, 00:03:15.970 --> 00:03:18.580 align:middle line:84% and that's what led to these flows here. 00:03:18.580 --> 00:03:26.400 align:middle line:84% Now, eventually, because of this and something 00:03:26.400 --> 00:03:30.820 align:middle line:84% I'll explain in a few minutes, they 00:03:30.820 --> 00:03:35.680 align:middle line:84% decided, SV Bank decided to issue new equity, 00:03:35.680 --> 00:03:39.760 align:middle line:84% issue new equity to cover certain losses 00:03:39.760 --> 00:03:40.840 align:middle line:90% they had incurred. 00:03:40.840 --> 00:03:42.940 align:middle line:84% And today, in the modern of social-- 00:03:42.940 --> 00:03:45.700 align:middle line:84% in the world of social media, that immediately 00:03:45.700 --> 00:03:48.980 align:middle line:84% led to sort of massive spread that this bank was in trouble. 00:03:48.980 --> 00:03:52.660 align:middle line:84% And then you saw enormous attempts to withdraw deposits. 00:03:52.660 --> 00:03:54.580 align:middle line:84% Now, not all of these were fulfilled, 00:03:54.580 --> 00:03:58.990 align:middle line:84% but there was a massive pressure to withdraw the deposits. 00:03:58.990 --> 00:04:01.840 align:middle line:84% And that's the end, always, for a bank 00:04:01.840 --> 00:04:04.360 align:middle line:84% that doesn't find an alternative source of funding. 00:04:04.360 --> 00:04:07.540 align:middle line:84% And often, for withdrawals of that size, 00:04:07.540 --> 00:04:09.250 align:middle line:84% the only alternative source of funding 00:04:09.250 --> 00:04:11.380 align:middle line:84% is either that some other bank buys you [CHUCKLES] 00:04:11.380 --> 00:04:14.260 align:middle line:84% or that the Fed comes in and gives you a line. 00:04:14.260 --> 00:04:16.940 align:middle line:90% 00:04:16.940 --> 00:04:20.959 align:middle line:84% Anyway, so what is the-- that was immediate, and it's always-- 00:04:20.959 --> 00:04:22.130 align:middle line:90% whenever you ask-- 00:04:22.130 --> 00:04:25.730 align:middle line:84% you hear about the bank run, the immediate cause of the problem 00:04:25.730 --> 00:04:30.700 align:middle line:84% is a run of the depositors from deposits in that bank. 00:04:30.700 --> 00:04:36.230 align:middle line:84% Now, why did this happen in this particular bank? 00:04:36.230 --> 00:04:38.060 align:middle line:90% Again, I explained why. 00:04:38.060 --> 00:04:41.240 align:middle line:84% You saw those small withdrawals of deposits. 00:04:41.240 --> 00:04:45.080 align:middle line:84% But what happens to them is actually their-- 00:04:45.080 --> 00:04:48.470 align:middle line:84% as I said before, their deposits grew very rapidly 00:04:48.470 --> 00:04:50.300 align:middle line:90% over the last two, three years. 00:04:50.300 --> 00:04:54.320 align:middle line:84% And then, rather than being very risky lenders, 00:04:54.320 --> 00:04:56.420 align:middle line:84% rather than investing-- sometimes 00:04:56.420 --> 00:05:00.140 align:middle line:84% when banks grow very rapidly they do lots of crazy things. 00:05:00.140 --> 00:05:03.920 align:middle line:84% They make lots of loans without doing the due diligence 00:05:03.920 --> 00:05:05.330 align:middle line:90% process and all that. 00:05:05.330 --> 00:05:06.840 align:middle line:90% That's not what they did. 00:05:06.840 --> 00:05:10.790 align:middle line:84% They bought Treasury bonds, the safest assets you can imagine. 00:05:10.790 --> 00:05:14.240 align:middle line:84% They bought 10-year Treasury bonds, lots of them. 00:05:14.240 --> 00:05:16.370 align:middle line:84% But they bought them at the wrong time. 00:05:16.370 --> 00:05:19.430 align:middle line:84% They bought them right before the hike in interest rates 00:05:19.430 --> 00:05:22.760 align:middle line:90% that we began to see in 2022. 00:05:22.760 --> 00:05:25.400 align:middle line:84% And we already looked at the relationship between interest 00:05:25.400 --> 00:05:26.640 align:middle line:90% rates and price of bonds. 00:05:26.640 --> 00:05:30.080 align:middle line:84% Well, you have a 10-year bond, and the interest rate starts 00:05:30.080 --> 00:05:32.910 align:middle line:84% going up, the price of that bond starts declining. 00:05:32.910 --> 00:05:36.180 align:middle line:84% Now, that is not-- is problematic for a bank, 00:05:36.180 --> 00:05:39.000 align:middle line:84% but not entirely the end of the story, 00:05:39.000 --> 00:05:41.520 align:middle line:84% because that means that the market 00:05:41.520 --> 00:05:43.860 align:middle line:84% value of the bonds you are holding among your assets 00:05:43.860 --> 00:05:45.300 align:middle line:90% starts declining. 00:05:45.300 --> 00:05:50.310 align:middle line:84% But banks do not need to recognize that loss unless they 00:05:50.310 --> 00:05:53.850 align:middle line:84% sell the bonds, because the logic 00:05:53.850 --> 00:05:55.907 align:middle line:84% is that, well, if the guy just sits on the bond, 00:05:55.907 --> 00:05:57.990 align:middle line:84% the bond hasn't really lost any value in the sense 00:05:57.990 --> 00:05:59.698 align:middle line:84% that it will get the same coupons that it 00:05:59.698 --> 00:06:01.000 align:middle line:90% was planning to get and so on. 00:06:01.000 --> 00:06:03.018 align:middle line:84% This is US treasuries US treasuries are not 00:06:03.018 --> 00:06:04.560 align:middle line:84% going to default on the coupons let's 00:06:04.560 --> 00:06:07.710 align:middle line:84% hope it's not going to happen in a few months from now. 00:06:07.710 --> 00:06:11.040 align:middle line:84% But typically they don't default on coupons. 00:06:11.040 --> 00:06:15.360 align:middle line:84% So the logic-- the regulation is designed in such a way-- perhaps 00:06:15.360 --> 00:06:16.110 align:middle line:90% that is a failure. 00:06:16.110 --> 00:06:17.485 align:middle line:84% I think there is a problem there. 00:06:17.485 --> 00:06:21.930 align:middle line:84% But they don't need to recognize the losses 00:06:21.930 --> 00:06:24.130 align:middle line:90% unless they sell the bonds. 00:06:24.130 --> 00:06:27.000 align:middle line:84% So they look pretty healthy because they had massive amounts 00:06:27.000 --> 00:06:27.780 align:middle line:90% of Treasury bonds. 00:06:27.780 --> 00:06:30.360 align:middle line:84% They didn't need to recognize that. 00:06:30.360 --> 00:06:35.400 align:middle line:84% Problem is that when these relatively small withdrawals 00:06:35.400 --> 00:06:38.490 align:middle line:84% start, at some point, they needed 00:06:38.490 --> 00:06:40.560 align:middle line:84% to find a substitute for those funds. 00:06:40.560 --> 00:06:43.950 align:middle line:84% They need to honor the deposits that were being withdrawn. 00:06:43.950 --> 00:06:46.180 align:middle line:84% And at that point, they had to sell assets. 00:06:46.180 --> 00:06:48.810 align:middle line:84% And when they sold assets, they made the loss 00:06:48.810 --> 00:06:51.060 align:middle line:84% because, at that point, you have to recognize the loss 00:06:51.060 --> 00:06:54.580 align:middle line:84% because you're not going to hold the bond until expiration 00:06:54.580 --> 00:06:56.660 align:middle line:84% and clip all the coupons that come from it. 00:06:56.660 --> 00:06:58.570 align:middle line:84% So you have to recognize the loss. 00:06:58.570 --> 00:07:04.000 align:middle line:84% That's the loss that led the CEO to announce that they needed 00:07:04.000 --> 00:07:07.990 align:middle line:84% fundraising to cover up $2.5-billion hole they had 00:07:07.990 --> 00:07:10.870 align:middle line:90% as a result of the losses. 00:07:10.870 --> 00:07:16.160 align:middle line:84% Now-- OK, so now we know where the losses came from. 00:07:16.160 --> 00:07:18.340 align:middle line:84% Now, if you notice, the losses are not that big. 00:07:18.340 --> 00:07:20.590 align:middle line:84% I mean, this is a bank with $200 billion, 00:07:20.590 --> 00:07:24.590 align:middle line:84% and the losses were relatively small. 00:07:24.590 --> 00:07:26.900 align:middle line:84% Where is the other leg of the problem? 00:07:26.900 --> 00:07:29.170 align:middle line:90% It's here. 00:07:29.170 --> 00:07:34.540 align:middle line:84% In the US, deposits are insured up to $250,000. 00:07:34.540 --> 00:07:36.970 align:middle line:84% That means, no matter what happens to the bank where you 00:07:36.970 --> 00:07:40.810 align:middle line:84% have the money, if that bank goes under, 00:07:40.810 --> 00:07:43.570 align:middle line:84% and you have deposits for below $250,000, 00:07:43.570 --> 00:07:45.650 align:middle line:84% the FDIC comes and gives you a check. 00:07:45.650 --> 00:07:47.600 align:middle line:90% So there is no risk. 00:07:47.600 --> 00:07:50.162 align:middle line:84% So you have a deposit under $250,000, 00:07:50.162 --> 00:07:51.620 align:middle line:84% you don't need to worry about this. 00:07:51.620 --> 00:07:54.460 align:middle line:84% You may go-- you don't need to read the news about this bank, 00:07:54.460 --> 00:07:57.050 align:middle line:90% because you will get your funds. 00:07:57.050 --> 00:08:01.000 align:middle line:84% In fact, when the bank was shut down on Friday, 00:08:01.000 --> 00:08:05.380 align:middle line:84% the FDIC announced immediately every deposit under $250,000 can 00:08:05.380 --> 00:08:07.670 align:middle line:84% come on Monday and get this money. 00:08:07.670 --> 00:08:09.400 align:middle line:90% So there is no issue there. 00:08:09.400 --> 00:08:12.337 align:middle line:84% And most banks have a large share of depositors 00:08:12.337 --> 00:08:13.420 align:middle line:90% that are small depositors. 00:08:13.420 --> 00:08:16.780 align:middle line:84% That means that they are covered by this deposit insurance 00:08:16.780 --> 00:08:21.113 align:middle line:84% mechanism, which was designed precisely to prevent runs 00:08:21.113 --> 00:08:22.780 align:middle line:84% because if you don't need to worry about 00:08:22.780 --> 00:08:25.810 align:middle line:84% whether you get your money, you don't need to run on the bank. 00:08:25.810 --> 00:08:28.850 align:middle line:84% The problem is that this bank was very different 00:08:28.850 --> 00:08:30.230 align:middle line:84% in the composition of depositors. 00:08:30.230 --> 00:08:34.080 align:middle line:84% It had primarily business deposits, 00:08:34.080 --> 00:08:36.500 align:middle line:84% meaning it was all these start up companies and so on 00:08:36.500 --> 00:08:37.309 align:middle line:90% in the tech sector. 00:08:37.309 --> 00:08:39.049 align:middle line:90% They had their deposits there. 00:08:39.049 --> 00:08:42.350 align:middle line:84% And those deposits were much larger than $250,000. 00:08:42.350 --> 00:08:45.650 align:middle line:90% If you see, it's about-- 00:08:45.650 --> 00:08:48.620 align:middle line:84% I think it's close to 95% of the deposits were not 00:08:48.620 --> 00:08:52.580 align:middle line:84% covered by the insurance, by the FDIC insurance. 00:08:52.580 --> 00:08:55.010 align:middle line:84% That means it's a very different calculation when 00:08:55.010 --> 00:08:58.170 align:middle line:84% you have a deposit that is not covered by insurance, 00:08:58.170 --> 00:09:00.850 align:middle line:84% and then you start feeling that the bank may go under. 00:09:00.850 --> 00:09:02.150 align:middle line:90% What do you do? 00:09:02.150 --> 00:09:04.450 align:middle line:84% You take your money out, put it in some-- 00:09:04.450 --> 00:09:07.570 align:middle line:84% you send it to JPMorgan, where there is no risk, 00:09:07.570 --> 00:09:10.950 align:middle line:84% and wait until this thing is resolved. 00:09:10.950 --> 00:09:12.113 align:middle line:90% Now, in this case-- 00:09:12.113 --> 00:09:13.530 align:middle line:84% and that's what typically happens. 00:09:13.530 --> 00:09:15.960 align:middle line:84% In this case, it happens even faster than normally. 00:09:15.960 --> 00:09:16.710 align:middle line:90% Why? 00:09:16.710 --> 00:09:18.930 align:middle line:84% Because many of the depositors, the businesses 00:09:18.930 --> 00:09:22.380 align:middle line:84% that were deposited in there, were 00:09:22.380 --> 00:09:28.140 align:middle line:84% startups that were being seeded by some venture capital funds. 00:09:28.140 --> 00:09:29.733 align:middle line:84% And venture capital funds, as soon 00:09:29.733 --> 00:09:31.650 align:middle line:84% as they noticed that there was a problem here, 00:09:31.650 --> 00:09:34.440 align:middle line:84% began to call all the startups and tell them, hey, 00:09:34.440 --> 00:09:36.610 align:middle line:84% take that money out of there because, you know, 00:09:36.610 --> 00:09:38.260 align:middle line:84% [CHUCKLES] they may run into trouble. 00:09:38.260 --> 00:09:41.130 align:middle line:84% So it was a venture capital world that 00:09:41.130 --> 00:09:43.420 align:middle line:90% caused the run, effectively. 00:09:43.420 --> 00:09:47.440 align:middle line:90% And that's what happened, OK? 00:09:47.440 --> 00:09:49.637 align:middle line:90% Now-- so that's what happened. 00:09:49.637 --> 00:09:50.887 align:middle line:90% That's the reason for the run. 00:09:50.887 --> 00:09:53.750 align:middle line:90% 00:09:53.750 --> 00:09:55.920 align:middle line:90% And so there was a problem. 00:09:55.920 --> 00:09:57.950 align:middle line:84% The problem was not that big, but the problem 00:09:57.950 --> 00:09:59.943 align:middle line:84% is that the deposits were very unsafe. 00:09:59.943 --> 00:10:00.860 align:middle line:90% They were not covered. 00:10:00.860 --> 00:10:02.930 align:middle line:84% And moving deposits out is very easy. 00:10:02.930 --> 00:10:08.060 align:middle line:84% I mean, you just [CHUCKLES] wire your money to another bank. 00:10:08.060 --> 00:10:09.650 align:middle line:90% So why wait there? 00:10:09.650 --> 00:10:10.280 align:middle line:90% Why risk it? 00:10:10.280 --> 00:10:12.720 align:middle line:90% And that's what happened. 00:10:12.720 --> 00:10:15.680 align:middle line:84% It's called, in economics, coordination failure. 00:10:15.680 --> 00:10:17.340 align:middle line:84% I mean, if everyone freezes and says, 00:10:17.340 --> 00:10:19.190 align:middle line:84% OK, nobody takes the money out and so on, 00:10:19.190 --> 00:10:22.190 align:middle line:84% this stuff is going to pass, then we're safe. 00:10:22.190 --> 00:10:24.167 align:middle line:84% But since we don't call each other, 00:10:24.167 --> 00:10:26.750 align:middle line:84% and we don't trust each other to really leave the money there, 00:10:26.750 --> 00:10:29.990 align:middle line:84% we make the call only after we have taken our money out. 00:10:29.990 --> 00:10:31.490 align:middle line:84% And since we all think the same way, 00:10:31.490 --> 00:10:34.433 align:middle line:90% then you get a run on the bank. 00:10:34.433 --> 00:10:36.350 align:middle line:84% Now, let me start connecting this a little bit 00:10:36.350 --> 00:10:40.820 align:middle line:84% with the kind of things we have done in this course. 00:10:40.820 --> 00:10:44.390 align:middle line:84% I made-- actually, this runs later 00:10:44.390 --> 00:10:47.965 align:middle line:84% in the course as a topic, crisis, speculative attacks, 00:10:47.965 --> 00:10:48.840 align:middle line:90% and things like that. 00:10:48.840 --> 00:10:54.430 align:middle line:84% But for now, here what you have is an indicator of-- 00:10:54.430 --> 00:10:57.340 align:middle line:90% essentially, this is the VIX. 00:10:57.340 --> 00:11:00.340 align:middle line:84% It's an indicator of implied volatility, something 00:11:00.340 --> 00:11:02.440 align:middle line:84% that's extracted from the price of options. 00:11:02.440 --> 00:11:04.580 align:middle line:84% You don't need to know the details. 00:11:04.580 --> 00:11:09.310 align:middle line:84% But the point is that it's one of the main indicators of fear, 00:11:09.310 --> 00:11:13.150 align:middle line:84% of how afraid are investors in a moment in the market. 00:11:13.150 --> 00:11:17.230 align:middle line:84% And what you can see here is that this indicator, 00:11:17.230 --> 00:11:25.540 align:middle line:84% the VIX, essentially, spiked Thursday and Friday, went up-- 00:11:25.540 --> 00:11:27.460 align:middle line:84% Friday, went up very, very rapidly. 00:11:27.460 --> 00:11:30.070 align:middle line:84% And then it got stabilized a little. 00:11:30.070 --> 00:11:34.270 align:middle line:84% Now, it turned out that-- it turns out that, 00:11:34.270 --> 00:11:40.190 align:middle line:84% over the weekend, you may have heard, the government, 00:11:40.190 --> 00:11:43.460 align:middle line:84% the consolidated government, came up with a very massive 00:11:43.460 --> 00:11:48.953 align:middle line:84% package to prevent runs on the remaining banks and also 00:11:48.953 --> 00:11:50.120 align:middle line:90% to prevent-- the fact that-- 00:11:50.120 --> 00:11:52.370 align:middle line:84% I mean, all of these were business deposits 00:11:52.370 --> 00:11:57.080 align:middle line:84% of small companies that used even this bank for the payroll 00:11:57.080 --> 00:11:58.490 align:middle line:90% and so on. 00:11:58.490 --> 00:12:01.460 align:middle line:84% So what was done this weekend is that all the deposits, 00:12:01.460 --> 00:12:04.010 align:middle line:84% not only the ones under $250,000, 00:12:04.010 --> 00:12:06.830 align:middle line:90% were guaranteed by the FDIC. 00:12:06.830 --> 00:12:09.510 align:middle line:84% There are mechanisms in which you can activate that. 00:12:09.510 --> 00:12:13.460 align:middle line:84% So that means that now all the depositors were made whole. 00:12:13.460 --> 00:12:16.610 align:middle line:90% 00:12:16.610 --> 00:12:18.955 align:middle line:90% But the idea was not-- it was-- 00:12:18.955 --> 00:12:20.330 align:middle line:84% partly, the reason to do that, it 00:12:20.330 --> 00:12:23.630 align:middle line:84% was to prevent a mess in the payrolls 00:12:23.630 --> 00:12:25.880 align:middle line:84% of the small companies and all that that 00:12:25.880 --> 00:12:27.810 align:middle line:90% had their account in this bank. 00:12:27.810 --> 00:12:30.035 align:middle line:84% But it was also to prevent runs on other banks. 00:12:30.035 --> 00:12:33.020 align:middle line:90% 00:12:33.020 --> 00:12:36.260 align:middle line:84% And so on top of this, the Fed now 00:12:36.260 --> 00:12:41.870 align:middle line:84% has a line of credit for banks to not 00:12:41.870 --> 00:12:43.220 align:middle line:90% have to sell their assets. 00:12:43.220 --> 00:12:46.220 align:middle line:84% For small banks, they can just pledge the assets 00:12:46.220 --> 00:12:48.830 align:middle line:84% to the central bank and get in exchange for that the cash 00:12:48.830 --> 00:12:50.270 align:middle line:90% they need. 00:12:50.270 --> 00:12:54.170 align:middle line:84% And they can do that without recognizing the implicit loss 00:12:54.170 --> 00:12:58.470 align:middle line:84% or without marking to market the price of the bonds. 00:12:58.470 --> 00:13:03.820 align:middle line:84% So had this mechanism existed before, the plunge of SVB-- 00:13:03.820 --> 00:13:05.570 align:middle line:84% we would not have seen anything like that. 00:13:05.570 --> 00:13:08.420 align:middle line:84% But the whole idea was to prevent that other banks running 00:13:08.420 --> 00:13:09.950 align:middle line:90% into that kind of trouble. 00:13:09.950 --> 00:13:13.650 align:middle line:84% Now, the markets reacted well to all that overnight and so on. 00:13:13.650 --> 00:13:15.600 align:middle line:84% But the VIX kept going up this morning. 00:13:15.600 --> 00:13:16.927 align:middle line:90% Now it's coming down again. 00:13:16.927 --> 00:13:18.510 align:middle line:84% I mean, there's still a lot of stress. 00:13:18.510 --> 00:13:20.750 align:middle line:84% And if you see the shares of First Republic Bank, 00:13:20.750 --> 00:13:24.620 align:middle line:84% for example, had declined by 60% today and things like that. 00:13:24.620 --> 00:13:27.390 align:middle line:84% So there is a still panic going on, OK? 00:13:27.390 --> 00:13:32.220 align:middle line:84% And as a result of that, all these indicators of stress 00:13:32.220 --> 00:13:34.050 align:middle line:90% are very stressed out. 00:13:34.050 --> 00:13:35.880 align:middle line:84% [CHUCKLES] Remember credit spreads. 00:13:35.880 --> 00:13:39.127 align:middle line:84% I told you about that x that we had several lectures 00:13:39.127 --> 00:13:41.460 align:middle line:84% ago, the probability of default of a bond, the perceived 00:13:41.460 --> 00:13:44.760 align:middle line:84% possibility of default. All those things went up a lot. 00:13:44.760 --> 00:13:47.220 align:middle line:84% And the riskier the bonds, the closer you 00:13:47.220 --> 00:13:49.830 align:middle line:84% are to the financial system, particularly to small banks, 00:13:49.830 --> 00:13:51.540 align:middle line:84% the larger those spreads have become. 00:13:51.540 --> 00:13:54.150 align:middle line:90% So x went up a lot. 00:13:54.150 --> 00:13:57.330 align:middle line:84% This picture that comes next, I find 00:13:57.330 --> 00:14:01.080 align:middle line:84% it very interesting from the point of view of this course. 00:14:01.080 --> 00:14:03.100 align:middle line:90% What this is is the following. 00:14:03.100 --> 00:14:11.940 align:middle line:84% This is the market expectation of the next hike by the Fed. 00:14:11.940 --> 00:14:16.400 align:middle line:84% The Fed next announcement on policy rate happens on the 22nd, 00:14:16.400 --> 00:14:17.850 align:middle line:90% March 22. 00:14:17.850 --> 00:14:19.830 align:middle line:84% So remember what has been happening 00:14:19.830 --> 00:14:24.390 align:middle line:84% is that, since the US has been running sort of very hot, 00:14:24.390 --> 00:14:26.400 align:middle line:84% with lots of inflation, interest rates 00:14:26.400 --> 00:14:28.530 align:middle line:84% were increased very rapidly, at clips 00:14:28.530 --> 00:14:30.150 align:middle line:84% of 50 basis points, a clip that's 00:14:30.150 --> 00:14:33.270 align:middle line:84% very large changes in policy rates for a country 00:14:33.270 --> 00:14:34.890 align:middle line:90% as large as the US. 00:14:34.890 --> 00:14:39.570 align:middle line:84% And so we had this big 25 basis points increases. 00:14:39.570 --> 00:14:41.370 align:middle line:84% And a few meetings ago, they decided 00:14:41.370 --> 00:14:45.090 align:middle line:84% to lower the pace of the increases to 25 basis points, 00:14:45.090 --> 00:14:47.045 align:middle line:84% rather than 50 basis points per meeting. 00:14:47.045 --> 00:14:49.420 align:middle line:84% So they said, we're going to keep raising interest rates. 00:14:49.420 --> 00:14:52.150 align:middle line:84% But we're going to go out to 25 basis points. 00:14:52.150 --> 00:14:55.800 align:middle line:84% Now, it turns out-- so this is 25 basis points. 00:14:55.800 --> 00:14:57.600 align:middle line:90% The data has become very hot. 00:14:57.600 --> 00:14:59.610 align:middle line:84% Remember we said inflation looked to have peaked 00:14:59.610 --> 00:15:01.530 align:middle line:84% and now is beginning sort of to turn around again, 00:15:01.530 --> 00:15:02.790 align:middle line:90% and it's beginning to rise. 00:15:02.790 --> 00:15:05.730 align:middle line:84% So what has been happening is that the market says, 00:15:05.730 --> 00:15:10.500 align:middle line:84% OK, 25% basis points is the most likely next hike. 00:15:10.500 --> 00:15:12.850 align:middle line:84% But you see, the expectation of that 00:15:12.850 --> 00:15:15.580 align:middle line:84% is it was sort of steady around 30 basis points. 00:15:15.580 --> 00:15:17.560 align:middle line:84% Some people expected-- some major players 00:15:17.560 --> 00:15:20.590 align:middle line:84% expected the Fed to hike by 50 basis points, not 00:15:20.590 --> 00:15:22.120 align:middle line:90% 25 basis points. 00:15:22.120 --> 00:15:25.520 align:middle line:84% By early last week, data came very hot. 00:15:25.520 --> 00:15:27.520 align:middle line:84% So there was indication that, clearly, inflation 00:15:27.520 --> 00:15:28.540 align:middle line:90% was picking up again. 00:15:28.540 --> 00:15:31.010 align:middle line:84% The labor market was very strong and so on. 00:15:31.010 --> 00:15:32.500 align:middle line:84% So look what happened to the bets. 00:15:32.500 --> 00:15:34.510 align:middle line:84% Immediately, as expected, value went up. 00:15:34.510 --> 00:15:35.890 align:middle line:90% This is all traded. 00:15:35.890 --> 00:15:36.850 align:middle line:90% It went up. 00:15:36.850 --> 00:15:39.130 align:middle line:84% And the expectation was, for the next meeting, 00:15:39.130 --> 00:15:42.453 align:middle line:90% was north of 40 basis points. 00:15:42.453 --> 00:15:43.870 align:middle line:84% So essentially, most of the market 00:15:43.870 --> 00:15:49.930 align:middle line:84% thought that the next hike would be 50 basis points, OK? 00:15:49.930 --> 00:15:50.920 align:middle line:90% But look what happened. 00:15:50.920 --> 00:15:54.170 align:middle line:84% And then the problems with this bank began. 00:15:54.170 --> 00:15:55.700 align:middle line:90% And look how this plummeted. 00:15:55.700 --> 00:15:59.750 align:middle line:84% Today, it's 15 basis points expected value. 00:15:59.750 --> 00:16:03.050 align:middle line:84% That means very few people are expecting 50 basis points. 00:16:03.050 --> 00:16:05.300 align:middle line:84% A lot of people are thinking 25 still. 00:16:05.300 --> 00:16:08.180 align:middle line:84% But about an equal size is expecting 0-- 00:16:08.180 --> 00:16:13.010 align:middle line:84% so a pause in the interest rate hike by the Fed. 00:16:13.010 --> 00:16:15.800 align:middle line:84% And all that is a result of the events of the last two or three 00:16:15.800 --> 00:16:17.860 align:middle line:90% days. 00:16:17.860 --> 00:16:19.378 align:middle line:90% Yeah? 00:16:19.378 --> 00:16:21.170 align:middle line:84% AUDIENCE: What is there to learn from this, 00:16:21.170 --> 00:16:23.170 align:middle line:84% I guess, in the bigger structure? 00:16:23.170 --> 00:16:25.150 align:middle line:90% Or who's at fault? 00:16:25.150 --> 00:16:27.820 align:middle line:84% Is it the people who got really scared-- 00:16:27.820 --> 00:16:29.950 align:middle line:84% all these depositors that got potentially 00:16:29.950 --> 00:16:32.410 align:middle line:84% scared or fear-mongering that capacity? 00:16:32.410 --> 00:16:35.210 align:middle line:84% Is it that the banks don't necessarily have-- 00:16:35.210 --> 00:16:36.128 align:middle line:90% I mean, I can't-- 00:16:36.128 --> 00:16:37.420 align:middle line:90% feel like it's an unrealistic-- 00:16:37.420 --> 00:16:38.470 align:middle line:84% RICARDO J. CABALLERO: There are many good questions, 00:16:38.470 --> 00:16:40.360 align:middle line:84% and you're going to see a lot of that. 00:16:40.360 --> 00:16:42.443 align:middle line:84% And politicians are going to talk a lot about that 00:16:42.443 --> 00:16:43.750 align:middle line:90% in the next few days and so on. 00:16:43.750 --> 00:16:46.580 align:middle line:84% It's very clear that there was some sort of regulatory failure 00:16:46.580 --> 00:16:47.080 align:middle line:90% here. 00:16:47.080 --> 00:16:49.660 align:middle line:84% The regulator-- it was pretty obvious that-- 00:16:49.660 --> 00:16:53.200 align:middle line:84% I mean, this bank had doubled the asset size in a year. 00:16:53.200 --> 00:16:55.090 align:middle line:90% That's already a red flag. 00:16:55.090 --> 00:16:57.970 align:middle line:84% And these guys are regulated by the Fed. 00:16:57.970 --> 00:17:00.070 align:middle line:84% So the San Francisco Fed should have 00:17:00.070 --> 00:17:03.880 align:middle line:90% been worried about this bank. 00:17:03.880 --> 00:17:06.940 align:middle line:84% There is issues, conventional issues of diversification. 00:17:06.940 --> 00:17:09.339 align:middle line:84% I mean it's pretty crazy to have all your savings 00:17:09.339 --> 00:17:12.069 align:middle line:84% in one bank, [CHUCKLES] especially if you're not 00:17:12.069 --> 00:17:13.750 align:middle line:90% insured. 00:17:13.750 --> 00:17:16.870 align:middle line:84% There is issues-- there is also-- 00:17:16.870 --> 00:17:20.039 align:middle line:84% remember, after the global financial crisis, 00:17:20.039 --> 00:17:24.130 align:middle line:90% there was a bill designed to-- 00:17:24.130 --> 00:17:25.988 align:middle line:84% legislation designed to strengthen 00:17:25.988 --> 00:17:27.280 align:middle line:90% the balance sheet of the banks. 00:17:27.280 --> 00:17:29.780 align:middle line:84% It made them hold a lot more capital. 00:17:29.780 --> 00:17:31.690 align:middle line:84% They are subject to-- if they're systemic, 00:17:31.690 --> 00:17:34.270 align:middle line:84% they are considered-- they are subject to stress tests, where 00:17:34.270 --> 00:17:37.510 align:middle line:84% regulators go in there and check whether portfolios can survive 00:17:37.510 --> 00:17:40.690 align:middle line:90% major macro shocks and so on. 00:17:40.690 --> 00:17:42.970 align:middle line:84% And that's called the Dodd-Frank bill, OK? 00:17:42.970 --> 00:17:44.110 align:middle line:90% So that was done. 00:17:44.110 --> 00:17:48.280 align:middle line:84% In 2018, that got partially undone, 00:17:48.280 --> 00:17:51.220 align:middle line:84% and partially undone precisely for this type of banks. 00:17:51.220 --> 00:17:53.440 align:middle line:84% And these guys were actually lobbying for that. 00:17:53.440 --> 00:17:57.240 align:middle line:84% They said, OK, why don't you-- because to be sort of really 00:17:57.240 --> 00:17:58.990 align:middle line:84% stress-tested and so on by the regulators, 00:17:58.990 --> 00:18:00.448 align:middle line:84% you have to be big enough to really 00:18:00.448 --> 00:18:03.580 align:middle line:90% be able to leave a big mess. 00:18:03.580 --> 00:18:08.410 align:middle line:84% And so what these guys and banks like them did 00:18:08.410 --> 00:18:09.850 align:middle line:90% is they lobby a lot. 00:18:09.850 --> 00:18:13.700 align:middle line:84% So they got the threshold of assets 00:18:13.700 --> 00:18:17.480 align:middle line:84% that you need to have in order to be stress-tested 00:18:17.480 --> 00:18:19.620 align:middle line:90% and so on raised dramatically. 00:18:19.620 --> 00:18:22.220 align:middle line:84% So they were right below the level 00:18:22.220 --> 00:18:26.490 align:middle line:84% that you need to be really sort of monitored very, 00:18:26.490 --> 00:18:29.480 align:middle line:84% very closely by the regulators, by the Fed. 00:18:29.480 --> 00:18:32.630 align:middle line:84% If you're a systemic bank, then the Fed regulates you. 00:18:32.630 --> 00:18:34.850 align:middle line:84% These guys were lightly regulated by the Fed 00:18:34.850 --> 00:18:37.050 align:middle line:84% because they were below that threshold. 00:18:37.050 --> 00:18:39.170 align:middle line:84% So there are regulatory failures. 00:18:39.170 --> 00:18:43.250 align:middle line:84% It's clear that the regulator failed in what it did. 00:18:43.250 --> 00:18:48.140 align:middle line:84% Depositors didn't diversify enough. 00:18:48.140 --> 00:18:50.810 align:middle line:84% They didn't diversify enough, the bank itself, 00:18:50.810 --> 00:18:53.285 align:middle line:84% didn't diversify enough the source of funding. 00:18:53.285 --> 00:18:55.160 align:middle line:84% I mean, what is very special with this bank-- 00:18:55.160 --> 00:18:56.990 align:middle line:84% and that's what gives us hope that this stuff is not going 00:18:56.990 --> 00:18:58.340 align:middle line:90% to spread all around-- 00:18:58.340 --> 00:19:01.520 align:middle line:84% is that their funding was very sort of-- 00:19:01.520 --> 00:19:05.240 align:middle line:84% was all coming from the same sector, large saver-- 00:19:05.240 --> 00:19:07.105 align:middle line:90% large depositors and so on. 00:19:07.105 --> 00:19:08.480 align:middle line:84% A typical bank doesn't have that. 00:19:08.480 --> 00:19:10.710 align:middle line:84% They have a much broader source of funding, 00:19:10.710 --> 00:19:13.520 align:middle line:84% which is what you need because otherwise-- 00:19:13.520 --> 00:19:18.260 align:middle line:84% so there are lots of lessons for bankers, for regulators, 00:19:18.260 --> 00:19:19.850 align:middle line:90% for macroeconomists as well. 00:19:19.850 --> 00:19:21.890 align:middle line:84% I mean, to tell you the truth, one 00:19:21.890 --> 00:19:25.610 align:middle line:84% of the concerns with the pace at which the Fed has been hiking 00:19:25.610 --> 00:19:28.490 align:middle line:84% interest rates is that people were wondering, well, 00:19:28.490 --> 00:19:30.795 align:middle line:84% do we know whether something will break at some point? 00:19:30.795 --> 00:19:33.170 align:middle line:84% And there was lots of concern that something could break. 00:19:33.170 --> 00:19:34.253 align:middle line:90% Well, something broke now. 00:19:34.253 --> 00:19:37.580 align:middle line:90% And this broke entirely-- 00:19:37.580 --> 00:19:40.250 align:middle line:84% the part of the loss comes entirely 00:19:40.250 --> 00:19:41.510 align:middle line:90% from interest rate hikes. 00:19:41.510 --> 00:19:43.340 align:middle line:84% Essentially, they got into a portfolio 00:19:43.340 --> 00:19:47.010 align:middle line:84% of long-- that was very long rates when rates began to rise. 00:19:47.010 --> 00:19:49.860 align:middle line:84% So they had losses entirely from that. 00:19:49.860 --> 00:19:51.140 align:middle line:90% And that's the risk. 00:19:51.140 --> 00:19:53.420 align:middle line:84% I mean, when you do monetary policy, 00:19:53.420 --> 00:19:56.670 align:middle line:84% is that some people will be stretched out there. 00:19:56.670 --> 00:20:00.620 align:middle line:84% And if you sometimes miss one that is important, 00:20:00.620 --> 00:20:01.490 align:middle line:90% that's very costly. 00:20:01.490 --> 00:20:04.610 align:middle line:84% And I think that's one of the reasons they wanted 00:20:04.610 --> 00:20:09.680 align:middle line:84% to lower the interest rate hikes from 50 basis points to 25 basis 00:20:09.680 --> 00:20:12.200 align:middle line:84% points because they knew that something 00:20:12.200 --> 00:20:15.020 align:middle line:90% could be fragile out there. 00:20:15.020 --> 00:20:19.070 align:middle line:84% And this was one of those things. 00:20:19.070 --> 00:20:21.140 align:middle line:90% So those are lessons. 00:20:21.140 --> 00:20:24.140 align:middle line:84% Now, I was about to connect with the things we 00:20:24.140 --> 00:20:26.090 align:middle line:90% did in a few lectures ago. 00:20:26.090 --> 00:20:29.360 align:middle line:84% I said, look, so this is telling you the markets, 00:20:29.360 --> 00:20:34.140 align:middle line:84% when they saw this x going up, it's sort of betting 00:20:34.140 --> 00:20:36.990 align:middle line:84% that the Fed will not hike interest rates as much 00:20:36.990 --> 00:20:38.730 align:middle line:84% and, in fact, that it may even pause. 00:20:38.730 --> 00:20:40.855 align:middle line:84% Rather than raise the interest rate as was planned, 00:20:40.855 --> 00:20:42.850 align:middle line:84% they may even pause interest rates. 00:20:42.850 --> 00:20:49.690 align:middle line:90% We talked about this, lecture 7. 00:20:49.690 --> 00:20:50.800 align:middle line:90% Remember? 00:20:50.800 --> 00:20:55.870 align:middle line:84% In lecture 7, when we talk about the expanded IS-LM model, 00:20:55.870 --> 00:20:57.910 align:middle line:90% we had this x variable. 00:20:57.910 --> 00:21:01.510 align:middle line:84% And we said, look, if x goes up, that measure of riskiness 00:21:01.510 --> 00:21:03.670 align:middle line:84% and so on that increases the cost of borrowing 00:21:03.670 --> 00:21:06.880 align:middle line:84% for the private sector, that is like a shift 00:21:06.880 --> 00:21:08.170 align:middle line:90% in the IS to the left. 00:21:08.170 --> 00:21:12.280 align:middle line:84% For any given safe interest rate set by the central bank, 00:21:12.280 --> 00:21:15.310 align:middle line:84% now, all of a sudden, the cost of borrowing for companies 00:21:15.310 --> 00:21:15.880 align:middle line:90% is higher. 00:21:15.880 --> 00:21:18.460 align:middle line:84% And therefore, this is contractionary. 00:21:18.460 --> 00:21:21.070 align:middle line:90% 00:21:21.070 --> 00:21:24.580 align:middle line:84% And then we went on, remember, we went on and said, well, here 00:21:24.580 --> 00:21:26.710 align:middle line:84% it is, the question, what should the central bank 00:21:26.710 --> 00:21:32.110 align:middle line:84% do in this case in which x went up? 00:21:32.110 --> 00:21:32.610 align:middle line:90% Yeah? 00:21:32.610 --> 00:21:34.020 align:middle line:90% AUDIENCE: Lower interest rates. 00:21:34.020 --> 00:21:36.990 align:middle line:84% RICARDO J. CABALLERO: That was the next slide, in fact, lower 00:21:36.990 --> 00:21:38.580 align:middle line:84% the interest rate because there's 00:21:38.580 --> 00:21:40.200 align:middle line:84% one component of cost of borrowing 00:21:40.200 --> 00:21:45.780 align:middle line:84% that's going up for firms, which is the x. 00:21:45.780 --> 00:21:49.630 align:middle line:84% Well, the Fed can offset that by lowering the interest rate. 00:21:49.630 --> 00:21:52.230 align:middle line:84% Now, here they're not planning yet to lower the interest rate. 00:21:52.230 --> 00:21:53.730 align:middle line:84% They were planning to raise interest rates, 00:21:53.730 --> 00:21:54.938 align:middle line:90% and now they're slowing down. 00:21:54.938 --> 00:21:56.110 align:middle line:90% That's the bet. 00:21:56.110 --> 00:22:00.060 align:middle line:84% So the market knows some basic and expanded IS-LM model 00:22:00.060 --> 00:22:03.840 align:middle line:84% because that's what explains exactly what you 00:22:03.840 --> 00:22:09.277 align:middle line:84% should anticipate that's what is likely to happen. 00:22:09.277 --> 00:22:11.110 align:middle line:84% Anyways, that's where we are at this moment. 00:22:11.110 --> 00:22:14.408 align:middle line:90% 00:22:14.408 --> 00:22:15.450 align:middle line:90% Any questions about this? 00:22:15.450 --> 00:22:17.970 align:middle line:84% Otherwise, I'm going to move to the lecture, really. 00:22:17.970 --> 00:22:22.830 align:middle line:84% [CHUCKLES] But I thought we had to talk about it. 00:22:22.830 --> 00:22:26.048 align:middle line:84% Well, anyways, if he gets a lot messier-- 00:22:26.048 --> 00:22:27.090 align:middle line:90% I'm hoping that it won't. 00:22:27.090 --> 00:22:28.732 align:middle line:84% But if it gets a lot messier, then we 00:22:28.732 --> 00:22:29.940 align:middle line:90% can add a section at the end. 00:22:29.940 --> 00:22:33.060 align:middle line:84% I can replace something for something 00:22:33.060 --> 00:22:35.733 align:middle line:84% on banking crisis and something like that, OK? 00:22:35.733 --> 00:22:39.120 align:middle line:90% 00:22:39.120 --> 00:22:41.610 align:middle line:84% Which is what I teach in one of my graduate courses. 00:22:41.610 --> 00:22:43.760 align:middle line:90% So it would be fun. 00:22:43.760 --> 00:22:46.310 align:middle line:90% 00:22:46.310 --> 00:22:51.110 align:middle line:84% Anyway, so now what I want to do is start this IS-LM-PC model. 00:22:51.110 --> 00:22:54.060 align:middle line:84% And sort of the number-- the name is not very creative. 00:22:54.060 --> 00:22:56.390 align:middle line:84% It's pretty obvious what we're going to do here, no? 00:22:56.390 --> 00:22:58.400 align:middle line:84% [CHUCKLES] It's going to combine the IS-LM 00:22:58.400 --> 00:23:01.770 align:middle line:90% model with the Phillips curve. 00:23:01.770 --> 00:23:04.020 align:middle line:90% And what this will do for us-- 00:23:04.020 --> 00:23:06.620 align:middle line:84% it will allow us to think not only 00:23:06.620 --> 00:23:08.960 align:middle line:84% about the impact of a policy or a shock, 00:23:08.960 --> 00:23:10.370 align:middle line:84% but also think about what happens 00:23:10.370 --> 00:23:13.310 align:middle line:90% over time with that shock, OK? 00:23:13.310 --> 00:23:16.550 align:middle line:84% Not to the long run, but we call this analysis sort 00:23:16.550 --> 00:23:18.410 align:middle line:84% of the short run, which is what happens 00:23:18.410 --> 00:23:20.760 align:middle line:84% in the very few early weeks, months, 00:23:20.760 --> 00:23:24.410 align:middle line:84% and what happens in the medium run-- say, a year, a year 00:23:24.410 --> 00:23:25.560 align:middle line:90% and a half from now. 00:23:25.560 --> 00:23:29.435 align:middle line:84% And so this model will allow us to put all of this together. 00:23:29.435 --> 00:23:34.020 align:middle line:90% 00:23:34.020 --> 00:23:37.080 align:middle line:84% But so you don't get lost on this, 00:23:37.080 --> 00:23:39.870 align:middle line:84% so the analysis of the short run, 00:23:39.870 --> 00:23:41.935 align:middle line:84% essentially, will remain unchanged. 00:23:41.935 --> 00:23:43.470 align:middle line:90% It's our IS-LM model. 00:23:43.470 --> 00:23:46.440 align:middle line:84% It's just that, give it a little time, 00:23:46.440 --> 00:23:50.040 align:middle line:84% and you start seeing other certain effects get undone, 00:23:50.040 --> 00:23:52.560 align:middle line:84% and some others get exacerbated and so on, OK? 00:23:52.560 --> 00:23:56.220 align:middle line:84% But the short run is still IS-LM is your basic model. 00:23:56.220 --> 00:24:00.250 align:middle line:84% But then we're going to see that things happen over time. 00:24:00.250 --> 00:24:04.140 align:middle line:84% So remember the IS-LM model was essentially 00:24:04.140 --> 00:24:05.850 align:middle line:84% this is equilibrium in the goods market, 00:24:05.850 --> 00:24:11.190 align:middle line:84% and then we had an LM which said i equal to i bar. 00:24:11.190 --> 00:24:15.150 align:middle line:84% And so I'm going to replace the LM already inside this, 00:24:15.150 --> 00:24:16.930 align:middle line:90% and I get my IS-LM model. 00:24:16.930 --> 00:24:19.860 align:middle line:84% So for any given i bar, I could solve out 00:24:19.860 --> 00:24:21.490 align:middle line:90% for equilibrium output. 00:24:21.490 --> 00:24:26.160 align:middle line:84% Now, here, I'm going to I'm going to adopt the-- 00:24:26.160 --> 00:24:27.660 align:middle line:84% I didn't want to do it before, but I 00:24:27.660 --> 00:24:30.720 align:middle line:84% think at this point is useful because it will simplify 00:24:30.720 --> 00:24:34.620 align:middle line:84% the diagrams when we draw them to really think of the Fed 00:24:34.620 --> 00:24:37.780 align:middle line:84% as setting the real interest rate. 00:24:37.780 --> 00:24:39.910 align:middle line:84% So I'm going to assume now, and then I'm 00:24:39.910 --> 00:24:45.080 align:middle line:84% going to explain what happens when that's a bad assumption. 00:24:45.080 --> 00:24:47.240 align:middle line:84% But I'm going to assume for now that, rather than 00:24:47.240 --> 00:24:48.740 align:middle line:84% the Fed setting the nominal interest 00:24:48.740 --> 00:24:53.250 align:middle line:84% rate, that the Fed is setting the real interest rate, OK? 00:24:53.250 --> 00:24:55.260 align:middle line:90% So it's setting this. 00:24:55.260 --> 00:24:58.570 align:middle line:84% And then we're going to talk about problems. 00:24:58.570 --> 00:25:01.930 align:middle line:84% I mean, in principle, if the interest rate is not 00:25:01.930 --> 00:25:06.110 align:middle line:84% against the 0 lower bound, the Fed can always do that. 00:25:06.110 --> 00:25:07.870 align:middle line:84% And say, OK, I'm going to give them-- 00:25:07.870 --> 00:25:09.460 align:middle line:84% I'm going to give you the nominal interest rate that, 00:25:09.460 --> 00:25:11.835 align:middle line:84% given this expected inflation, gives me the real interest 00:25:11.835 --> 00:25:13.167 align:middle line:90% rate I want, OK? 00:25:13.167 --> 00:25:15.500 align:middle line:84% That's what the Fed is really trying to do all the time. 00:25:15.500 --> 00:25:17.740 align:middle line:84% The Fed is not trying to figure out 00:25:17.740 --> 00:25:19.810 align:middle line:84% what is the equilibrium nominal interest rate. 00:25:19.810 --> 00:25:22.420 align:middle line:84% It's always trying to figure out whether the real interest 00:25:22.420 --> 00:25:25.030 align:middle line:84% rate is at the right level or not for the economy. 00:25:25.030 --> 00:25:27.550 align:middle line:84% Now, the tool they have is a nominal interest rate. 00:25:27.550 --> 00:25:30.250 align:middle line:84% But they are thinking always about the real interest rate. 00:25:30.250 --> 00:25:36.365 align:middle line:84% And sometimes there is a problem because when you are against a 0 00:25:36.365 --> 00:25:38.740 align:middle line:84% lower bound, then you can't affect the real interest rate 00:25:38.740 --> 00:25:39.910 align:middle line:90% in the same way. 00:25:39.910 --> 00:25:41.720 align:middle line:90% But most of the time you can. 00:25:41.720 --> 00:25:43.390 align:middle line:90% And so I'm going to think-- 00:25:43.390 --> 00:25:45.560 align:middle line:84% I'm going to rewrite the IS-LM model now. 00:25:45.560 --> 00:25:48.550 align:middle line:84% But I'm going to call this r bar. 00:25:48.550 --> 00:25:50.890 align:middle line:84% And the bar is there just to tell you, remind you, 00:25:50.890 --> 00:25:55.550 align:middle line:84% that it's something that the Fed is setting, OK? 00:25:55.550 --> 00:25:56.870 align:middle line:90% So that's our IS-LM. 00:25:56.870 --> 00:25:59.312 align:middle line:84% Remember the Phillips curve part. 00:25:59.312 --> 00:26:01.520 align:middle line:84% The Phillips-- that was our Phillips curve, remember? 00:26:01.520 --> 00:26:04.400 align:middle line:84% It's the last ones we replaced the natural rate of unemployment 00:26:04.400 --> 00:26:05.060 align:middle line:90% in there. 00:26:05.060 --> 00:26:08.090 align:middle line:84% We had an inflation minus expected inflation 00:26:08.090 --> 00:26:11.040 align:middle line:84% was a decreasing function of the unemployment gap. 00:26:11.040 --> 00:26:13.760 align:middle line:84% So if unemployment was above the natural rate of unemployment, 00:26:13.760 --> 00:26:16.670 align:middle line:84% inflation was lower than expected inflation. 00:26:16.670 --> 00:26:19.370 align:middle line:84% And conversely, if the unemployment rate was lower, 00:26:19.370 --> 00:26:23.030 align:middle line:84% then the unemployment rate-- and the situation of the US today 00:26:23.030 --> 00:26:27.890 align:middle line:84% is that everything seems to point towards a situation 00:26:27.890 --> 00:26:29.463 align:middle line:90% where u is below u n. 00:26:29.463 --> 00:26:31.880 align:middle line:84% And that's the reason we're seeing sort of high inflation, 00:26:31.880 --> 00:26:32.690 align:middle line:90% OK? 00:26:32.690 --> 00:26:34.700 align:middle line:84% Now, what I'm going to do next is 00:26:34.700 --> 00:26:36.960 align:middle line:84% I'm going to go from unemployment to output. 00:26:36.960 --> 00:26:40.550 align:middle line:84% So I can put-- you see, I don't have unemployment anywhere here. 00:26:40.550 --> 00:26:41.910 align:middle line:90% I have output. 00:26:41.910 --> 00:26:45.880 align:middle line:84% So what I want to do is play with the Phillips curve 00:26:45.880 --> 00:26:48.910 align:middle line:84% until I write it in the space of inflation and output, 00:26:48.910 --> 00:26:50.650 align:middle line:84% not inflation and unemployment so I can 00:26:50.650 --> 00:26:51.880 align:middle line:90% put the two curves together. 00:26:51.880 --> 00:26:52.990 align:middle line:90% That's what I want to do. 00:26:52.990 --> 00:26:56.530 align:middle line:84% Remember, I want to [CHUCKLES] merge here the IS-LM 00:26:56.530 --> 00:27:00.370 align:middle line:84% with the PC, so I want to put them in the same variable. 00:27:00.370 --> 00:27:04.290 align:middle line:84% So remember, we have operated with a very simple production 00:27:04.290 --> 00:27:07.390 align:middle line:84% function in which output is equal to employment. 00:27:07.390 --> 00:27:08.550 align:middle line:90% Remember? 00:27:08.550 --> 00:27:09.630 align:middle line:90% That's what we assume. 00:27:09.630 --> 00:27:11.700 align:middle line:90% Employment, we call it n. 00:27:11.700 --> 00:27:14.160 align:middle line:84% Well, I can rewrite n, employment, 00:27:14.160 --> 00:27:17.820 align:middle line:84% as the labor force times 1 minus n, employment rate. 00:27:17.820 --> 00:27:20.280 align:middle line:90% That's employment, OK? 00:27:20.280 --> 00:27:23.710 align:middle line:84% So I can think of output as that. 00:27:23.710 --> 00:27:27.267 align:middle line:84% Similarly, I can define what we call-- 00:27:27.267 --> 00:27:28.600 align:middle line:90% we don't call it natural output. 00:27:28.600 --> 00:27:31.910 align:middle line:90% We call it potential output, no? 00:27:31.910 --> 00:27:35.900 align:middle line:84% Potential output is defined as the output 00:27:35.900 --> 00:27:37.460 align:middle line:84% that you get when unemployment is 00:27:37.460 --> 00:27:40.010 align:middle line:84% at the natural rate of unemployment, OK? 00:27:40.010 --> 00:27:42.620 align:middle line:84% So that's our definition, three lines. 00:27:42.620 --> 00:27:48.600 align:middle line:84% The potential output is when the output you get, 00:27:48.600 --> 00:27:50.820 align:middle line:84% which in this-- with this production function, 00:27:50.820 --> 00:27:52.740 align:middle line:84% is the employment you get when you 00:27:52.740 --> 00:27:55.800 align:middle line:84% are at the unemployment-- at the natural rate of unemployment. 00:27:55.800 --> 00:27:59.520 align:middle line:84% And now we can construct the difference, this minus that. 00:27:59.520 --> 00:28:01.800 align:middle line:84% This is something we call the output gap. 00:28:01.800 --> 00:28:04.560 align:middle line:90% And you may hear-- 00:28:04.560 --> 00:28:12.160 align:middle line:84% typically, when people talk about issues of monetary policy, 00:28:12.160 --> 00:28:14.770 align:middle line:84% often it's described in terms of this variable more 00:28:14.770 --> 00:28:16.335 align:middle line:90% than this gap. 00:28:16.335 --> 00:28:17.710 align:middle line:84% People talk about the output gap. 00:28:17.710 --> 00:28:19.510 align:middle line:84% If the output gap is positive, that 00:28:19.510 --> 00:28:21.670 align:middle line:84% means output is above the natural rate 00:28:21.670 --> 00:28:23.110 align:middle line:90% of the potential output. 00:28:23.110 --> 00:28:25.300 align:middle line:84% When the output gap is negative, that's 00:28:25.300 --> 00:28:27.440 align:middle line:84% output is below potential output. 00:28:27.440 --> 00:28:29.130 align:middle line:90% So I can rewrite this. 00:28:29.130 --> 00:28:31.330 align:middle line:90% This minus that is just that. 00:28:31.330 --> 00:28:34.030 align:middle line:84% And now I can replace u minus u n 00:28:34.030 --> 00:28:39.910 align:middle line:84% here for minus Y minus Yn over L. 00:28:39.910 --> 00:28:42.400 align:middle line:84% And I get the Phillips curve now written 00:28:42.400 --> 00:28:44.600 align:middle line:84% in terms of the output gap and inflation. 00:28:44.600 --> 00:28:48.910 align:middle line:84% So this says when output is above potential output, when 00:28:48.910 --> 00:28:51.670 align:middle line:84% the output gap is positive, then inflation 00:28:51.670 --> 00:28:53.410 align:middle line:90% exceeds expected inflation. 00:28:53.410 --> 00:28:56.560 align:middle line:84% Conversely, when output is below potential output, 00:28:56.560 --> 00:29:00.130 align:middle line:84% then inflation is below expected inflation, OK? 00:29:00.130 --> 00:29:03.530 align:middle line:84% But the logic is exactly the same as the logic we have here. 00:29:03.530 --> 00:29:05.350 align:middle line:90% Why is it that this happens? 00:29:05.350 --> 00:29:08.380 align:middle line:84% Well, because when output is above the potential output, 00:29:08.380 --> 00:29:09.910 align:middle line:84% that means, also, unemployment is 00:29:09.910 --> 00:29:12.650 align:middle line:84% lower than the natural rate of unemployment, OK? 00:29:12.650 --> 00:29:15.790 align:middle line:90% So that's the logic. 00:29:15.790 --> 00:29:18.350 align:middle line:90% Any question about this? 00:29:18.350 --> 00:29:20.390 align:middle line:90% No? 00:29:20.390 --> 00:29:21.410 align:middle line:90% OK, good. 00:29:21.410 --> 00:29:25.910 align:middle line:84% So anyway, so now we have a Phillips curve and our IS-LM 00:29:25.910 --> 00:29:26.820 align:middle line:90% model. 00:29:26.820 --> 00:29:29.840 align:middle line:90% So let's put them together. 00:29:29.840 --> 00:29:31.553 align:middle line:84% And suppose for now-- and I'm going 00:29:31.553 --> 00:29:33.470 align:middle line:84% to-- that's the example I want to carry around 00:29:33.470 --> 00:29:37.153 align:middle line:84% is that expected inflation is equal to lagged inflation. 00:29:37.153 --> 00:29:39.320 align:middle line:84% So this is a case in which expected inflation is not 00:29:39.320 --> 00:29:39.890 align:middle line:90% well anchored. 00:29:39.890 --> 00:29:41.480 align:middle line:84% And then we're going to talk about what happens when 00:29:41.480 --> 00:29:42.800 align:middle line:90% it's anchored and not anchored. 00:29:42.800 --> 00:29:46.130 align:middle line:84% So suppose that inflation is actually-- whatever 00:29:46.130 --> 00:29:49.700 align:middle line:84% is this year's inflation, that's what you expect for next year, 00:29:49.700 --> 00:29:50.510 align:middle line:90% OK? 00:29:50.510 --> 00:29:53.660 align:middle line:84% So here I have an example in which here I'm 00:29:53.660 --> 00:29:56.090 align:middle line:84% plotting our IS-LM now, which I'm 00:29:56.090 --> 00:29:59.630 align:middle line:84% using remember the real interest rate here. 00:29:59.630 --> 00:30:05.235 align:middle line:84% And in this diagram down here, I'm plotting the Phillips curve. 00:30:05.235 --> 00:30:08.930 align:middle line:84% OK, so first thing, let's look about this Phillips curve. 00:30:08.930 --> 00:30:11.450 align:middle line:90% Why is it upward sloping? 00:30:11.450 --> 00:30:14.840 align:middle line:84% Here is output, so this is a parameter by n. 00:30:14.840 --> 00:30:17.070 align:middle line:84% And this is the left-hand-side variable. 00:30:17.070 --> 00:30:19.260 align:middle line:84% So it's obviously increasing in output. 00:30:19.260 --> 00:30:20.400 align:middle line:90% Why is that? 00:30:20.400 --> 00:30:22.640 align:middle line:84% Well, because if output grows, that 00:30:22.640 --> 00:30:24.110 align:middle line:90% means unemployment goes down. 00:30:24.110 --> 00:30:28.610 align:middle line:84% That means wages go up, prices go up, and you get inflation. 00:30:28.610 --> 00:30:31.220 align:middle line:90% That's the mechanism, OK? 00:30:31.220 --> 00:30:35.590 align:middle line:84% So in this particular example, we have-- 00:30:35.590 --> 00:30:37.600 align:middle line:84% this is the real interest rate that the Fed 00:30:37.600 --> 00:30:39.100 align:middle line:90% has set at this moment. 00:30:39.100 --> 00:30:40.702 align:middle line:90% That's the equilibrium output. 00:30:40.702 --> 00:30:42.160 align:middle line:84% What I'm trying to tell you here is 00:30:42.160 --> 00:30:45.920 align:middle line:84% that nothing has changed in the way you calculate equilibrium 00:30:45.920 --> 00:30:46.420 align:middle line:90% output. 00:30:46.420 --> 00:30:47.500 align:middle line:90% If you just use-- 00:30:47.500 --> 00:30:51.600 align:middle line:84% for that, you only need this top diagram in the short run. 00:30:51.600 --> 00:30:55.200 align:middle line:84% I tell you what the real interest rate is set by the-- 00:30:55.200 --> 00:31:00.690 align:middle line:84% is, which is a decision by the Fed, then I know where my IS is. 00:31:00.690 --> 00:31:01.980 align:middle line:90% I can pin down output. 00:31:01.980 --> 00:31:04.750 align:middle line:84% I don't need this diagram to really pin down 00:31:04.750 --> 00:31:08.240 align:middle line:90% equilibrium output, OK? 00:31:08.240 --> 00:31:10.340 align:middle line:90% So nothing is different there. 00:31:10.340 --> 00:31:13.910 align:middle line:90% But-- and this is an example-- 00:31:13.910 --> 00:31:20.140 align:middle line:84% in this particular case, we have that inflation is rising here. 00:31:20.140 --> 00:31:21.880 align:middle line:90% And the question is, why? 00:31:21.880 --> 00:31:23.590 align:middle line:84% So for this-- what I'm trying to say 00:31:23.590 --> 00:31:27.760 align:middle line:84% is that, for this IS, which is a function of fiscal policy, 00:31:27.760 --> 00:31:31.450 align:middle line:84% of how confident consumers are, and stuff like that, 00:31:31.450 --> 00:31:34.090 align:middle line:84% if the Fed chooses this real interest rate, 00:31:34.090 --> 00:31:35.530 align:middle line:90% we end up with this output. 00:31:35.530 --> 00:31:37.480 align:middle line:84% But it turns out that this level of output 00:31:37.480 --> 00:31:41.280 align:middle line:90% is increasing inflation. 00:31:41.280 --> 00:31:43.440 align:middle line:84% And the increase in inflation I can read here. 00:31:43.440 --> 00:31:46.330 align:middle line:84% I see the change in inflation is positive here. 00:31:46.330 --> 00:31:48.477 align:middle line:90% Why is this happening? 00:31:48.477 --> 00:31:50.310 align:middle line:84% AUDIENCE: If you're changing the output that 00:31:50.310 --> 00:31:52.518 align:middle line:84% means you have a different level of employment, which 00:31:52.518 --> 00:31:55.545 align:middle line:84% changes the expected inflation, which will raise interest rates. 00:31:55.545 --> 00:31:56.670 align:middle line:90% RICARDO J. CABALLERO: Yeah. 00:31:56.670 --> 00:31:59.760 align:middle line:84% Well, actually, here, I don't need to take-- 00:31:59.760 --> 00:32:01.260 align:middle line:84% this diagram would have also worked 00:32:01.260 --> 00:32:04.200 align:middle line:84% with expected inflation as a constant. 00:32:04.200 --> 00:32:07.050 align:middle line:84% Here, I'm more looking at what happens to inflation. 00:32:07.050 --> 00:32:10.050 align:middle line:84% I'm saying, if output is above the natural rate of output, 00:32:10.050 --> 00:32:12.300 align:middle line:84% then inflation is above expected inflation. 00:32:12.300 --> 00:32:14.430 align:middle line:84% But I can take expected inflation as a constant. 00:32:14.430 --> 00:32:16.770 align:middle line:84% In fact, here it is a constant because-- 00:32:16.770 --> 00:32:18.780 align:middle line:84% a constant in the sense that it's given at time 00:32:18.780 --> 00:32:21.100 align:middle line:84% t because it's a previous year's inflation. 00:32:21.100 --> 00:32:23.542 align:middle line:84% But what is important is that you have too match 00:32:23.542 --> 00:32:24.250 align:middle line:90% aggregate demand. 00:32:24.250 --> 00:32:25.770 align:middle line:84% This economy is running very hot. 00:32:25.770 --> 00:32:30.030 align:middle line:84% [CHUCKLES] If output gap is positive, then 00:32:30.030 --> 00:32:32.730 align:middle line:84% that is going to lead to inflationary pressures. 00:32:32.730 --> 00:32:34.965 align:middle line:84% In this particular model, where expected inflation 00:32:34.965 --> 00:32:36.840 align:middle line:84% equal to lagged inflation, this is pretty bad 00:32:36.840 --> 00:32:38.465 align:middle line:84% because it's not only you get inflation 00:32:38.465 --> 00:32:43.770 align:middle line:84% above the target of the Fed, but inflation is rising over time. 00:32:43.770 --> 00:32:46.670 align:middle line:84% So this is a case in which this central bank 00:32:46.670 --> 00:32:51.110 align:middle line:84% is setting the real interest rate too low, OK? 00:32:51.110 --> 00:32:53.750 align:middle line:84% You may want-- Japan is doing a little bit of this. 00:32:53.750 --> 00:32:57.140 align:middle line:84% But they have a reason, is that they have had inflation so low 00:32:57.140 --> 00:33:00.900 align:middle line:84% that it makes sense for them to build a little inflation. 00:33:00.900 --> 00:33:03.030 align:middle line:90% In the US, it made less sense. 00:33:03.030 --> 00:33:04.528 align:middle line:84% The US got into trouble because it 00:33:04.528 --> 00:33:06.820 align:middle line:84% was in a situation like this for a long period of time. 00:33:06.820 --> 00:33:10.770 align:middle line:84% I mean, the reason we have today 6% inflation-- well, 00:33:10.770 --> 00:33:12.300 align:middle line:84% it depends which indicator you use-- 00:33:12.300 --> 00:33:16.170 align:middle line:84% is because the US experienced sort of a year 00:33:16.170 --> 00:33:20.250 align:middle line:84% with a situation like this, a year and a half. 00:33:20.250 --> 00:33:21.850 align:middle line:84% And that's what-- sometimes people say 00:33:21.850 --> 00:33:23.170 align:middle line:90% the Fed was behind the curve. 00:33:23.170 --> 00:33:25.400 align:middle line:90% They-- for a variety of reasons. 00:33:25.400 --> 00:33:28.630 align:middle line:84% One, initially, potential output declined because of all 00:33:28.630 --> 00:33:30.310 align:middle line:90% the COVID-related issues. 00:33:30.310 --> 00:33:32.140 align:middle line:84% They expected that to recover quickly. 00:33:32.140 --> 00:33:34.210 align:middle line:84% So they said, let it go because I'm not 00:33:34.210 --> 00:33:36.130 align:middle line:84% going to start moving my policy rate around 00:33:36.130 --> 00:33:38.560 align:middle line:84% for something that will recover quickly as soon as COVID 00:33:38.560 --> 00:33:39.160 align:middle line:90% is gone. 00:33:39.160 --> 00:33:41.650 align:middle line:84% Well, it took longer to recover, and then it 00:33:41.650 --> 00:33:44.380 align:middle line:84% came sort of the Russian war shock and so on. 00:33:44.380 --> 00:33:47.650 align:middle line:84% And so natural rate of unemployment moved to the left 00:33:47.650 --> 00:33:48.580 align:middle line:90% to start. 00:33:48.580 --> 00:33:52.600 align:middle line:84% And second, because of an enormous policy support, 00:33:52.600 --> 00:33:56.290 align:middle line:84% primarily, and the fact that houses 00:33:56.290 --> 00:33:59.200 align:middle line:84% were able to save a lot during COVID, 00:33:59.200 --> 00:34:00.910 align:middle line:84% there was a lot of pent-up demand. 00:34:00.910 --> 00:34:04.510 align:middle line:84% Then we had enormous aggregate demand when we came out of it. 00:34:04.510 --> 00:34:06.310 align:middle line:84% And the real interest rate that we had 00:34:06.310 --> 00:34:09.070 align:middle line:84% was just way too low for all that aggregate demand 00:34:09.070 --> 00:34:12.530 align:middle line:90% and that low potential output. 00:34:12.530 --> 00:34:14.139 align:middle line:84% So we were in a situation like this. 00:34:14.139 --> 00:34:16.600 align:middle line:90% And inflation began to climb. 00:34:16.600 --> 00:34:19.997 align:middle line:84% Initially, expected inflation was very well anchored. 00:34:19.997 --> 00:34:21.580 align:middle line:84% And then we began to lose that anchor. 00:34:21.580 --> 00:34:23.800 align:middle line:84% Then we recovered, and now we're losing it again. 00:34:23.800 --> 00:34:26.260 align:middle line:84% We shall see what happens after this current episode. 00:34:26.260 --> 00:34:28.330 align:middle line:84% But that was exactly the situation of the US 00:34:28.330 --> 00:34:30.679 align:middle line:84% and of most economies around the world. 00:34:30.679 --> 00:34:32.300 align:middle line:90% China is in a different story. 00:34:32.300 --> 00:34:35.230 align:middle line:84% But in most economies around the world, 00:34:35.230 --> 00:34:39.010 align:middle line:84% certainly Europe, all of them, the UK, continental Europe, 00:34:39.010 --> 00:34:41.010 align:middle line:90% and the UK, Latin America. 00:34:41.010 --> 00:34:43.449 align:middle line:84% Regardless of where you look, the situation was like that. 00:34:43.449 --> 00:34:45.760 align:middle line:84% Yes, real interest rates were way too low 00:34:45.760 --> 00:34:51.250 align:middle line:84% for the natural rate, the potential-- 00:34:51.250 --> 00:34:53.929 align:middle line:84% the level of the potential output we had at that time. 00:34:53.929 --> 00:34:57.640 align:middle line:84% And so we got into a situation like this. 00:34:57.640 --> 00:34:58.870 align:middle line:90% OK, so that's the short run. 00:34:58.870 --> 00:35:02.270 align:middle line:84% In the short run, if you have an interest rate that is very low-- 00:35:02.270 --> 00:35:03.970 align:middle line:84% I mean, again, in the short run, you 00:35:03.970 --> 00:35:06.357 align:middle line:84% know how to determine output given a real interest rate. 00:35:06.357 --> 00:35:07.940 align:middle line:84% And then now you can say a little more 00:35:07.940 --> 00:35:09.440 align:middle line:84% and say, OK, but that's going to put 00:35:09.440 --> 00:35:12.327 align:middle line:84% inflation-- is going to cause inflationary pressures, up 00:35:12.327 --> 00:35:14.410 align:middle line:84% or down, depending on whether you are to the right 00:35:14.410 --> 00:35:16.285 align:middle line:84% or to the left of the natural rate of output. 00:35:16.285 --> 00:35:19.270 align:middle line:84% That's a new twist about the short run that you know. 00:35:19.270 --> 00:35:21.830 align:middle line:84% But now let's start moving over time. 00:35:21.830 --> 00:35:24.380 align:middle line:90% So what happens over time? 00:35:24.380 --> 00:35:26.930 align:middle line:84% Well, first, let me define something. 00:35:26.930 --> 00:35:29.965 align:middle line:84% With potential output, we know what it is. 00:35:29.965 --> 00:35:31.340 align:middle line:84% But I'm going to define something 00:35:31.340 --> 00:35:34.710 align:middle line:84% which is called the natural rate of interest rate. 00:35:34.710 --> 00:35:36.710 align:middle line:84% Sometimes it's called the neutral interest rate. 00:35:36.710 --> 00:35:38.877 align:middle line:84% Sometimes it's called the Wicksellian interest rate. 00:35:38.877 --> 00:35:40.620 align:middle line:90% Let me not get into that story. 00:35:40.620 --> 00:35:43.040 align:middle line:84% But I'm going to define implicitly 00:35:43.040 --> 00:35:46.040 align:middle line:84% the natural rate of interest rate, 00:35:46.040 --> 00:35:48.500 align:middle line:84% or the neutral rate of interest-- or some people 00:35:48.500 --> 00:35:49.550 align:middle line:90% call it r star. 00:35:49.550 --> 00:35:52.700 align:middle line:84% You may have heard of r star in the newspapers. 00:35:52.700 --> 00:35:53.810 align:middle line:90% People talk about r star. 00:35:53.810 --> 00:35:55.268 align:middle line:84% When they are talking about r star, 00:35:55.268 --> 00:35:57.050 align:middle line:90% they're talking about that, OK? 00:35:57.050 --> 00:35:59.840 align:middle line:84% It's simply the interest rate that 00:35:59.840 --> 00:36:04.020 align:middle line:84% makes the potential output the equilibrium of the goods market, 00:36:04.020 --> 00:36:04.520 align:middle line:90% OK? 00:36:04.520 --> 00:36:05.660 align:middle line:90% So I'm solving implicitly. 00:36:05.660 --> 00:36:07.730 align:middle line:84% I say, I want to get as a result-- 00:36:07.730 --> 00:36:10.700 align:middle line:84% as an-- I want to get as a result of this equilibrium 00:36:10.700 --> 00:36:13.830 align:middle line:90% here the natural rate of output. 00:36:13.830 --> 00:36:18.560 align:middle line:84% What is the interest rate I need to pick so that's the case? 00:36:18.560 --> 00:36:20.630 align:middle line:84% So I want to get the natural rate of output 00:36:20.630 --> 00:36:22.340 align:middle line:90% here, the potential output. 00:36:22.340 --> 00:36:24.830 align:middle line:84% I know that there is an interest rate, real interest 00:36:24.830 --> 00:36:27.240 align:middle line:90% rate, at which that holds. 00:36:27.240 --> 00:36:30.400 align:middle line:84% It's a matter of looking for the interest rate that does that. 00:36:30.400 --> 00:36:32.760 align:middle line:84% And in this particular diagram, it's this, you see? 00:36:32.760 --> 00:36:38.240 align:middle line:84% At this interest rate, the [INAUDIBLE] equilibrium output 00:36:38.240 --> 00:36:40.340 align:middle line:84% is exactly the natural rate of output. 00:36:40.340 --> 00:36:42.960 align:middle line:90% 00:36:42.960 --> 00:36:47.270 align:middle line:84% So what I know is that, eventually, the economy 00:36:47.270 --> 00:36:48.440 align:middle line:90% will have to go there. 00:36:48.440 --> 00:36:51.201 align:middle line:90% 00:36:51.201 --> 00:36:53.880 align:middle line:84% Eventually, the economy will have to go there. 00:36:53.880 --> 00:36:56.880 align:middle line:84% So how will this happen in practice? 00:36:56.880 --> 00:37:00.000 align:middle line:84% The way it will happen is, OK, this 00:37:00.000 --> 00:37:02.055 align:middle line:84% is the point we're at in the previous slide. 00:37:02.055 --> 00:37:04.750 align:middle line:90% 00:37:04.750 --> 00:37:07.060 align:middle line:90% So we're here. 00:37:07.060 --> 00:37:11.680 align:middle line:84% Well, that's building inflationary pressure. 00:37:11.680 --> 00:37:13.117 align:middle line:90% What do you think will happen? 00:37:13.117 --> 00:37:14.200 align:middle line:90% Inflation starts climbing. 00:37:14.200 --> 00:37:18.480 align:middle line:90% 00:37:18.480 --> 00:37:19.380 align:middle line:90% Who will react? 00:37:19.380 --> 00:37:23.655 align:middle line:84% Who's in charge of not letting inflation get carried away? 00:37:23.655 --> 00:37:26.255 align:middle line:90% 00:37:26.255 --> 00:37:28.007 align:middle line:90% The central bank, the Fed. 00:37:28.007 --> 00:37:30.090 align:middle line:84% So what they start doing is hiking interest rates, 00:37:30.090 --> 00:37:32.150 align:middle line:84% which is exactly what they have been doing. 00:37:32.150 --> 00:37:36.970 align:middle line:84% And as they hike interest rate, they're going to keep-- 00:37:36.970 --> 00:37:39.590 align:middle line:84% they start increasing the real interest rate until they 00:37:39.590 --> 00:37:41.300 align:middle line:90% get to this point, OK? 00:37:41.300 --> 00:37:43.260 align:middle line:90% That's the idea. 00:37:43.260 --> 00:37:49.686 align:middle line:84% So the point is that, in the medium run, 00:37:49.686 --> 00:37:51.670 align:middle line:84% the real interest-- real variables 00:37:51.670 --> 00:37:53.660 align:middle line:84% determine real variables, not monetary policy. 00:37:53.660 --> 00:37:55.637 align:middle line:84% Monetary policy has to follow whatever 00:37:55.637 --> 00:37:57.220 align:middle line:84% it is that the economy throws at them. 00:37:57.220 --> 00:37:59.277 align:middle line:84% Central banks have to follow whatever 00:37:59.277 --> 00:38:00.360 align:middle line:90% is the real interest rate. 00:38:00.360 --> 00:38:03.010 align:middle line:84% If they made a mistake, and they set a real interest rate which 00:38:03.010 --> 00:38:05.650 align:middle line:84% is not consistent with a stable inflation, 00:38:05.650 --> 00:38:07.030 align:middle line:90% they're going to learn about it. 00:38:07.030 --> 00:38:09.160 align:middle line:84% And over time, they're going to have to fix that. 00:38:09.160 --> 00:38:11.260 align:middle line:84% And when will the problem go away? 00:38:11.260 --> 00:38:17.650 align:middle line:84% Only when they reach the natural rate of unemployment. 00:38:17.650 --> 00:38:19.150 align:middle line:90% And so that's what will happen. 00:38:19.150 --> 00:38:22.570 align:middle line:84% As the real interest rates start going up, from here to there, 00:38:22.570 --> 00:38:25.300 align:middle line:84% then you start seeing the change in inflation 00:38:25.300 --> 00:38:29.485 align:middle line:84% in this particular model, a declining and declining. 00:38:29.485 --> 00:38:31.360 align:middle line:84% And when you get to a natural rate of output, 00:38:31.360 --> 00:38:33.130 align:middle line:84% at least you get a stable inflation. 00:38:33.130 --> 00:38:37.030 align:middle line:90% 00:38:37.030 --> 00:38:38.140 align:middle line:90% Is this adjustment clear? 00:38:38.140 --> 00:38:40.690 align:middle line:90% 00:38:40.690 --> 00:38:41.740 align:middle line:90% OK, good. 00:38:41.740 --> 00:38:44.320 align:middle line:84% OK, so this is what happened in the medium run. 00:38:44.320 --> 00:38:48.500 align:middle line:84% So the medium run is described as moving from that point here, 00:38:48.500 --> 00:38:52.000 align:middle line:84% the whole process of going back to a situation where we converge 00:38:52.000 --> 00:38:55.410 align:middle line:84% to a natural rate of interest rate 00:38:55.410 --> 00:38:57.360 align:middle line:84% and therefore the natural rate of output 00:38:57.360 --> 00:38:58.890 align:middle line:84% and the natural rate of unemployment 00:38:58.890 --> 00:39:00.600 align:middle line:90% and all these kind of things. 00:39:00.600 --> 00:39:03.900 align:middle line:84% So that's-- the short run is whatever its output is. 00:39:03.900 --> 00:39:05.550 align:middle line:90% That's your IS-LM. 00:39:05.550 --> 00:39:08.670 align:middle line:84% The medium run is whatever the natural rate 00:39:08.670 --> 00:39:11.113 align:middle line:84% tells you should be the natural rate of unemployment, 00:39:11.113 --> 00:39:13.530 align:middle line:84% the natural rate of output, and therefore the natural rate 00:39:13.530 --> 00:39:15.330 align:middle line:84% of interest rate, the Wicksellian interest 00:39:15.330 --> 00:39:18.680 align:middle line:84% rate or the neutral interest rate, or r star. 00:39:18.680 --> 00:39:21.730 align:middle line:84% That's all pinned down there in the medium run. 00:39:21.730 --> 00:39:23.650 align:middle line:84% And the transition is obviously going 00:39:23.650 --> 00:39:25.720 align:middle line:84% from the short run, the pure IS-LM, 00:39:25.720 --> 00:39:30.890 align:middle line:84% to the natural rate type analysis. 00:39:30.890 --> 00:39:33.620 align:middle line:90% Now, I assume here-- 00:39:33.620 --> 00:39:35.570 align:middle line:84% and that's related to your answer. 00:39:35.570 --> 00:39:40.310 align:middle line:84% I assume here that the expected inflation was an anchor-- 00:39:40.310 --> 00:39:44.990 align:middle line:84% that is, that expected inflation was equal to log inflation. 00:39:44.990 --> 00:39:48.350 align:middle line:84% That's-- I told you before that's not where central banks 00:39:48.350 --> 00:39:51.860 align:middle line:84% want to be, because that means that, if you mess up, 00:39:51.860 --> 00:39:54.920 align:middle line:90% inflation is high. 00:39:54.920 --> 00:39:57.147 align:middle line:84% Then, in order to bring it down, you also 00:39:57.147 --> 00:39:58.730 align:middle line:84% have to bring down expected inflation. 00:39:58.730 --> 00:40:00.150 align:middle line:90% You need to cause a recession. 00:40:00.150 --> 00:40:01.650 align:middle line:90% And you can see that here. 00:40:01.650 --> 00:40:05.077 align:middle line:84% So suppose that the central bank starts with a level of inflation 00:40:05.077 --> 00:40:05.660 align:middle line:90% that it likes. 00:40:05.660 --> 00:40:07.080 align:middle line:90% Suppose that this is the model. 00:40:07.080 --> 00:40:09.140 align:middle line:84% So what I said before, the expected inflation 00:40:09.140 --> 00:40:10.670 align:middle line:90% is equal to lagged inflation. 00:40:10.670 --> 00:40:13.790 align:middle line:84% Suppose that the central bank starts at the level of inflation 00:40:13.790 --> 00:40:16.970 align:middle line:90% that it likes, 2% in the US, OK? 00:40:16.970 --> 00:40:21.560 align:middle line:84% But suppose that, for whatever reason, whatever shock, 00:40:21.560 --> 00:40:24.590 align:middle line:84% it finds itself with an interest rate that is too low, 00:40:24.590 --> 00:40:26.790 align:middle line:90% a real interest rate is too low. 00:40:26.790 --> 00:40:30.720 align:middle line:84% That means inflation exceeds expected inflation, which 00:40:30.720 --> 00:40:33.140 align:middle line:90% was 2%. 00:40:33.140 --> 00:40:36.980 align:middle line:84% Well, by next year, say, suppose this gap is 2%. 00:40:36.980 --> 00:40:41.740 align:middle line:84% Well, by next year, the inflation is 4%. 00:40:41.740 --> 00:40:42.280 align:middle line:90% OK? 00:40:42.280 --> 00:40:45.430 align:middle line:90% So if inflation is 4%-- 00:40:45.430 --> 00:40:48.010 align:middle line:84% in fact, in the US it's got to be 9%. 00:40:48.010 --> 00:40:50.230 align:middle line:84% If you're at 9% level of inflation-- 00:40:50.230 --> 00:40:54.250 align:middle line:84% and this is the model of expected inflation you have-- 00:40:54.250 --> 00:40:56.110 align:middle line:84% then, Houston, you have a problem 00:40:56.110 --> 00:40:58.990 align:middle line:84% because it's not enough with raising interest rates up 00:40:58.990 --> 00:40:59.900 align:middle line:90% to this point. 00:40:59.900 --> 00:41:03.070 align:middle line:84% Suppose that the Fed says, well, I don't like 9%. 00:41:03.070 --> 00:41:04.510 align:middle line:90% I'm going to go back to-- 00:41:04.510 --> 00:41:06.340 align:middle line:84% that clearly tells me that my output 00:41:06.340 --> 00:41:08.050 align:middle line:84% is way above the natural rate of output. 00:41:08.050 --> 00:41:09.383 align:middle line:90% I'm going to hike interest rate. 00:41:09.383 --> 00:41:13.158 align:middle line:84% And somebody tells the Fed, this is your natural interest rate. 00:41:13.158 --> 00:41:15.200 align:middle line:84% A very good research department tells them, look, 00:41:15.200 --> 00:41:16.160 align:middle line:84% this is your natural interest rate. 00:41:16.160 --> 00:41:17.030 align:middle line:90% Hike it to there. 00:41:17.030 --> 00:41:19.520 align:middle line:84% Suppose the Fed hikes the interest rate to that point. 00:41:19.520 --> 00:41:21.300 align:middle line:90% What happens? 00:41:21.300 --> 00:41:24.830 align:middle line:84% So the Fed realized here this was going really wrong. 00:41:24.830 --> 00:41:27.125 align:middle line:90% They end up with 9% inflation. 00:41:27.125 --> 00:41:29.480 align:middle line:84% But somebody tells them, look, this is your natural-- 00:41:29.480 --> 00:41:31.730 align:middle line:84% your neutral interest rate, your r star. 00:41:31.730 --> 00:41:32.840 align:middle line:90% Bring it there. 00:41:32.840 --> 00:41:35.478 align:middle line:84% And the Fed immediately reacts and takes it there. 00:41:35.478 --> 00:41:36.020 align:middle line:90% What happens? 00:41:36.020 --> 00:41:38.580 align:middle line:90% 00:41:38.580 --> 00:41:40.490 align:middle line:84% Is the Fed happy with the final outcome? 00:41:40.490 --> 00:41:42.800 align:middle line:84% And suppose the research department was really good, 00:41:42.800 --> 00:41:44.720 align:middle line:90% so they got it right. 00:41:44.720 --> 00:41:49.910 align:middle line:84% So the r star was the right r star, 00:41:49.910 --> 00:41:51.680 align:middle line:84% and the Fed implemented that policy, 00:41:51.680 --> 00:41:54.320 align:middle line:84% moving to-- suppose that the interest rate, the real interest 00:41:54.320 --> 00:41:56.152 align:middle line:90% rate they had, was minus 1%. 00:41:56.152 --> 00:41:57.860 align:middle line:84% I'm telling you numbers that are not that 00:41:57.860 --> 00:41:59.900 align:middle line:90% different from what we had-- 00:41:59.900 --> 00:42:00.890 align:middle line:90% minus 1%. 00:42:00.890 --> 00:42:04.610 align:middle line:84% And the research department tells them, no, your rn 00:42:04.610 --> 00:42:05.960 align:middle line:90% is really 1%. 00:42:05.960 --> 00:42:09.665 align:middle line:84% So they hike interest rate by 2% immediately. 00:42:09.665 --> 00:42:10.540 align:middle line:90% And now what happens? 00:42:10.540 --> 00:42:20.770 align:middle line:90% 00:42:20.770 --> 00:42:23.940 align:middle line:84% So I guess that question is a little vague. 00:42:23.940 --> 00:42:26.520 align:middle line:84% But I'm saying, is the central bank happy 00:42:26.520 --> 00:42:30.840 align:middle line:84% now that it-- ooh, I got-- we got the right natural rate, 00:42:30.840 --> 00:42:31.900 align:middle line:90% neutral rate? 00:42:31.900 --> 00:42:34.565 align:middle line:90% It's called neutral rate. 00:42:34.565 --> 00:42:35.940 align:middle line:84% Well, I'm telling you, I wouldn't 00:42:35.940 --> 00:42:38.160 align:middle line:84% be asking you if the Fed was happy after that. 00:42:38.160 --> 00:42:40.590 align:middle line:84% So why do you think-- why are they unhappy? 00:42:40.590 --> 00:42:43.910 align:middle line:84% Why is the Fed unhappy after that? 00:42:43.910 --> 00:42:47.390 align:middle line:84% Not unhappy with the policy, but what I'm saying, 00:42:47.390 --> 00:42:49.426 align:middle line:84% the adjustment is not completed at that point. 00:42:49.426 --> 00:42:49.926 align:middle line:90% Why? 00:42:49.926 --> 00:42:56.758 align:middle line:90% 00:42:56.758 --> 00:42:58.860 align:middle line:84% And I'm trying to make the bigger point 00:42:58.860 --> 00:43:01.680 align:middle line:84% for why central banks are so eager to maintain 00:43:01.680 --> 00:43:03.720 align:middle line:84% credibility and not have this kind of model 00:43:03.720 --> 00:43:04.650 align:middle line:90% of expected inflation. 00:43:04.650 --> 00:43:08.370 align:middle line:84% They want the markets to believe them that they have a target 00:43:08.370 --> 00:43:11.220 align:middle line:84% and that they want to go to that target and that, 00:43:11.220 --> 00:43:13.560 align:middle line:84% to set an expected inflation equal to that constant 00:43:13.560 --> 00:43:16.380 align:middle line:84% equal to the target, that's what they dream with because, 00:43:16.380 --> 00:43:19.200 align:middle line:84% if they don't get that, if they get this instead, 00:43:19.200 --> 00:43:21.260 align:middle line:90% things are nasty. 00:43:21.260 --> 00:43:23.120 align:middle line:84% And I'm trying to describe that nastiness-- 00:43:23.120 --> 00:43:25.850 align:middle line:90% I mean, what is happening now. 00:43:25.850 --> 00:43:26.770 align:middle line:90% So what happens here? 00:43:26.770 --> 00:43:28.300 align:middle line:90% OK, so we went here. 00:43:28.300 --> 00:43:30.340 align:middle line:90% Inflation got to be 9%. 00:43:30.340 --> 00:43:32.380 align:middle line:84% And now the Fed, boom, hikes interest rate 00:43:32.380 --> 00:43:35.200 align:middle line:90% by 200 basis points. 00:43:35.200 --> 00:43:36.790 align:middle line:90% It got to a natural rate. 00:43:36.790 --> 00:43:39.070 align:middle line:84% We're back at output equal to natural rate of output. 00:43:39.070 --> 00:43:40.570 align:middle line:84% What is happening to inflation here? 00:43:40.570 --> 00:43:44.647 align:middle line:90% 00:43:44.647 --> 00:43:46.230 align:middle line:84% So now we're back at the natural rate. 00:43:46.230 --> 00:43:49.560 align:middle line:90% What is happening to inflation? 00:43:49.560 --> 00:43:52.470 align:middle line:84% Well, this diagram tells you something very specific. 00:43:52.470 --> 00:43:54.420 align:middle line:90% It says it's not changing. 00:43:54.420 --> 00:43:58.280 align:middle line:84% So now your inflation, at least, is not changing. 00:43:58.280 --> 00:43:58.910 align:middle line:90% OK? 00:43:58.910 --> 00:44:01.248 align:middle line:90% So that's good. 00:44:01.248 --> 00:44:02.540 align:middle line:90% Yeah, at least it's not rising. 00:44:02.540 --> 00:44:04.040 align:middle line:90% Here it was rising. 00:44:04.040 --> 00:44:05.080 align:middle line:90% It's not changing. 00:44:05.080 --> 00:44:06.080 align:middle line:90% But what is the problem? 00:44:06.080 --> 00:44:08.700 align:middle line:90% 00:44:08.700 --> 00:44:11.060 align:middle line:84% Inflation not changing when you're at 9% 00:44:11.060 --> 00:44:13.040 align:middle line:84% is not a good outcome for the Fed. 00:44:13.040 --> 00:44:16.300 align:middle line:90% The Fed wants 2%, not 9%. 00:44:16.300 --> 00:44:16.960 align:middle line:90% OK? 00:44:16.960 --> 00:44:19.270 align:middle line:84% So they-- when you have this modification, 00:44:19.270 --> 00:44:22.360 align:middle line:84% you need to do more than that because you need to bring 00:44:22.360 --> 00:44:23.990 align:middle line:90% expected inflation down. 00:44:23.990 --> 00:44:25.420 align:middle line:90% So you need to overshoot. 00:44:25.420 --> 00:44:27.970 align:middle line:84% A Fed that finds itself with 9% inflation 00:44:27.970 --> 00:44:30.070 align:middle line:84% and has expected inflation an anchor 00:44:30.070 --> 00:44:32.763 align:middle line:84% needs to be inflation much lower. 00:44:32.763 --> 00:44:35.180 align:middle line:84% So it needs to raise interest in the short run much higher 00:44:35.180 --> 00:44:36.805 align:middle line:84% than the natural rate of interest rate. 00:44:36.805 --> 00:44:39.140 align:middle line:84% So it gets negative inflation here 00:44:39.140 --> 00:44:42.230 align:middle line:84% so you can bring the 9% back to 2%. 00:44:42.230 --> 00:44:42.730 align:middle line:90% No? 00:44:42.730 --> 00:44:46.810 align:middle line:84% So I have to generate the minus 7% here. 00:44:46.810 --> 00:44:48.730 align:middle line:84% And to generate the minus 7% here, 00:44:48.730 --> 00:44:51.700 align:middle line:84% I need to bring output much below the natural rate 00:44:51.700 --> 00:44:52.250 align:middle line:90% of output. 00:44:52.250 --> 00:44:54.890 align:middle line:84% I need to cause a big recession to do that. 00:44:54.890 --> 00:44:57.610 align:middle line:84% And that's the reason the central banks don't 00:44:57.610 --> 00:44:59.290 align:middle line:84% want to be in this scenario, because 00:44:59.290 --> 00:45:03.550 align:middle line:84% with this level of inflation, if expected inflation becomes 00:45:03.550 --> 00:45:05.710 align:middle line:84% an anchor, then there is no way around that. 00:45:05.710 --> 00:45:08.143 align:middle line:84% The Fed will have to cause a big recession to get out 00:45:08.143 --> 00:45:09.310 align:middle line:90% of the inflationary problem. 00:45:09.310 --> 00:45:12.040 align:middle line:90% 00:45:12.040 --> 00:45:13.930 align:middle line:84% Contrast that with a case in which 00:45:13.930 --> 00:45:15.460 align:middle line:84% the market-- the expected inflation 00:45:15.460 --> 00:45:17.440 align:middle line:84% is not equal to lagged inflation but is 00:45:17.440 --> 00:45:20.050 align:middle line:84% equal to whatever the Fed tells them is the long run 00:45:20.050 --> 00:45:21.900 align:middle line:90% average, 2%. 00:45:21.900 --> 00:45:23.960 align:middle line:84% So now, suppose that, therefore, rather 00:45:23.960 --> 00:45:29.030 align:middle line:84% than having here pi minus 1, I have that target, pi bar, which 00:45:29.030 --> 00:45:30.390 align:middle line:90% is 2%. 00:45:30.390 --> 00:45:33.390 align:middle line:90% So yeah, we got to 9%. 00:45:33.390 --> 00:45:36.380 align:middle line:90% But for the Fed to go back to-- 00:45:36.380 --> 00:45:38.510 align:middle line:84% the Fed would say, oop, I messed up. 00:45:38.510 --> 00:45:41.280 align:middle line:84% Clearly, I set a real interest rate that was way too low, 00:45:41.280 --> 00:45:43.170 align:middle line:84% and so I end up with 9% inflation. 00:45:43.170 --> 00:45:44.900 align:middle line:84% But if credibility is maintained, 00:45:44.900 --> 00:45:47.810 align:middle line:84% and still people expect 2% in the medium run, 00:45:47.810 --> 00:45:49.490 align:middle line:84% then that means that the Fed doesn't 00:45:49.490 --> 00:45:52.160 align:middle line:84% need to cause a recession to bring inflation back 00:45:52.160 --> 00:45:53.450 align:middle line:90% to the normal level. 00:45:53.450 --> 00:45:56.870 align:middle line:84% It just needs to bring output to a level 00:45:56.870 --> 00:45:59.260 align:middle line:90% equal to potential output. 00:45:59.260 --> 00:46:00.930 align:middle line:84% So it just needs to raise interest rate 00:46:00.930 --> 00:46:05.100 align:middle line:84% to rn, to the natural rate of the r star, 00:46:05.100 --> 00:46:07.410 align:middle line:84% not to r star plus something in order 00:46:07.410 --> 00:46:10.880 align:middle line:84% to have disinflation in the short run, OK? 00:46:10.880 --> 00:46:13.392 align:middle line:84% And we're there at this moment, on the verge 00:46:13.392 --> 00:46:14.225 align:middle line:90% of these two worlds. 00:46:14.225 --> 00:46:17.150 align:middle line:84% We have been alternating between the two worlds, 00:46:17.150 --> 00:46:20.780 align:middle line:84% still more biased towards the good world 00:46:20.780 --> 00:46:23.990 align:middle line:84% in which the Fed doesn't need to cause a-- they need-- 00:46:23.990 --> 00:46:25.670 align:middle line:84% the Fed needs to slow down the economy 00:46:25.670 --> 00:46:28.730 align:middle line:84% because it still needs to bring output down to Yn. 00:46:28.730 --> 00:46:30.200 align:middle line:90% But that's a small change. 00:46:30.200 --> 00:46:33.240 align:middle line:84% In practice, all these things are growing over time. 00:46:33.240 --> 00:46:35.420 align:middle line:84% It just means that the economy grows at a lower 00:46:35.420 --> 00:46:38.870 align:middle line:90% pace for a few quarters, OK? 00:46:38.870 --> 00:46:41.810 align:middle line:84% But it's very different to have to bring temporary output down 00:46:41.810 --> 00:46:44.960 align:middle line:84% here because, for that, you need to sort of bring the-- 00:46:44.960 --> 00:46:48.560 align:middle line:84% growth has to become negative for some period of time 00:46:48.560 --> 00:46:50.780 align:middle line:84% in order to bring inflation down. 00:46:50.780 --> 00:46:53.400 align:middle line:90% 00:46:53.400 --> 00:46:55.220 align:middle line:90% Good. 00:46:55.220 --> 00:47:01.240 align:middle line:84% So big lessons from this part are 00:47:01.240 --> 00:47:03.510 align:middle line:84% that, as I said before, in the medium run-- 00:47:03.510 --> 00:47:04.943 align:middle line:90% so I haven't changed-- 00:47:04.943 --> 00:47:06.610 align:middle line:84% I haven't changed any of the two models. 00:47:06.610 --> 00:47:09.027 align:middle line:84% I told you what was the model of the short run, the IS-LM. 00:47:09.027 --> 00:47:10.840 align:middle line:90% That's still true here. 00:47:10.840 --> 00:47:13.090 align:middle line:84% I told you then what was the model of the natural rate 00:47:13.090 --> 00:47:15.007 align:middle line:84% of unemployment and all that and that there we 00:47:15.007 --> 00:47:17.257 align:middle line:84% didn't have any monetary policy or anything like that. 00:47:17.257 --> 00:47:19.460 align:middle line:84% We look at what happened in the labor market, 00:47:19.460 --> 00:47:21.760 align:middle line:84% and we determine the natural rate of unemployment. 00:47:21.760 --> 00:47:24.340 align:middle line:90% And that was it, OK? 00:47:24.340 --> 00:47:27.072 align:middle line:84% So the medium run here is when we 00:47:27.072 --> 00:47:28.780 align:middle line:84% are in that world in which it has nothing 00:47:28.780 --> 00:47:30.070 align:middle line:90% to do with monetary policy. 00:47:30.070 --> 00:47:33.220 align:middle line:84% It has all to do with real variables, OK? 00:47:33.220 --> 00:47:36.970 align:middle line:84% What is an equilibrium, long-run real interest rate, 00:47:36.970 --> 00:47:38.850 align:middle line:84% what is a natural rate of unemployment, 00:47:38.850 --> 00:47:39.850 align:middle line:90% and things of that kind. 00:47:39.850 --> 00:47:42.650 align:middle line:90% 00:47:42.650 --> 00:47:45.170 align:middle line:84% But monetary policy, what it does do 00:47:45.170 --> 00:47:49.880 align:middle line:84% is certainly determine, in the short run, equilibrium output. 00:47:49.880 --> 00:47:52.438 align:middle line:84% But in the medium run, it determines 00:47:52.438 --> 00:47:54.980 align:middle line:84% what is a nominal interest rate, equilibrium nominal interest 00:47:54.980 --> 00:47:57.860 align:middle line:84% rate, and the level of inflation because the economy will 00:47:57.860 --> 00:48:03.080 align:middle line:84% have a real interest rate, which is the r star and rn. 00:48:03.080 --> 00:48:04.760 align:middle line:90% The economy has rn. 00:48:04.760 --> 00:48:09.050 align:middle line:84% But the Fed-- and the Fed will not get to pick what rn is. 00:48:09.050 --> 00:48:12.230 align:middle line:84% The only thing that the Fed will get to pick in the medium run 00:48:12.230 --> 00:48:14.090 align:middle line:84% is what is a nominal interest rate that 00:48:14.090 --> 00:48:17.780 align:middle line:84% is consistent with that rn, because suppose that the rn is, 00:48:17.780 --> 00:48:20.260 align:middle line:90% say, 2%. 00:48:20.260 --> 00:48:24.490 align:middle line:84% If the economy ends up having 3% inflation on average, 00:48:24.490 --> 00:48:27.790 align:middle line:84% that means that the nominal interest rate for the long run 00:48:27.790 --> 00:48:29.830 align:middle line:90% is going to have to be 5%. 00:48:29.830 --> 00:48:33.230 align:middle line:84% If instead, that economy has 2% inflation average, 00:48:33.230 --> 00:48:35.470 align:middle line:84% then that means that the long-run nominal interest 00:48:35.470 --> 00:48:37.010 align:middle line:90% rate will be 4%. 00:48:37.010 --> 00:48:39.760 align:middle line:84% So monetary policy affects the nominal interest rate, 00:48:39.760 --> 00:48:42.550 align:middle line:84% nominal variables in the medium run, but not the real variables. 00:48:42.550 --> 00:48:44.830 align:middle line:84% The real variables are determined by the real sector. 00:48:44.830 --> 00:48:47.890 align:middle line:84% And that's often referred as the neutrality of money. 00:48:47.890 --> 00:48:52.240 align:middle line:84% In the medium run and the long run, money tends to be neutral. 00:48:52.240 --> 00:48:56.132 align:middle line:84% And that's what it means, is that real variables 00:48:56.132 --> 00:48:58.090 align:middle line:84% are determined by something entirely different. 00:48:58.090 --> 00:49:02.380 align:middle line:84% But in the short run, monetary policy is the main game in town. 00:49:02.380 --> 00:49:05.180 align:middle line:84% And in the medium run, it's just about inflation. 00:49:05.180 --> 00:49:07.030 align:middle line:90% It's not about real activity. 00:49:07.030 --> 00:49:12.140 align:middle line:90% 00:49:12.140 --> 00:49:15.070 align:middle line:90% Let me stop here. 00:49:15.070 --> 00:49:27.000 align:middle line:90%