WEBVTT 00:00:00.000 --> 00:00:17.610 align:middle line:84% [SQUEAKING] [RUSTLING] [CLICKING] 00:00:17.610 --> 00:00:22.900 align:middle line:84% RICARDO CABALLERO: All right, let's start. 00:00:22.900 --> 00:00:28.060 align:middle line:84% So today I want to talk about interest rates. 00:00:28.060 --> 00:00:30.480 align:middle line:84% If you have followed the news, there 00:00:30.480 --> 00:00:34.620 align:middle line:84% is a lot of debate on these days on where 00:00:34.620 --> 00:00:36.960 align:middle line:84% will the interest rate in the US end 00:00:36.960 --> 00:00:40.350 align:middle line:84% at the end of this tightening cycle. 00:00:40.350 --> 00:00:47.640 align:middle line:90% 00:00:47.640 --> 00:00:50.360 align:middle line:90% And so I'll show you. 00:00:50.360 --> 00:00:52.700 align:middle line:84% There has been a very aggressive monetary policy 00:00:52.700 --> 00:00:56.510 align:middle line:84% trying to fight the inflationary episode we're going through. 00:00:56.510 --> 00:00:59.160 align:middle line:84% And that's done through interest rates. 00:00:59.160 --> 00:01:02.150 align:middle line:84% And the question that I want to address today 00:01:02.150 --> 00:01:06.030 align:middle line:84% is well, how is it that the interest rate is determined? 00:01:06.030 --> 00:01:10.610 align:middle line:84% So when a central bank decides to hike interest rates, 00:01:10.610 --> 00:01:12.560 align:middle line:90% how do they do that? 00:01:12.560 --> 00:01:14.930 align:middle line:84% And obviously this is about financial markets. 00:01:14.930 --> 00:01:17.510 align:middle line:84% Interest rates are set in financial markets. 00:01:17.510 --> 00:01:19.980 align:middle line:84% And financial markets are very, very complicated. 00:01:19.980 --> 00:01:22.750 align:middle line:84% So we're going to keep it very, very simple. 00:01:22.750 --> 00:01:24.590 align:middle line:84% We're going to introduce more complexity 00:01:24.590 --> 00:01:25.650 align:middle line:90% later on in the course. 00:01:25.650 --> 00:01:27.608 align:middle line:84% But still, we're going to keep it pretty simple 00:01:27.608 --> 00:01:31.340 align:middle line:84% because our main objective in studying financial markets 00:01:31.340 --> 00:01:37.760 align:middle line:84% is really to achieve some sort of understanding of how 00:01:37.760 --> 00:01:41.540 align:middle line:84% the interest rate policy that the central bank controls 00:01:41.540 --> 00:01:43.980 align:middle line:90% is determined. 00:01:43.980 --> 00:01:53.690 align:middle line:84% So before I get into specifics, let's see some trivia here. 00:01:53.690 --> 00:01:55.670 align:middle line:90% Who knows who that person is? 00:01:55.670 --> 00:01:57.640 align:middle line:90% OK. 00:01:57.640 --> 00:01:59.144 align:middle line:90% You, sir. 00:01:59.144 --> 00:02:00.380 align:middle line:90% AUDIENCE: Jerome Powell. 00:02:00.380 --> 00:02:02.130 align:middle line:84% RICARDO CABALLERO: Jerome Powell, exactly. 00:02:02.130 --> 00:02:03.676 align:middle line:90% And who is Jerome Powell? 00:02:03.676 --> 00:02:05.470 align:middle line:84% AUDIENCE: The chair of the Federal Reserve. 00:02:05.470 --> 00:02:08.770 align:middle line:84% RICARDO CABALLERO: The chair of the Federal Reserve 00:02:08.770 --> 00:02:12.260 align:middle line:84% System in the US, which is the central bank of the US. 00:02:12.260 --> 00:02:16.570 align:middle line:90% OK, so that was an easy one. 00:02:16.570 --> 00:02:18.580 align:middle line:84% And if you are into financial markets, 00:02:18.580 --> 00:02:20.770 align:middle line:84% everyone is worried about what this guy is thinking 00:02:20.770 --> 00:02:23.050 align:middle line:84% and his friends are thinking at this moment 00:02:23.050 --> 00:02:25.317 align:middle line:84% because they determine the interest rate. 00:02:25.317 --> 00:02:26.150 align:middle line:90% How do they do that? 00:02:26.150 --> 00:02:29.380 align:middle line:84% Well, that's what we're going to talk about later on. 00:02:29.380 --> 00:02:30.250 align:middle line:90% A little trickier. 00:02:30.250 --> 00:02:30.835 align:middle line:90% Who is this? 00:02:30.835 --> 00:02:35.100 align:middle line:90% 00:02:35.100 --> 00:02:35.600 align:middle line:90% No, no. 00:02:35.600 --> 00:02:36.455 align:middle line:90% That's cheating. 00:02:36.455 --> 00:02:39.050 align:middle line:90% 00:02:39.050 --> 00:02:40.910 align:middle line:90% Katsuo Ueda. 00:02:40.910 --> 00:02:45.050 align:middle line:84% He's the next president of the Bank of Japan, 00:02:45.050 --> 00:02:47.120 align:middle line:90% the central bank of Japan. 00:02:47.120 --> 00:02:50.690 align:middle line:84% And an interesting-- there are many interesting things of him, 00:02:50.690 --> 00:02:53.690 align:middle line:84% about him-- but he's a he's a graduate from our program, 00:02:53.690 --> 00:02:58.130 align:middle line:84% the PhD program, which actually is 00:02:58.130 --> 00:03:00.470 align:middle line:84% an incredibly successful program at producing 00:03:00.470 --> 00:03:02.120 align:middle line:90% major central bankers. 00:03:02.120 --> 00:03:04.940 align:middle line:90% Ben Bernanke is our alumnus. 00:03:04.940 --> 00:03:08.990 align:middle line:84% He was the chairman of the central bank, 00:03:08.990 --> 00:03:11.180 align:middle line:84% the chair of the central bank of the Fed 00:03:11.180 --> 00:03:12.980 align:middle line:90% during the financial crisis. 00:03:12.980 --> 00:03:16.650 align:middle line:84% Mario Draghi is one of our graduates. 00:03:16.650 --> 00:03:21.830 align:middle line:84% Mario Draghi was the most successful central banker 00:03:21.830 --> 00:03:22.550 align:middle line:90% in Europe. 00:03:22.550 --> 00:03:27.170 align:middle line:84% He was the president of the ECB, European Central Bank, 00:03:27.170 --> 00:03:28.730 align:middle line:84% for many years, and in particular, 00:03:28.730 --> 00:03:32.458 align:middle line:84% during the global financial crisis and the European crisis, 00:03:32.458 --> 00:03:34.250 align:middle line:84% which followed the global financial crisis. 00:03:34.250 --> 00:03:36.770 align:middle line:90% 00:03:36.770 --> 00:03:37.940 align:middle line:90% But you name it-- 00:03:37.940 --> 00:03:41.030 align:middle line:84% Stan Fisher in the past of the Bank of Israel. 00:03:41.030 --> 00:03:45.710 align:middle line:84% And nowadays, Phil Lowe of the chair of the Reserve 00:03:45.710 --> 00:03:47.300 align:middle line:90% Bank of Australia. 00:03:47.300 --> 00:03:51.620 align:middle line:84% In Chile we have had two or three presidents and so on. 00:03:51.620 --> 00:03:53.780 align:middle line:84% So if this is your career, this is a good program. 00:03:53.780 --> 00:03:55.190 align:middle line:90% You should join our program. 00:03:55.190 --> 00:03:57.420 align:middle line:90% You may end up in a good place. 00:03:57.420 --> 00:04:00.200 align:middle line:84% But that's the next one for Japan. 00:04:00.200 --> 00:04:02.600 align:middle line:84% And Japan is a very interesting place 00:04:02.600 --> 00:04:04.940 align:middle line:84% from the point of view of monetary policy, 00:04:04.940 --> 00:04:08.810 align:middle line:84% precisely because they haven't had much space to do 00:04:08.810 --> 00:04:10.320 align:middle line:90% conventional monetary policy. 00:04:10.320 --> 00:04:12.530 align:middle line:84% So they have had to do lots of unconventional things 00:04:12.530 --> 00:04:16.550 align:middle line:84% from the point of view of what a central bank typically does. 00:04:16.550 --> 00:04:18.930 align:middle line:84% But today, we're going to study conventional things. 00:04:18.930 --> 00:04:21.430 align:middle line:84% And we'll talk a little bit more about unconventional things 00:04:21.430 --> 00:04:23.280 align:middle line:90% later in the course. 00:04:23.280 --> 00:04:25.490 align:middle line:84% Now, some institutional knowledge-- 00:04:25.490 --> 00:04:29.510 align:middle line:84% this is, again, in the US, the central bank of the US 00:04:29.510 --> 00:04:31.400 align:middle line:84% is called the Federal Reserve System. 00:04:31.400 --> 00:04:33.410 align:middle line:90% And it's a system, really. 00:04:33.410 --> 00:04:41.250 align:middle line:84% It has the Board of Governors which sits in Washington DC. 00:04:41.250 --> 00:04:43.430 align:middle line:90% And there are seven governors. 00:04:43.430 --> 00:04:47.600 align:middle line:84% And the governors are nominated by the president 00:04:47.600 --> 00:04:50.030 align:middle line:84% and then confirmed by the Senate. 00:04:50.030 --> 00:04:55.700 align:middle line:84% And the president of that board is-- 00:04:55.700 --> 00:05:01.490 align:middle line:84% so the president of the Fed will be one of those members. 00:05:01.490 --> 00:05:05.780 align:middle line:84% Now, in addition to that, the US has a Federal Reserve bank 00:05:05.780 --> 00:05:06.350 align:middle line:90% system. 00:05:06.350 --> 00:05:10.240 align:middle line:90% There are 12 regional banks. 00:05:10.240 --> 00:05:11.750 align:middle line:90% There is one in Boston. 00:05:11.750 --> 00:05:14.330 align:middle line:84% In fact, if you look at the skyline near the waterfront, 00:05:14.330 --> 00:05:18.470 align:middle line:84% there is a building built out of recycled aluminum. 00:05:18.470 --> 00:05:21.320 align:middle line:84% Well, that's the Reserve Bank of Boston. 00:05:21.320 --> 00:05:27.920 align:middle line:84% And of those 12 regional banks, they rotate. 00:05:27.920 --> 00:05:30.230 align:middle line:84% So the policy, the policy interest rate, 00:05:30.230 --> 00:05:35.390 align:middle line:84% is set in a committee, which is called the FOMC, Federal Open 00:05:35.390 --> 00:05:37.160 align:middle line:90% Market Committee. 00:05:37.160 --> 00:05:39.860 align:middle line:84% And the member of that, the voting members of that committee 00:05:39.860 --> 00:05:45.840 align:middle line:84% are the seven governors plus 4 out of the 12. 00:05:45.840 --> 00:05:46.910 align:middle line:90% And they rotate. 00:05:46.910 --> 00:05:48.380 align:middle line:90% Most of them rotate. 00:05:48.380 --> 00:05:50.630 align:middle line:84% The only one I think does not rotate 00:05:50.630 --> 00:05:55.940 align:middle line:84% is the president of the New York Fed, 00:05:55.940 --> 00:05:57.950 align:middle line:84% because they are so important, because that's 00:05:57.950 --> 00:06:01.100 align:middle line:84% the financial heart of the US that you certainly 00:06:01.100 --> 00:06:06.920 align:middle line:84% want that president to be involved in interest rate 00:06:06.920 --> 00:06:07.700 align:middle line:90% decisions. 00:06:07.700 --> 00:06:10.940 align:middle line:84% And it's really the Fed that is in charge of communication 00:06:10.940 --> 00:06:14.330 align:middle line:84% with financial markets, which is a huge thing for the Fed. 00:06:14.330 --> 00:06:18.200 align:middle line:84% They are in New York and they're crucial for that. 00:06:18.200 --> 00:06:22.010 align:middle line:84% OK so those are the people that-- 00:06:22.010 --> 00:06:24.350 align:middle line:84% and in most places around the world 00:06:24.350 --> 00:06:28.670 align:middle line:84% you're going to have at least something equivalent to the 7 00:06:28.670 --> 00:06:30.470 align:middle line:90% governors out there-- 00:06:30.470 --> 00:06:31.490 align:middle line:90% most places. 00:06:31.490 --> 00:06:35.130 align:middle line:84% Obviously, the ECB is different because it's multiple countries. 00:06:35.130 --> 00:06:37.465 align:middle line:84% So each country sends one member. 00:06:37.465 --> 00:06:40.320 align:middle line:90% 00:06:40.320 --> 00:06:45.470 align:middle line:84% But otherwise, it tends to be like the US 00:06:45.470 --> 00:06:49.560 align:middle line:90% without the regional banks. 00:06:49.560 --> 00:06:51.970 align:middle line:84% So why do we care about monetary policy? 00:06:51.970 --> 00:06:54.050 align:middle line:84% Well, because the thing is one of the main policy 00:06:54.050 --> 00:06:55.730 align:middle line:84% tools you have in the short run remember 00:06:55.730 --> 00:06:57.105 align:middle line:84% in this part of the course, we're 00:06:57.105 --> 00:07:00.150 align:middle line:84% trying to understand output in the short term. 00:07:00.150 --> 00:07:02.340 align:middle line:84% And one of the main policy levers-- 00:07:02.340 --> 00:07:04.040 align:middle line:84% I mean, how can you affect output-- 00:07:04.040 --> 00:07:06.300 align:middle line:90% is monetary policy. 00:07:06.300 --> 00:07:09.700 align:middle line:90% Which one is the other one? 00:07:09.700 --> 00:07:11.095 align:middle line:90% There are two major ones. 00:07:11.095 --> 00:07:11.560 align:middle line:90% AUDIENCE: Fiscal policy. 00:07:11.560 --> 00:07:12.490 align:middle line:84% RICARDO CABALLERO: Fiscal policy. 00:07:12.490 --> 00:07:13.235 align:middle line:90% Exactly. 00:07:13.235 --> 00:07:15.610 align:middle line:84% And fiscal policy we did look at in the previous lecture. 00:07:15.610 --> 00:07:18.130 align:middle line:84% Remember, we said an expansionary fiscal policy 00:07:18.130 --> 00:07:20.590 align:middle line:84% is an increasing G while a decline in T 00:07:20.590 --> 00:07:22.690 align:middle line:84% would lead to an expansion in aggregate demand. 00:07:22.690 --> 00:07:25.360 align:middle line:90% Equilibrium output would go up. 00:07:25.360 --> 00:07:27.670 align:middle line:84% So fiscal policy is something you always 00:07:27.670 --> 00:07:30.490 align:middle line:90% use in deep recessions. 00:07:30.490 --> 00:07:33.820 align:middle line:84% But monetary policy is much more nimble. 00:07:33.820 --> 00:07:35.440 align:middle line:84% I mean, it's a bunch of people that 00:07:35.440 --> 00:07:37.870 align:middle line:84% need to meet and just change the interest rate. 00:07:37.870 --> 00:07:40.930 align:middle line:84% Anything that is fiscal, there are some automatic stabilizers, 00:07:40.930 --> 00:07:41.560 align:middle line:90% by the way. 00:07:41.560 --> 00:07:43.690 align:middle line:84% So automatically, fiscal policy becomes 00:07:43.690 --> 00:07:46.420 align:middle line:84% more expansionary during recessions and stuff like that. 00:07:46.420 --> 00:07:49.900 align:middle line:84% But any deviation from the typical automatic stabilizers 00:07:49.900 --> 00:07:51.730 align:middle line:84% require Congress to approve things. 00:07:51.730 --> 00:07:53.090 align:middle line:90% It's a long process. 00:07:53.090 --> 00:07:55.990 align:middle line:84% And so it's not something that can react as 00:07:55.990 --> 00:07:59.428 align:middle line:90% quickly as monetary policy can. 00:07:59.428 --> 00:08:00.970 align:middle line:84% And so that's what we're going to do. 00:08:00.970 --> 00:08:04.600 align:middle line:84% That's the reason why monetary policy is important for us 00:08:04.600 --> 00:08:05.950 align:middle line:90% at this point. 00:08:05.950 --> 00:08:08.600 align:middle line:84% Then there are medium and long run issues. 00:08:08.600 --> 00:08:12.230 align:middle line:84% Fiscal policy still affects equilibrium output 00:08:12.230 --> 00:08:13.580 align:middle line:90% in the medium and long run. 00:08:13.580 --> 00:08:15.950 align:middle line:84% Monetary policy is much less effective at that. 00:08:15.950 --> 00:08:19.520 align:middle line:84% It's very difficult to change sort of equilibrium growth 00:08:19.520 --> 00:08:21.260 align:middle line:84% or things like that with monetary policy. 00:08:21.260 --> 00:08:22.940 align:middle line:90% It's very pretty minor. 00:08:22.940 --> 00:08:26.510 align:middle line:84% Most of the impact of monetary policy in the medium and long 00:08:26.510 --> 00:08:28.820 align:middle line:84% run is really on the price level and inflation 00:08:28.820 --> 00:08:30.800 align:middle line:90% more than on real activity. 00:08:30.800 --> 00:08:33.080 align:middle line:84% But in the short run it's very powerful for reasons 00:08:33.080 --> 00:08:35.600 align:middle line:84% that we're going to discuss in this and the next lecture. 00:08:35.600 --> 00:08:41.230 align:middle line:90% 00:08:41.230 --> 00:08:44.830 align:middle line:84% OK, so as I said, monetary policy 00:08:44.830 --> 00:08:46.450 align:middle line:90% acts through financial markets. 00:08:46.450 --> 00:08:50.280 align:middle line:84% I think it's a very interesting part of my research agenda 00:08:50.280 --> 00:08:51.310 align:middle line:90% is about that. 00:08:51.310 --> 00:08:54.420 align:middle line:84% I think the central bank is a very strange institution 00:08:54.420 --> 00:08:57.780 align:middle line:84% because most of its mandates are in terms of what 00:08:57.780 --> 00:08:59.820 align:middle line:90% happens in the goods market. 00:08:59.820 --> 00:09:03.030 align:middle line:84% It says try not to get into recession. 00:09:03.030 --> 00:09:05.530 align:middle line:84% Try to get us out of a recession, and so on. 00:09:05.530 --> 00:09:08.970 align:middle line:84% But unlike fiscal policy, which has tools that are directly 00:09:08.970 --> 00:09:10.870 align:middle line:84% aimed at the goods market, remember, 00:09:10.870 --> 00:09:13.043 align:middle line:84% is a purchases by the government of goods. 00:09:13.043 --> 00:09:14.460 align:middle line:84% So if there is insufficient demand 00:09:14.460 --> 00:09:17.760 align:middle line:84% for goods, the fiscal policy, the fiscal authority 00:09:17.760 --> 00:09:19.290 align:middle line:90% can go out there and buy goods. 00:09:19.290 --> 00:09:21.030 align:middle line:90% That creates more demand. 00:09:21.030 --> 00:09:25.230 align:middle line:84% The central bank is given the same mandate aside 00:09:25.230 --> 00:09:27.240 align:middle line:84% from price stability and things like that we 00:09:27.240 --> 00:09:28.380 align:middle line:90% want to worry about later. 00:09:28.380 --> 00:09:30.150 align:middle line:90% But it doesn't have any tools. 00:09:30.150 --> 00:09:32.610 align:middle line:84% The central bank, if there is insufficient demand, 00:09:32.610 --> 00:09:35.850 align:middle line:84% the central bank cannot go out there and buy hamburgers. 00:09:35.850 --> 00:09:38.280 align:middle line:84% Fiscal policy can do that and expand the demand 00:09:38.280 --> 00:09:41.040 align:middle line:84% for hamburgers, but not monetary policy. 00:09:41.040 --> 00:09:45.570 align:middle line:84% What monetary policy can do is buy bonds, buy instruments 00:09:45.570 --> 00:09:46.770 align:middle line:90% in the financial markets. 00:09:46.770 --> 00:09:49.810 align:middle line:84% And through that, affects real activity. 00:09:49.810 --> 00:09:54.820 align:middle line:84% So it's the fastest policy tool but it's the most indirect, 00:09:54.820 --> 00:09:58.690 align:middle line:84% in a sense, because it has to go through financial markets. 00:09:58.690 --> 00:10:02.210 align:middle line:84% And those channels can be very complex. 00:10:02.210 --> 00:10:05.950 align:middle line:84% But obviously, we're not in the business of complicating things 00:10:05.950 --> 00:10:06.980 align:middle line:90% in this course. 00:10:06.980 --> 00:10:09.170 align:middle line:84% So we're going to make it very, very simple. 00:10:09.170 --> 00:10:13.120 align:middle line:84% We're going to assume that financial markets only 00:10:13.120 --> 00:10:14.920 align:middle line:90% have two instruments. 00:10:14.920 --> 00:10:16.600 align:middle line:90% Obviously a huge simplification. 00:10:16.600 --> 00:10:19.270 align:middle line:84% There are millions of financial instruments out there. 00:10:19.270 --> 00:10:21.690 align:middle line:84% But I'm going to isolate only two instruments because this 00:10:21.690 --> 00:10:27.720 align:middle line:84% happens to be the instrument where the central banks 00:10:27.720 --> 00:10:30.270 align:middle line:90% typically participate. 00:10:30.270 --> 00:10:32.910 align:middle line:84% They affect all asset prices around. 00:10:32.910 --> 00:10:35.647 align:middle line:84% But the direct interventions typically-- 00:10:35.647 --> 00:10:37.230 align:middle line:84% recently has been a little different-- 00:10:37.230 --> 00:10:41.862 align:middle line:84% but typically it's only in these kind of instruments. 00:10:41.862 --> 00:10:43.820 align:middle line:84% And so we're going to focus all of our analysis 00:10:43.820 --> 00:10:45.633 align:middle line:84% on those two instruments for now. 00:10:45.633 --> 00:10:47.800 align:middle line:84% Later on, we're going to talk about equity and stuff 00:10:47.800 --> 00:10:49.300 align:middle line:90% like that. 00:10:49.300 --> 00:10:53.710 align:middle line:84% But just to isolate how monetary policy works, 00:10:53.710 --> 00:10:56.920 align:middle line:84% it's sufficient to just focus on two financial instruments. 00:10:56.920 --> 00:10:58.420 align:middle line:84% So we're going to assume that people 00:10:58.420 --> 00:11:03.870 align:middle line:84% have their wealth in only two forms, in two financial assets. 00:11:03.870 --> 00:11:06.950 align:middle line:84% One, we're going to call it money. 00:11:06.950 --> 00:11:10.490 align:middle line:84% And the other one we want to call it bonds. 00:11:10.490 --> 00:11:14.570 align:middle line:84% Money, the characteristic of money, what we call money, 00:11:14.570 --> 00:11:17.190 align:middle line:84% there are many definitions of money, and 1, and 2, and 3, 00:11:17.190 --> 00:11:17.690 align:middle line:90% and 4. 00:11:17.690 --> 00:11:19.960 align:middle line:90% But let's keep it very simple. 00:11:19.960 --> 00:11:21.820 align:middle line:84% Money essentially means something 00:11:21.820 --> 00:11:26.090 align:middle line:84% that you can use very easily for transactions. 00:11:26.090 --> 00:11:31.895 align:middle line:84% So for example, the most important example of money-- 00:11:31.895 --> 00:11:33.770 align:middle line:84% not the largest, but the most important one-- 00:11:33.770 --> 00:11:37.070 align:middle line:90% is cash, currency. 00:11:37.070 --> 00:11:39.140 align:middle line:90% You can buy anything with cash. 00:11:39.140 --> 00:11:41.070 align:middle line:90% It's no problem whatsoever. 00:11:41.070 --> 00:11:48.370 align:middle line:84% Now the characteristics of the money typically does not have, 00:11:48.370 --> 00:11:50.830 align:middle line:90% it doesn't give you any return. 00:11:50.830 --> 00:11:52.540 align:middle line:90% You don't invest in cash. 00:11:52.540 --> 00:11:56.040 align:middle line:84% You have cash because you need to do transactions. 00:11:56.040 --> 00:11:59.140 align:middle line:84% But it's not the way you get a return. 00:11:59.140 --> 00:12:02.130 align:middle line:84% And so money, that's what it's going to mean for us, 00:12:02.130 --> 00:12:04.230 align:middle line:84% is something that is used in transactions. 00:12:04.230 --> 00:12:06.780 align:middle line:84% But it pays no interest rate, no interest. 00:12:06.780 --> 00:12:09.000 align:middle line:90% There's no interest on that. 00:12:09.000 --> 00:12:11.890 align:middle line:84% A bond is going to be the polar opposite. 00:12:11.890 --> 00:12:15.190 align:middle line:84% It's going to be something that pays a positive interest rate. 00:12:15.190 --> 00:12:18.390 align:middle line:84% So if you buy a bond for 100, for 95, 00:12:18.390 --> 00:12:20.560 align:middle line:84% you're going to get $100 a year from now. 00:12:20.560 --> 00:12:22.560 align:middle line:84% So you get something out of that bond. 00:12:22.560 --> 00:12:24.540 align:middle line:84% But it's not very useful for transactions. 00:12:24.540 --> 00:12:28.110 align:middle line:84% I mean, you cannot go and buy your lunch with a bond. 00:12:28.110 --> 00:12:29.850 align:middle line:84% You get the piece of bond for that. 00:12:29.850 --> 00:12:31.840 align:middle line:90% And many things cannot be-- 00:12:31.840 --> 00:12:33.780 align:middle line:90% even within financial markets-- 00:12:33.780 --> 00:12:35.400 align:middle line:84% you cannot buy assets with asset. 00:12:35.400 --> 00:12:38.640 align:middle line:84% You have to go through some process in which you can sell 00:12:38.640 --> 00:12:41.610 align:middle line:84% something, get cash, and with cash you 00:12:41.610 --> 00:12:43.770 align:middle line:84% pay for that stuff-- not necessarily cash. 00:12:43.770 --> 00:12:46.740 align:middle line:84% It could be other forms of money. 00:12:46.740 --> 00:12:48.630 align:middle line:84% But typically, financial instruments 00:12:48.630 --> 00:12:51.530 align:middle line:84% need to be sold before you can buy something else. 00:12:51.530 --> 00:12:52.440 align:middle line:90% You don't swap them. 00:12:52.440 --> 00:12:54.690 align:middle line:90% It's not a barter. 00:12:54.690 --> 00:12:56.310 align:middle line:84% But this is what it means for us. 00:12:56.310 --> 00:12:59.560 align:middle line:84% So this, whenever you see something like this, 00:12:59.560 --> 00:13:01.840 align:middle line:84% is always interesting for an economist. 00:13:01.840 --> 00:13:02.340 align:middle line:90% Why? 00:13:02.340 --> 00:13:07.700 align:middle line:90% 00:13:07.700 --> 00:13:11.120 align:middle line:84% Any economists, microeconomists or whatever. 00:13:11.120 --> 00:13:15.860 align:middle line:84% What have I done there that makes-- 00:13:15.860 --> 00:13:17.270 align:middle line:90% Economics is about decisions. 00:13:17.270 --> 00:13:19.430 align:middle line:84% And then it's about the equilibrium-- 00:13:19.430 --> 00:13:21.195 align:middle line:90% decisions and equilibrium. 00:13:21.195 --> 00:13:23.570 align:middle line:84% AUDIENCE: What makes people decide how much [INAUDIBLE]?? 00:13:23.570 --> 00:13:25.820 align:middle line:84% RICARDO CABALLERO: There's a decision to be made here. 00:13:25.820 --> 00:13:27.050 align:middle line:90% There's a trade off. 00:13:27.050 --> 00:13:30.110 align:middle line:84% If I need to do lots of transactions, 00:13:30.110 --> 00:13:34.520 align:middle line:84% I better bias my portfolio towards cash, towards money. 00:13:34.520 --> 00:13:37.040 align:middle line:84% If I don't need to do lots of transaction 00:13:37.040 --> 00:13:38.760 align:middle line:84% and the interest rate is very high, 00:13:38.760 --> 00:13:41.000 align:middle line:84% particularly, then this is an issue today. 00:13:41.000 --> 00:13:42.650 align:middle line:84% Today interest rates are very high. 00:13:42.650 --> 00:13:47.030 align:middle line:84% Nobody cares about bonds or anything two years ago 00:13:47.030 --> 00:13:48.290 align:middle line:90% when the interest rate was 0. 00:13:48.290 --> 00:13:50.550 align:middle line:90% But today interest rate is 5%. 00:13:50.550 --> 00:13:51.477 align:middle line:90% So it's an issue. 00:13:51.477 --> 00:13:53.060 align:middle line:84% If you want to keep it in cash, you're 00:13:53.060 --> 00:13:55.610 align:middle line:84% going to give up a lot of return. 00:13:55.610 --> 00:13:56.987 align:middle line:84% So this is a decision to be made. 00:13:56.987 --> 00:13:58.070 align:middle line:90% It's a portfolio decision. 00:13:58.070 --> 00:14:01.460 align:middle line:84% And that's always interesting for economists. 00:14:01.460 --> 00:14:05.720 align:middle line:84% So let's talk about that decision. 00:14:05.720 --> 00:14:07.040 align:middle line:90% And we're going to talk-- 00:14:07.040 --> 00:14:10.077 align:middle line:84% you can describe this decision either from the side of bonds 00:14:10.077 --> 00:14:11.160 align:middle line:90% or from the side of money. 00:14:11.160 --> 00:14:13.118 align:middle line:84% We're going to describe from the side of money. 00:14:13.118 --> 00:14:15.440 align:middle line:84% Because there is a total amount of wealth and you 00:14:15.440 --> 00:14:19.490 align:middle line:84% have to decide what to allocate it to. 00:14:19.490 --> 00:14:22.340 align:middle line:84% It suffices, if I tell you there's a total amount of wealth 00:14:22.340 --> 00:14:25.483 align:middle line:84% and if I tell you how much you allocate to money, 00:14:25.483 --> 00:14:27.150 align:middle line:84% then I'm telling you implicitly how much 00:14:27.150 --> 00:14:28.560 align:middle line:90% you are allocating to bonds. 00:14:28.560 --> 00:14:30.270 align:middle line:90% It's a complement of that. 00:14:30.270 --> 00:14:32.108 align:middle line:84% So I cannot do an analysis either way. 00:14:32.108 --> 00:14:33.900 align:middle line:84% But I'm going to do it through money, which 00:14:33.900 --> 00:14:35.880 align:middle line:90% is the way it's normally done. 00:14:35.880 --> 00:14:41.430 align:middle line:84% So money demand, if I plot it in the space of m, money, 00:14:41.430 --> 00:14:46.240 align:middle line:84% and the interest rate, it's a downward sloping curve. 00:14:46.240 --> 00:14:48.010 align:middle line:84% Why is it a downward sloping curve? 00:14:48.010 --> 00:14:52.140 align:middle line:90% 00:14:52.140 --> 00:14:54.070 align:middle line:84% AUDIENCE: The interest rate is higher. 00:14:54.070 --> 00:14:56.655 align:middle line:84% It pays off more to get bonds, your utility shifted. 00:14:56.655 --> 00:14:57.780 align:middle line:90% RICARDO CABALLERO: Exactly. 00:14:57.780 --> 00:15:00.300 align:middle line:84% Your decision, if the interest rate is very high, 00:15:00.300 --> 00:15:02.300 align:middle line:90% is to go more towards bond. 00:15:02.300 --> 00:15:04.800 align:middle line:84% The interest is very low, I don't care too much about bonds. 00:15:04.800 --> 00:15:06.930 align:middle line:84% I'd rather keep the thing that helps me transact, 00:15:06.930 --> 00:15:09.000 align:middle line:90% which is money. 00:15:09.000 --> 00:15:13.590 align:middle line:84% And it's interesting because for most of your adult life, 00:15:13.590 --> 00:15:16.050 align:middle line:84% you have lived in a world in which that was not a very 00:15:16.050 --> 00:15:18.390 align:middle line:90% interesting decision, actually. 00:15:18.390 --> 00:15:20.805 align:middle line:84% Because interest rates were very close to zero. 00:15:20.805 --> 00:15:22.680 align:middle line:84% Now you're living in a different environment. 00:15:22.680 --> 00:15:26.580 align:middle line:84% Interest, for the first time, sort of high for you. 00:15:26.580 --> 00:15:29.070 align:middle line:84% For you, there may be a bigger decision between investing 00:15:29.070 --> 00:15:30.600 align:middle line:90% in equities and cash. 00:15:30.600 --> 00:15:34.560 align:middle line:84% But bonds-- and these are safe bonds, 00:15:34.560 --> 00:15:36.840 align:middle line:84% by the way, US treasuries and things like that. 00:15:36.840 --> 00:15:41.020 align:middle line:84% And money is not something you have to worry about. 00:15:41.020 --> 00:15:42.855 align:middle line:90% OK, good. 00:15:42.855 --> 00:15:44.980 align:middle line:84% What I'm saying is interest rates were around here. 00:15:44.980 --> 00:15:47.270 align:middle line:84% So you were all in cash one way or the other. 00:15:47.270 --> 00:15:50.120 align:middle line:84% And now interest rates are a lot higher. 00:15:50.120 --> 00:15:53.320 align:middle line:84% The other thing that-- so that's a movement along the curve. 00:15:53.320 --> 00:15:56.980 align:middle line:84% I'm plotting something in the space of interest rate, money 00:15:56.980 --> 00:15:57.730 align:middle line:90% and interest rate. 00:15:57.730 --> 00:16:00.430 align:middle line:84% Then when I tell you what happens when the interest 00:16:00.430 --> 00:16:06.300 align:middle line:84% rate rises, I'm asking you for a movement along the curve. 00:16:06.300 --> 00:16:10.790 align:middle line:84% So if I raise interest rate, I move along the curve up. 00:16:10.790 --> 00:16:13.413 align:middle line:84% So the second thing that we have there, argument we have 00:16:13.413 --> 00:16:15.580 align:middle line:84% is something that shifts the curve, because it's not 00:16:15.580 --> 00:16:16.790 align:middle line:90% part of my axis. 00:16:16.790 --> 00:16:18.220 align:middle line:90% So it will shift the curve. 00:16:18.220 --> 00:16:20.200 align:middle line:84% It's a parameter for each of these curves. 00:16:20.200 --> 00:16:22.520 align:middle line:90% And that's nominal income. 00:16:22.520 --> 00:16:27.670 align:middle line:84% So in particular, if nominal income goes up, 00:16:27.670 --> 00:16:30.175 align:middle line:84% I'm showing you there, that money demand goes out. 00:16:30.175 --> 00:16:32.050 align:middle line:84% Meaning for any given level of interest rate, 00:16:32.050 --> 00:16:34.570 align:middle line:84% you're going to demand more money. 00:16:34.570 --> 00:16:36.950 align:middle line:84% Why do you think that's the case? 00:16:36.950 --> 00:16:39.370 align:middle line:84% And again, I'm looking here at the aggregate. 00:16:39.370 --> 00:16:42.130 align:middle line:84% But it applies to an individual, as well. 00:16:42.130 --> 00:16:45.660 align:middle line:90% 00:16:45.660 --> 00:16:52.670 align:middle line:84% So for the same level of wealth, now nominal GDP is higher. 00:16:52.670 --> 00:16:55.700 align:middle line:84% Remember that nominal GDP is the same as nominal expenditure 00:16:55.700 --> 00:16:57.500 align:middle line:90% here. 00:16:57.500 --> 00:16:59.872 align:middle line:84% So if nominal GDP is higher, then that 00:16:59.872 --> 00:17:02.330 align:middle line:84% means there's going to be more transactions because there's 00:17:02.330 --> 00:17:05.770 align:middle line:90% going to be more expenditure. 00:17:05.770 --> 00:17:07.990 align:middle line:84% and therefore, you need more of the thing that 00:17:07.990 --> 00:17:11.000 align:middle line:90% is useful for transactions. 00:17:11.000 --> 00:17:12.020 align:middle line:90% Money demand goes up. 00:17:12.020 --> 00:17:16.829 align:middle line:84% The second point to highlight is that while, in most places, 00:17:16.829 --> 00:17:20.150 align:middle line:84% we use Y, here I'm using dollar y, nominal y. 00:17:20.150 --> 00:17:21.290 align:middle line:90% Why do you think is that? 00:17:21.290 --> 00:17:25.400 align:middle line:84% Why don't I just put there real GDP rather than nominal GDP? 00:17:25.400 --> 00:17:30.300 align:middle line:90% 00:17:30.300 --> 00:17:31.010 align:middle line:90% Is it a typo? 00:17:31.010 --> 00:17:35.690 align:middle line:90% 00:17:35.690 --> 00:17:38.110 align:middle line:90% Let's go into steps. 00:17:38.110 --> 00:17:44.790 align:middle line:84% Suppose that prices are totally fixed and real GDP goes up. 00:17:44.790 --> 00:17:47.090 align:middle line:84% That means that this economy needs more transactions 00:17:47.090 --> 00:17:49.610 align:middle line:84% because it's going to be more expenditure. 00:17:49.610 --> 00:17:54.300 align:middle line:84% So that explains that yeah, when real output goes up, 00:17:54.300 --> 00:17:55.640 align:middle line:90% then money demand goes up. 00:17:55.640 --> 00:17:57.230 align:middle line:84% When I say money demand goes up, I 00:17:57.230 --> 00:18:01.790 align:middle line:84% said for any given interest rate we have more money demand. 00:18:01.790 --> 00:18:04.242 align:middle line:90% Now fix real output. 00:18:04.242 --> 00:18:06.575 align:middle line:84% And I tell you, suppose that the price of goods doubles. 00:18:06.575 --> 00:18:09.860 align:middle line:90% 00:18:09.860 --> 00:18:12.190 align:middle line:84% Do you think you need more money to transact? 00:18:12.190 --> 00:18:15.070 align:middle line:84% Of course, because it's the same. 00:18:15.070 --> 00:18:16.540 align:middle line:90% It's equivalent. 00:18:16.540 --> 00:18:17.710 align:middle line:90% Money is dollars. 00:18:17.710 --> 00:18:19.030 align:middle line:90% I have $10. 00:18:19.030 --> 00:18:21.190 align:middle line:84% And now prices are twice what they used to be. 00:18:21.190 --> 00:18:25.000 align:middle line:84% Well, I'm going to need more dollars to transact. 00:18:25.000 --> 00:18:27.430 align:middle line:84% So that's the reason we have nominal GDP here 00:18:27.430 --> 00:18:28.795 align:middle line:90% rather than real GDP. 00:18:28.795 --> 00:18:33.990 align:middle line:90% 00:18:33.990 --> 00:18:35.920 align:middle line:84% Let's now determine the interest rate. 00:18:35.920 --> 00:18:38.310 align:middle line:84% And I'm to do it in the simplest possible model first. 00:18:38.310 --> 00:18:42.780 align:middle line:84% And by simplest, I mean here in particular, no banks. 00:18:42.780 --> 00:18:44.010 align:middle line:90% No intermediaries. 00:18:44.010 --> 00:18:46.812 align:middle line:84% OK, so there's only a central bank and people. 00:18:46.812 --> 00:18:49.910 align:middle line:90% 00:18:49.910 --> 00:18:54.500 align:middle line:84% OK, so suppose that the central bank 00:18:54.500 --> 00:18:58.040 align:middle line:84% decides that it wants to-- this is the way monetary policy used 00:18:58.040 --> 00:18:58.940 align:middle line:90% to be conducted. 00:18:58.940 --> 00:19:02.090 align:middle line:84% Suppose the size that it wants to offer 00:19:02.090 --> 00:19:04.670 align:middle line:90% m dollars to the economy. 00:19:04.670 --> 00:19:07.490 align:middle line:84% And the central bank is the one that produces at-- 00:19:07.490 --> 00:19:11.180 align:middle line:84% this moment in which I have no intermediaries, 00:19:11.180 --> 00:19:15.210 align:middle line:90% money is really currency. 00:19:15.210 --> 00:19:19.320 align:middle line:84% The only one that can produce currency-- forget Bitcoin-- 00:19:19.320 --> 00:19:24.240 align:middle line:84% only one that can produce currency is the central bank. 00:19:24.240 --> 00:19:25.710 align:middle line:90% I mean dollars. 00:19:25.710 --> 00:19:28.590 align:middle line:90% No one else can produce dollars. 00:19:28.590 --> 00:19:30.510 align:middle line:84% Watch out when we talk about banks later on. 00:19:30.510 --> 00:19:33.307 align:middle line:84% In this economy I'm describing, there are no banks. 00:19:33.307 --> 00:19:34.890 align:middle line:84% The only one that can produce dollars, 00:19:34.890 --> 00:19:37.410 align:middle line:90% currency, is the central bank. 00:19:37.410 --> 00:19:40.680 align:middle line:84% Any other one that produces dollars, that's illegal. 00:19:40.680 --> 00:19:42.490 align:middle line:90% So it's a central bank. 00:19:42.490 --> 00:19:46.350 align:middle line:84% So the central bank can decide how much money to supply. 00:19:46.350 --> 00:19:49.500 align:middle line:84% And suppose it decides to supply m. 00:19:49.500 --> 00:19:51.000 align:middle line:90% That's it. 00:19:51.000 --> 00:19:52.850 align:middle line:90% It's a decision. 00:19:52.850 --> 00:19:55.070 align:middle line:90% Well, what is now? 00:19:55.070 --> 00:19:58.560 align:middle line:84% For the first time I can answer the question is, well, 00:19:58.560 --> 00:20:00.480 align:middle line:84% what is the interest rate in this environment? 00:20:00.480 --> 00:20:02.070 align:middle line:90% Why do I know that? 00:20:02.070 --> 00:20:04.130 align:middle line:90% Because I have a money supply. 00:20:04.130 --> 00:20:05.540 align:middle line:90% I have a money demand. 00:20:05.540 --> 00:20:09.062 align:middle line:84% The intersection at this level of money supply, the equilibrium 00:20:09.062 --> 00:20:10.520 align:middle line:84% interest rate, that is the interest 00:20:10.520 --> 00:20:13.220 align:middle line:84% rate is consistent with money demand equal to money supply, 00:20:13.220 --> 00:20:14.840 align:middle line:90% is that one. 00:20:14.840 --> 00:20:20.700 align:middle line:90% 00:20:20.700 --> 00:20:21.420 align:middle line:90% Is it clear? 00:20:21.420 --> 00:20:23.920 align:middle line:90% So I have my money demand. 00:20:23.920 --> 00:20:27.780 align:middle line:84% And I'm saying the central bank, suppose the central bank decides 00:20:27.780 --> 00:20:28.740 align:middle line:90% to supply m. 00:20:28.740 --> 00:20:33.270 align:middle line:84% Well, in equilibrium, that will be the interest rate. 00:20:33.270 --> 00:20:36.950 align:middle line:84% That's the way the interest rate is determined. 00:20:36.950 --> 00:20:43.680 align:middle line:84% Now, suppose that the central bank increases. 00:20:43.680 --> 00:20:46.290 align:middle line:84% Remember, the goal of this lecture 00:20:46.290 --> 00:20:50.160 align:middle line:84% is that we get to understand how is it that the interest rate is 00:20:50.160 --> 00:20:51.420 align:middle line:90% determined. 00:20:51.420 --> 00:20:53.430 align:middle line:84% How is it that the Fed, the central bank, 00:20:53.430 --> 00:20:54.840 align:middle line:90% determines the interest rate? 00:20:54.840 --> 00:20:57.630 align:middle line:84% Here, we said, look, the central bank 00:20:57.630 --> 00:20:59.370 align:middle line:84% decides on certain amount of money. 00:20:59.370 --> 00:21:03.200 align:middle line:84% And then the market determines what the interest rate is. 00:21:03.200 --> 00:21:06.380 align:middle line:84% And this is the way monetary policy used to be conducted. 00:21:06.380 --> 00:21:08.330 align:middle line:84% The central banks would typically 00:21:08.330 --> 00:21:10.290 align:middle line:84% decide the amount of money in the system. 00:21:10.290 --> 00:21:12.320 align:middle line:84% It was called monetary aggregates. 00:21:12.320 --> 00:21:14.720 align:middle line:84% The amount of money in the system and then the market 00:21:14.720 --> 00:21:17.260 align:middle line:84% would determine the interest rate. 00:21:17.260 --> 00:21:20.330 align:middle line:84% It turned out that was a nightmare. 00:21:20.330 --> 00:21:23.620 align:middle line:84% And so now that's not what central banks do. 00:21:23.620 --> 00:21:27.100 align:middle line:84% And it was a nightmare because this money demand that 00:21:27.100 --> 00:21:29.320 align:middle line:84% looked so peaceful here, in practice 00:21:29.320 --> 00:21:33.340 align:middle line:84% is moving around all the time for a variety of reasons. 00:21:33.340 --> 00:21:36.190 align:middle line:84% Even holidays affect the money demand and all that. 00:21:36.190 --> 00:21:38.860 align:middle line:84% So if you fix the monetary aggregates, 00:21:38.860 --> 00:21:41.875 align:middle line:84% and money is moving all over the place, what happens? 00:21:41.875 --> 00:21:45.113 align:middle line:90% 00:21:45.113 --> 00:21:46.530 align:middle line:84% Suppose that the central bank says 00:21:46.530 --> 00:21:49.193 align:middle line:84% I'm going to offer this amount of m, that's it. 00:21:49.193 --> 00:21:51.610 align:middle line:84% And now I tell you the money is moving all over the place. 00:21:51.610 --> 00:21:55.230 align:middle line:84% There are weeks that have three days of weekend that 00:21:55.230 --> 00:21:58.560 align:middle line:84% have no vacations in between, or there is a Super Bowl 00:21:58.560 --> 00:22:03.960 align:middle line:84% and lots of people decide to buy tickets or whatever, or beer, so 00:22:03.960 --> 00:22:05.922 align:middle line:90% whatever. 00:22:05.922 --> 00:22:06.850 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:22:06.850 --> 00:22:08.017 align:middle line:90% RICARDO CABALLERO: Well, no. 00:22:08.017 --> 00:22:11.270 align:middle line:90% 00:22:11.270 --> 00:22:13.630 align:middle line:90% Because when you say shortage-- 00:22:13.630 --> 00:22:16.785 align:middle line:84% I mean, it depends what you mean by shortage. 00:22:16.785 --> 00:22:18.910 align:middle line:84% So you could be right with that part of the answer. 00:22:18.910 --> 00:22:21.670 align:middle line:84% But when you say excess demand, then I have a problem. 00:22:21.670 --> 00:22:26.460 align:middle line:84% Because that's true only if the interest rate doesn't move. 00:22:26.460 --> 00:22:30.000 align:middle line:84% But in a situation in which a central bank fix em. 00:22:30.000 --> 00:22:34.620 align:middle line:84% And let the market do its thing, then the interest rate will not 00:22:34.620 --> 00:22:35.220 align:middle line:90% be fixed. 00:22:35.220 --> 00:22:37.470 align:middle line:84% And that's exactly the problem, that the interest rate 00:22:37.470 --> 00:22:40.140 align:middle line:90% becomes very, very volatile. 00:22:40.140 --> 00:22:42.600 align:middle line:84% If you do it only through monetary aggregates 00:22:42.600 --> 00:22:45.760 align:middle line:84% because this guy is moving all over the place. 00:22:45.760 --> 00:22:47.293 align:middle line:90% And so imagine what happens. 00:22:47.293 --> 00:22:49.710 align:middle line:84% If this demand shift up, then an equilibrium interest rate 00:22:49.710 --> 00:22:52.950 align:middle line:84% goes up, precisely to avoid your excess demand. 00:22:52.950 --> 00:22:56.413 align:middle line:84% Because if this thing goes up, I have an excess demand 00:22:56.413 --> 00:22:57.330 align:middle line:90% at that interest rate. 00:22:57.330 --> 00:22:58.788 align:middle line:84% But what will happen in equilibrium 00:22:58.788 --> 00:23:02.550 align:middle line:84% is the interest rate will go up until the excess demand 00:23:02.550 --> 00:23:05.000 align:middle line:90% disappears. 00:23:05.000 --> 00:23:09.370 align:middle line:84% Now in central banks like the US, central bank the Fed, 00:23:09.370 --> 00:23:11.580 align:middle line:84% they can control this stuff fairly well. 00:23:11.580 --> 00:23:13.330 align:middle line:84% Many of the central banks don't have that. 00:23:13.330 --> 00:23:17.030 align:middle line:84% If you look at the Bank of China, 00:23:17.030 --> 00:23:19.427 align:middle line:84% for example, they have lots of high frequency movements 00:23:19.427 --> 00:23:21.010 align:middle line:84% in interest rates because they are not 00:23:21.010 --> 00:23:22.760 align:middle line:90% very good at doing this stuff. 00:23:22.760 --> 00:23:27.970 align:middle line:84% It's not that easy to control an interest rate, for example, 00:23:27.970 --> 00:23:29.260 align:middle line:90% to keep it fixed. 00:23:29.260 --> 00:23:31.602 align:middle line:84% But the central bank used to do that. 00:23:31.602 --> 00:23:32.560 align:middle line:90% That's what I'm saying. 00:23:32.560 --> 00:23:33.790 align:middle line:90% It used to do that. 00:23:33.790 --> 00:23:35.920 align:middle line:84% I'm saying in practice this system 00:23:35.920 --> 00:23:38.380 align:middle line:84% wasn't very good because in practice, the money 00:23:38.380 --> 00:23:41.960 align:middle line:84% is moving around for a lot of idiosyncratic reasons. 00:23:41.960 --> 00:23:43.210 align:middle line:90% Some of them are using credit. 00:23:43.210 --> 00:23:45.010 align:middle line:84% Some of them are very predictable. 00:23:45.010 --> 00:23:49.990 align:middle line:84% There was a lot of panic around the shift of the year 2000 00:23:49.990 --> 00:23:52.970 align:middle line:84% that the ATMs would stop working and stuff like that. 00:23:52.970 --> 00:23:55.240 align:middle line:84% So there was a massive increase in money demand 00:23:55.240 --> 00:23:57.970 align:middle line:84% because people wanted to have cash just in case ATMs stopped 00:23:57.970 --> 00:23:59.650 align:middle line:90% working. 00:23:59.650 --> 00:24:02.710 align:middle line:84% and so there are some things that are predictable and some. 00:24:02.710 --> 00:24:04.710 align:middle line:84% But you can get very large fluctuations. 00:24:04.710 --> 00:24:09.140 align:middle line:84% So in practice, what central banks do nowadays is really 00:24:09.140 --> 00:24:11.120 align:middle line:84% is they tell you what the interest rate is. 00:24:11.120 --> 00:24:14.270 align:middle line:84% And then they offer whatever m the market needs 00:24:14.270 --> 00:24:15.390 align:middle line:90% for that interest rate. 00:24:15.390 --> 00:24:17.930 align:middle line:84% That's the way modern monetary policy works. 00:24:17.930 --> 00:24:20.220 align:middle line:84% OK, I'll tell you a little bit more about that. 00:24:20.220 --> 00:24:22.678 align:middle line:84% So let's see what happens here if-- 00:24:22.678 --> 00:24:26.800 align:middle line:90% 00:24:26.800 --> 00:24:31.070 align:middle line:84% suppose the Fed, for reasons that you will understand better 00:24:31.070 --> 00:24:33.590 align:middle line:84% in the next lecture, suppose the Fed 00:24:33.590 --> 00:24:37.100 align:middle line:84% decides that they want to have an expansionary monetary policy. 00:24:37.100 --> 00:24:41.450 align:middle line:84% Expansionary monetary policy means it's going to expand m. 00:24:41.450 --> 00:24:43.490 align:middle line:84% It was offering a certain amount of m. 00:24:43.490 --> 00:24:47.650 align:middle line:84% And now it decides to offer more of that m. 00:24:47.650 --> 00:24:50.090 align:middle line:90% So what happens in equilibrium? 00:24:50.090 --> 00:24:52.940 align:middle line:84% Well, we start from an equilibrium here. 00:24:52.940 --> 00:24:55.100 align:middle line:84% If the interest rate remains at that level, 00:24:55.100 --> 00:24:59.960 align:middle line:84% now we have an excess supply of money. 00:24:59.960 --> 00:25:02.330 align:middle line:84% And the only way to restore that equilibrium 00:25:02.330 --> 00:25:05.690 align:middle line:84% is by people demanding more money. 00:25:05.690 --> 00:25:09.340 align:middle line:84% And when will people demand more money? 00:25:09.340 --> 00:25:12.380 align:middle line:84% Well, when the interest rate is lower. 00:25:12.380 --> 00:25:15.290 align:middle line:84% So excess demand, the interest rates are declining. 00:25:15.290 --> 00:25:18.500 align:middle line:84% Then the demand for money starts catching up with the new hire 00:25:18.500 --> 00:25:20.870 align:middle line:90% supply of money. 00:25:20.870 --> 00:25:24.380 align:middle line:84% And you end up with a lower interest rate. 00:25:24.380 --> 00:25:26.480 align:middle line:84% So that's an expansionary monetary policy, 00:25:26.480 --> 00:25:30.290 align:middle line:84% an increase in m that leads to a decline in the interest rate. 00:25:30.290 --> 00:25:33.050 align:middle line:84% Again, modern central banks don't tell you 00:25:33.050 --> 00:25:35.570 align:middle line:84% we're going to increase m by 20%. 00:25:35.570 --> 00:25:37.160 align:middle line:84% What they tell you is we're going 00:25:37.160 --> 00:25:42.160 align:middle line:84% to cut interest rate by, say, 50 basis points. 00:25:42.160 --> 00:25:43.750 align:middle line:84% When they tell you that they're going 00:25:43.750 --> 00:25:45.970 align:middle line:84% to cut interest by 50 basis points, 00:25:45.970 --> 00:25:48.120 align:middle line:90% they're reading you this axis. 00:25:48.120 --> 00:25:54.090 align:middle line:84% But behind that operation there must have been 00:25:54.090 --> 00:25:56.280 align:middle line:90% an increase in money supply. 00:25:56.280 --> 00:25:58.200 align:middle line:84% And then it comes all the fine tuning 00:25:58.200 --> 00:26:01.680 align:middle line:84% that they have to do now so the interest remains there 00:26:01.680 --> 00:26:04.150 align:middle line:84% when the money is vibrating around that thing there. 00:26:04.150 --> 00:26:07.260 align:middle line:84% But when we say an expansionary monetary policy, 00:26:07.260 --> 00:26:10.290 align:middle line:84% we really mean cutting interest rates. 00:26:10.290 --> 00:26:13.380 align:middle line:84% How is that the interest rate is cut effectively? 00:26:13.380 --> 00:26:15.438 align:middle line:84% By an increase in the money supply. 00:26:15.438 --> 00:26:17.480 align:middle line:84% But they don't tell you that they are doing that. 00:26:17.480 --> 00:26:18.730 align:middle line:90% But that's what they're doing. 00:26:18.730 --> 00:26:23.410 align:middle line:90% 00:26:23.410 --> 00:26:24.430 align:middle line:90% Good. 00:26:24.430 --> 00:26:27.220 align:middle line:84% So nowadays, we're in the opposite process. 00:26:27.220 --> 00:26:30.950 align:middle line:90% We're moving that way, up. 00:26:30.950 --> 00:26:33.890 align:middle line:84% But you seen, in every single meeting 00:26:33.890 --> 00:26:35.790 align:middle line:84% now for the last seven meetings or so, 00:26:35.790 --> 00:26:39.440 align:middle line:84% we have seen a hike in interest rates. 00:26:39.440 --> 00:26:41.695 align:middle line:90% Well, they don't tell you that. 00:26:41.695 --> 00:26:43.820 align:middle line:84% But they're saying, we're going to cut money supply 00:26:43.820 --> 00:26:45.406 align:middle line:90% and moving in that direction. 00:26:45.406 --> 00:26:48.515 align:middle line:90% 00:26:48.515 --> 00:26:50.140 align:middle line:84% Because if they move in that direction, 00:26:50.140 --> 00:26:53.430 align:middle line:90% then interest rate go up. 00:26:53.430 --> 00:26:55.620 align:middle line:90% It's clear. 00:26:55.620 --> 00:26:56.120 align:middle line:90% Good. 00:26:56.120 --> 00:26:59.570 align:middle line:90% 00:26:59.570 --> 00:27:02.750 align:middle line:90% What else shifts? 00:27:02.750 --> 00:27:05.360 align:middle line:84% This is a different kind of shift. 00:27:05.360 --> 00:27:07.740 align:middle line:84% Suppose that nominal income goes up. 00:27:07.740 --> 00:27:09.260 align:middle line:84% And this is happening all the time. 00:27:09.260 --> 00:27:12.090 align:middle line:84% Nominal income is growing in most economies most of the time. 00:27:12.090 --> 00:27:14.500 align:middle line:84% Unless you're in a recession, nominal income is growing. 00:27:14.500 --> 00:27:15.750 align:middle line:90% It's growing for two reasons-- 00:27:15.750 --> 00:27:17.083 align:middle line:90% one, because you have inflation. 00:27:17.083 --> 00:27:19.460 align:middle line:84% And the other one is because of real output is growing. 00:27:19.460 --> 00:27:24.040 align:middle line:84% That means that typically in an average year, 00:27:24.040 --> 00:27:25.840 align:middle line:84% money demand is shifting to the right. 00:27:25.840 --> 00:27:28.460 align:middle line:90% 00:27:28.460 --> 00:27:32.030 align:middle line:84% So if money demand shift to the right and money supply 00:27:32.030 --> 00:27:35.600 align:middle line:84% does not change, then what happens to the interest rate? 00:27:35.600 --> 00:27:39.360 align:middle line:90% 00:27:39.360 --> 00:27:42.780 align:middle line:84% Money demand goes up, money supplies doesn't change. 00:27:42.780 --> 00:27:45.840 align:middle line:84% What happens to the interest rate? 00:27:45.840 --> 00:27:48.960 align:middle line:84% Increases because at this interest rate 00:27:48.960 --> 00:27:52.060 align:middle line:84% here, we have an excess demand for money. 00:27:52.060 --> 00:27:55.300 align:middle line:84% So we have to reduce the money demand. 00:27:55.300 --> 00:27:56.550 align:middle line:90% How do we reduce money demand? 00:27:56.550 --> 00:27:58.970 align:middle line:90% By increasing the interest rate. 00:27:58.970 --> 00:28:00.910 align:middle line:90% That's the way we get there. 00:28:00.910 --> 00:28:04.440 align:middle line:84% So that's yet another reason why it's not a good idea 00:28:04.440 --> 00:28:06.930 align:middle line:84% to be targeting monetary aggregates. 00:28:06.930 --> 00:28:11.700 align:middle line:84% The Fed tells you we want the interest rate at 5%, say. 00:28:11.700 --> 00:28:14.015 align:middle line:84% And then the economy will be growing and so on. 00:28:14.015 --> 00:28:15.390 align:middle line:84% And what the Fed will be doing is 00:28:15.390 --> 00:28:17.700 align:middle line:84% if they want to maintain the interest rate at 5%, 00:28:17.700 --> 00:28:21.780 align:middle line:84% well, they keep expanding m so the interest rate doesn't go up. 00:28:21.780 --> 00:28:24.090 align:middle line:84% That's the way it's normally conducted. 00:28:24.090 --> 00:28:27.660 align:middle line:84% But if the Fed stays sleepy and they have 00:28:27.660 --> 00:28:28.980 align:middle line:90% an increase in money demand. 00:28:28.980 --> 00:28:31.770 align:middle line:84% Then the interest rate will tend to go up. 00:28:31.770 --> 00:28:36.340 align:middle line:90% 00:28:36.340 --> 00:28:44.670 align:middle line:84% So I told you that the central bank is moving m, increasing 00:28:44.670 --> 00:28:46.390 align:middle line:90% m, reducing m, or whatever. 00:28:46.390 --> 00:28:48.840 align:middle line:90% So how do they do that. 00:28:48.840 --> 00:28:52.140 align:middle line:90% I mean, it's not that they-- 00:28:52.140 --> 00:28:54.420 align:middle line:84% although that policy has been advocated. 00:28:54.420 --> 00:28:57.150 align:middle line:84% It's not that they go in a helicopter and sort of fly 00:28:57.150 --> 00:28:59.130 align:middle line:90% builds on top of all of us. 00:28:59.130 --> 00:29:00.540 align:middle line:90% They don't do that. 00:29:00.540 --> 00:29:03.390 align:middle line:84% Although, again, it has been advocated in extreme cases 00:29:03.390 --> 00:29:04.930 align:middle line:90% of recessions, and so on. 00:29:04.930 --> 00:29:06.590 align:middle line:84% And it's called helicopter money. 00:29:06.590 --> 00:29:07.680 align:middle line:90% Just give money away. 00:29:07.680 --> 00:29:11.210 align:middle line:90% 00:29:11.210 --> 00:29:12.960 align:middle line:84% But that's not the way it's normally done. 00:29:12.960 --> 00:29:15.520 align:middle line:84% For normal operations, is not done that way. 00:29:15.520 --> 00:29:16.965 align:middle line:90% So how is it done? 00:29:16.965 --> 00:29:18.840 align:middle line:84% Remember that we have a financial system that 00:29:18.840 --> 00:29:20.160 align:middle line:90% is very simple for now. 00:29:20.160 --> 00:29:22.750 align:middle line:90% We have money and bonds. 00:29:22.750 --> 00:29:25.713 align:middle line:84% So what the central bank does, the central bank 00:29:25.713 --> 00:29:27.380 align:middle line:84% wants to change the portfolio of people. 00:29:27.380 --> 00:29:30.240 align:middle line:84% They want people to have less bonds, say, and more money. 00:29:30.240 --> 00:29:32.440 align:middle line:84% That's to raise the interest rate. 00:29:32.440 --> 00:29:35.070 align:middle line:84% So what the central bank does is goes out 00:29:35.070 --> 00:29:37.260 align:middle line:84% there and expansionary open market operation. 00:29:37.260 --> 00:29:39.990 align:middle line:84% Open market is because they go into the open market 00:29:39.990 --> 00:29:45.750 align:middle line:84% to buy bonds, the as opposed to an operation that happens behind 00:29:45.750 --> 00:29:46.770 align:middle line:90% doors. 00:29:46.770 --> 00:29:49.500 align:middle line:84% If the Fed went directly to the Treasury and bought bonds, 00:29:49.500 --> 00:29:52.200 align:middle line:84% that would not be an open market operation. 00:29:52.200 --> 00:29:55.320 align:middle line:84% But what they do is they go to the financial system 00:29:55.320 --> 00:29:58.660 align:middle line:84% and they go with a big bag of money and say, 00:29:58.660 --> 00:30:01.350 align:middle line:90% OK, we want bonds. 00:30:01.350 --> 00:30:07.610 align:middle line:84% And so the public sells bonds to them in exchange for money. 00:30:07.610 --> 00:30:09.330 align:middle line:90% That's an expansionary market. 00:30:09.330 --> 00:30:13.550 align:middle line:84% So what we saw before when m shift to the right, what 00:30:13.550 --> 00:30:17.330 align:middle line:84% the central bank really did is went out there and bought bonds 00:30:17.330 --> 00:30:19.290 align:middle line:90% from the public. 00:30:19.290 --> 00:30:25.390 align:middle line:84% The public sold the bonds and got the cash at some price. 00:30:25.390 --> 00:30:27.610 align:middle line:84% When I show you equilibrium in the money market, 00:30:27.610 --> 00:30:30.680 align:middle line:84% that means also an equilibrium in the bond market necessarily. 00:30:30.680 --> 00:30:35.140 align:middle line:84% So it has to be the price is right for the portfolio 00:30:35.140 --> 00:30:36.370 align:middle line:90% of individuals. 00:30:36.370 --> 00:30:38.960 align:middle line:84% A contractionary open market operation is the opposite. 00:30:38.960 --> 00:30:42.400 align:middle line:84% It's a central bank goes out there and sells bonds 00:30:42.400 --> 00:30:45.520 align:middle line:84% to the market and takes the cash back. 00:30:45.520 --> 00:30:47.330 align:middle line:84% That's a contractionary monetary policy. 00:30:47.330 --> 00:30:48.640 align:middle line:90% So when the Fed wants to-- 00:30:48.640 --> 00:30:50.500 align:middle line:90% Yeah, let me finish. 00:30:50.500 --> 00:30:53.380 align:middle line:84% When the Fed wants to cut interest rates, what 00:30:53.380 --> 00:30:56.540 align:middle line:84% the Fed does is an expansionary monetary policy, 00:30:56.540 --> 00:30:59.410 align:middle line:84% which means it goes out there and buys bonds from the market 00:30:59.410 --> 00:31:00.970 align:middle line:90% and gives cash to the market. 00:31:00.970 --> 00:31:02.475 align:middle line:90% OK, yeah. 00:31:02.475 --> 00:31:04.600 align:middle line:84% AUDIENCE: How can a central bank, in this instance, 00:31:04.600 --> 00:31:08.170 align:middle line:84% guarantee that someone's going to buy their bonds? 00:31:08.170 --> 00:31:11.050 align:middle line:84% If their government didn't have the financial stability, 00:31:11.050 --> 00:31:13.480 align:middle line:84% I guess, the United States has, how 00:31:13.480 --> 00:31:15.878 align:middle line:84% would they guarantee that these bonds will be 00:31:15.878 --> 00:31:17.170 align:middle line:90% worth anything in the long run? 00:31:17.170 --> 00:31:18.370 align:middle line:84% RICARDO CABALLERO: Well, I mean, you're 00:31:18.370 --> 00:31:19.660 align:middle line:90% talking about risk premium. 00:31:19.660 --> 00:31:24.250 align:middle line:90% And that's an additional issue. 00:31:24.250 --> 00:31:30.610 align:middle line:84% Typically central banks intervene in very short duration 00:31:30.610 --> 00:31:31.250 align:middle line:90% bonds. 00:31:31.250 --> 00:31:35.200 align:middle line:84% So it's not the typical bond that is risky in many sense. 00:31:35.200 --> 00:31:39.160 align:middle line:84% It's very, very, very short duration bonds, treasuries, 00:31:39.160 --> 00:31:40.130 align:middle line:90% very short duration. 00:31:40.130 --> 00:31:42.280 align:middle line:90% In fact, it's even less. 00:31:42.280 --> 00:31:44.230 align:middle line:84% Nowadays central banks really intervene 00:31:44.230 --> 00:31:47.500 align:middle line:90% in the overnight market. 00:31:47.500 --> 00:31:51.340 align:middle line:84% But you're that countries that don't have a bond 00:31:51.340 --> 00:31:53.530 align:middle line:84% market, a well-developed bond market, 00:31:53.530 --> 00:31:55.697 align:middle line:84% have problems with the management of monetary policy 00:31:55.697 --> 00:31:57.697 align:middle line:84% and so on because they have a credit spread that 00:31:57.697 --> 00:31:59.030 align:middle line:90% is moving around, as well. 00:31:59.030 --> 00:32:01.240 align:middle line:84% But they tend to focus on the type of instruments. 00:32:01.240 --> 00:32:02.770 align:middle line:84% That thing becomes very important. 00:32:02.770 --> 00:32:07.240 align:middle line:84% I mean, for Japan, even big guys, very big guys, now 00:32:07.240 --> 00:32:10.240 align:middle line:84% they have an issue because they have been buying bonds, 00:32:10.240 --> 00:32:11.810 align:middle line:90% very long duration bonds-- 00:32:11.810 --> 00:32:14.610 align:middle line:84% so 10 year bonds and stuff like that. 00:32:14.610 --> 00:32:16.683 align:middle line:84% And there it's a little trickier. 00:32:16.683 --> 00:32:18.600 align:middle line:84% Market needs to trust you a lot more if you're 00:32:18.600 --> 00:32:21.360 align:middle line:84% dealing with 10 years things and you're dealing with three month 00:32:21.360 --> 00:32:24.460 align:middle line:90% horizons and so on. 00:32:24.460 --> 00:32:30.840 align:middle line:84% In other instances, for example, Chile 00:32:30.840 --> 00:32:32.910 align:middle line:84% has a situation like that, the central bank 00:32:32.910 --> 00:32:35.430 align:middle line:90% itself can issue bonds. 00:32:35.430 --> 00:32:38.160 align:middle line:84% And so those are bonds issued by central banks. 00:32:38.160 --> 00:32:40.260 align:middle line:84% And they tend to be very reliable bonds 00:32:40.260 --> 00:32:42.897 align:middle line:84% because these are bonds that are issuing your same currency. 00:32:42.897 --> 00:32:44.730 align:middle line:84% So you have the currency to always pay them. 00:32:44.730 --> 00:32:47.410 align:middle line:84% You can always print money and pay for those bonds. 00:32:47.410 --> 00:32:49.440 align:middle line:84% So it rarely happens that there is 00:32:49.440 --> 00:32:51.135 align:middle line:90% default on bonds of that kind. 00:32:51.135 --> 00:32:54.030 align:middle line:90% 00:32:54.030 --> 00:32:56.280 align:middle line:84% The typical bonds, government bond, 00:32:56.280 --> 00:33:00.030 align:middle line:84% that defaults is a bond that is issuing 00:33:00.030 --> 00:33:01.800 align:middle line:84% a currency different from the one you have 00:33:01.800 --> 00:33:03.550 align:middle line:84% because then you may not have the currency 00:33:03.550 --> 00:33:04.710 align:middle line:90% to pay for the stuff. 00:33:04.710 --> 00:33:07.380 align:middle line:84% And that's the reason emerging markets run into trouble 00:33:07.380 --> 00:33:10.580 align:middle line:90% and things of that kind. 00:33:10.580 --> 00:33:13.200 align:middle line:84% So in terms of the balance sheet of the central bank, 00:33:13.200 --> 00:33:15.350 align:middle line:84% how does an open market operation look? 00:33:15.350 --> 00:33:17.630 align:middle line:84% So if you look at the balance sheet, 00:33:17.630 --> 00:33:19.970 align:middle line:84% this is an incredibly simplified version of the balance 00:33:19.970 --> 00:33:22.190 align:middle line:90% sheet of the Fed. 00:33:22.190 --> 00:33:24.920 align:middle line:84% They have lots of things, more assets, gold, 00:33:24.920 --> 00:33:26.430 align:middle line:90% and all sorts of stuff. 00:33:26.430 --> 00:33:31.250 align:middle line:84% But in our simple economy, the government, the Fed, 00:33:31.250 --> 00:33:33.800 align:middle line:84% the assets of the Fed, they have some bonds. 00:33:33.800 --> 00:33:35.780 align:middle line:84% It has already some bonds out there. 00:33:35.780 --> 00:33:38.300 align:middle line:84% And the liabilities is the money they issue. 00:33:38.300 --> 00:33:39.590 align:middle line:90% They owe that to people. 00:33:39.590 --> 00:33:41.550 align:middle line:90% I mean, they issue currency. 00:33:41.550 --> 00:33:44.660 align:middle line:90% But that's a liability. 00:33:44.660 --> 00:33:47.060 align:middle line:84% People can do things with and buy things with that money 00:33:47.060 --> 00:33:47.560 align:middle line:90% and so on. 00:33:47.560 --> 00:33:48.600 align:middle line:90% It's a liability. 00:33:48.600 --> 00:33:51.230 align:middle line:84% So that's the way the balance sheet looks. 00:33:51.230 --> 00:33:56.000 align:middle line:84% So when the Fed decides to do an expansionary open market 00:33:56.000 --> 00:34:00.620 align:middle line:84% operation, then what it does is it goes out there. 00:34:00.620 --> 00:34:05.703 align:middle line:84% It issues, say, a $1 million expansionary 00:34:05.703 --> 00:34:06.620 align:middle line:90% open market operation. 00:34:06.620 --> 00:34:08.719 align:middle line:84% They do it in much bigger tickets on this. 00:34:08.719 --> 00:34:10.560 align:middle line:90% But let's make it simple. 00:34:10.560 --> 00:34:13.290 align:middle line:84% $1 million of an expansionary operation. 00:34:13.290 --> 00:34:17.159 align:middle line:84% When they go there, they print $1 million 00:34:17.159 --> 00:34:21.870 align:middle line:84% and they buy $1 million from the market. 00:34:21.870 --> 00:34:27.330 align:middle line:84% And so at the end, the balance sheet ends like it used to be. 00:34:27.330 --> 00:34:30.120 align:middle line:84% There is an extra $1 million of liabilities 00:34:30.120 --> 00:34:31.710 align:middle line:84% because now there's a million more 00:34:31.710 --> 00:34:35.370 align:middle line:84% of dollars circulating out there. 00:34:35.370 --> 00:34:39.030 align:middle line:84% But against that, the central bank also has a million more 00:34:39.030 --> 00:34:40.200 align:middle line:90% of bonds holdings. 00:34:40.200 --> 00:34:42.870 align:middle line:90% 00:34:42.870 --> 00:34:45.719 align:middle line:90% So that's what happens. 00:34:45.719 --> 00:34:48.060 align:middle line:84% With an expansionary monetary policy, 00:34:48.060 --> 00:34:50.520 align:middle line:84% the balance sheet of the central bank expands. 00:34:50.520 --> 00:34:54.929 align:middle line:84% Both sides expand by the same amount, but expands. 00:34:54.929 --> 00:34:58.560 align:middle line:84% And one of the big themes of recent years, 00:34:58.560 --> 00:35:00.570 align:middle line:84% starting from the global financial crisis, 00:35:00.570 --> 00:35:02.790 align:middle line:84% is that these balance sheets used 00:35:02.790 --> 00:35:06.540 align:middle line:84% to be small peanuts type things, for $1 trillion 00:35:06.540 --> 00:35:10.380 align:middle line:84% or something like that for something like the US, the size. 00:35:10.380 --> 00:35:12.900 align:middle line:84% Nowadays they're much, much larger than that 00:35:12.900 --> 00:35:15.507 align:middle line:84% because they have done so many operations to first get us out 00:35:15.507 --> 00:35:18.090 align:middle line:84% of the global financial crisis and then to get us out of COVID 00:35:18.090 --> 00:35:22.290 align:middle line:84% and so on, that these balance sheets are now an order 00:35:22.290 --> 00:35:26.250 align:middle line:84% or two orders of magnitude larger than they used to be. 00:35:26.250 --> 00:35:28.650 align:middle line:84% But in other words, they have had 00:35:28.650 --> 00:35:31.290 align:middle line:84% to do lots of expansionary monetary policy 00:35:31.290 --> 00:35:33.030 align:middle line:90% over the last couple of decades. 00:35:33.030 --> 00:35:38.250 align:middle line:90% 00:35:38.250 --> 00:35:42.500 align:middle line:84% So let me talk a little bit about interest rate and bond 00:35:42.500 --> 00:35:46.520 align:middle line:84% prices because that's the other side of this thing. 00:35:46.520 --> 00:35:50.063 align:middle line:84% So what is the connection-- because sometimes it's 00:35:50.063 --> 00:35:51.980 align:middle line:84% easier to understand things in terms of prices 00:35:51.980 --> 00:35:53.650 align:middle line:90% and in terms of bonds? 00:35:53.650 --> 00:35:57.920 align:middle line:84% So suppose a bond pays $100 a year from now 00:35:57.920 --> 00:35:59.490 align:middle line:90% and no coupon in between. 00:35:59.490 --> 00:36:02.630 align:middle line:84% So if you buy a bond now for some price PB, 00:36:02.630 --> 00:36:05.820 align:middle line:90% you get $100 a year from now. 00:36:05.820 --> 00:36:08.270 align:middle line:84% So what is the interest rate of that bond? 00:36:08.270 --> 00:36:10.520 align:middle line:84% That is, what is the excess return that you get out 00:36:10.520 --> 00:36:14.040 align:middle line:84% of that, or the return you get out of buying that bond? 00:36:14.040 --> 00:36:18.260 align:middle line:84% Well, it's going to be $100 minus whatever you pay today-- 00:36:18.260 --> 00:36:21.350 align:middle line:90% say you pay $95, then $5-- 00:36:21.350 --> 00:36:24.510 align:middle line:84% divided by your investment, initial investment, 00:36:24.510 --> 00:36:26.330 align:middle line:90% which was 95. 00:36:26.330 --> 00:36:32.493 align:middle line:84% So that's a bond that gives you a little bit more than 5%. 00:36:32.493 --> 00:36:33.410 align:middle line:90% OK, that's the return. 00:36:33.410 --> 00:36:34.243 align:middle line:90% That's the interest. 00:36:34.243 --> 00:36:37.280 align:middle line:84% So that's the connection between interest rate and prices. 00:36:37.280 --> 00:36:41.010 align:middle line:84% And notice that this is an inverse relation. 00:36:41.010 --> 00:36:44.770 align:middle line:84% When the price of a bone goes up, 00:36:44.770 --> 00:36:47.282 align:middle line:84% the interest rate goes down because you're paying more 00:36:47.282 --> 00:36:48.240 align:middle line:90% for the same principal. 00:36:48.240 --> 00:36:49.360 align:middle line:90% You're going to get 100. 00:36:49.360 --> 00:36:50.840 align:middle line:84% But now you're paying more for it. 00:36:50.840 --> 00:36:53.340 align:middle line:84% Well, that means the interest rate, the return on that bond, 00:36:53.340 --> 00:36:53.970 align:middle line:90% went down. 00:36:53.970 --> 00:36:57.010 align:middle line:90% 00:36:57.010 --> 00:36:58.810 align:middle line:84% Conversely, you can say that I went around. 00:36:58.810 --> 00:37:02.050 align:middle line:84% The high is the interest rate, the lower is the price of bond. 00:37:02.050 --> 00:37:04.885 align:middle line:84% So for example, today the interest rate is 5%. 00:37:04.885 --> 00:37:08.230 align:middle line:90% 00:37:08.230 --> 00:37:11.110 align:middle line:84% If I want to issue a bond that doesn't pay any coupon 00:37:11.110 --> 00:37:15.060 align:middle line:84% and I'm completely safe, so I'm the US Treasury, 00:37:15.060 --> 00:37:19.080 align:middle line:84% I'm going to be able to sell that bond for 95. 00:37:19.080 --> 00:37:22.400 align:middle line:84% Two years ago, when the interest rate was 0, 00:37:22.400 --> 00:37:27.870 align:middle line:84% the Fed would have been able to sell that bond for 100. 00:37:27.870 --> 00:37:29.400 align:middle line:84% So there is an inverse relationship 00:37:29.400 --> 00:37:31.960 align:middle line:84% between the interest rate and the price of bonds. 00:37:31.960 --> 00:37:35.980 align:middle line:84% And now I can take you back to my open market operations. 00:37:35.980 --> 00:37:37.313 align:middle line:90% So remember what I said. 00:37:37.313 --> 00:37:38.730 align:middle line:84% There's another way of remembering 00:37:38.730 --> 00:37:41.880 align:middle line:90% which way these signs go. 00:37:41.880 --> 00:37:44.400 align:middle line:84% Remember when you have an expansionary monetary operation, 00:37:44.400 --> 00:37:46.800 align:middle line:84% I said the Fed goes out there with a bag of money 00:37:46.800 --> 00:37:49.480 align:middle line:90% and buys bonds from the market. 00:37:49.480 --> 00:37:51.907 align:middle line:84% When bonds, when you buy something, 00:37:51.907 --> 00:37:53.740 align:middle line:84% when there is an enormous increase in demand 00:37:53.740 --> 00:37:55.407 align:middle line:84% for something, what do you think happens 00:37:55.407 --> 00:37:58.150 align:middle line:90% to the price of that something? 00:37:58.150 --> 00:38:01.280 align:middle line:84% Goes up for anything-- cars, whatever it is. 00:38:01.280 --> 00:38:05.290 align:middle line:84% It's a lot more demand, then prices will go up. 00:38:05.290 --> 00:38:08.360 align:middle line:90% And the Fed has a lot of cash. 00:38:08.360 --> 00:38:12.050 align:middle line:84% So he can really buy large amounts of bonds. 00:38:12.050 --> 00:38:14.140 align:middle line:84% And so when the Fed goes out there 00:38:14.140 --> 00:38:16.540 align:middle line:84% and does an expansionary open market operation, 00:38:16.540 --> 00:38:19.090 align:middle line:84% means it goes out there and buys a lot of bonds. 00:38:19.090 --> 00:38:21.260 align:middle line:84% The price of those bonds goes up. 00:38:21.260 --> 00:38:24.500 align:middle line:84% And by that formula, that means the interest rate is going down. 00:38:24.500 --> 00:38:27.540 align:middle line:84% So that's another way of understanding how is it 00:38:27.540 --> 00:38:31.130 align:middle line:84% an expansion open market operation lowers the interest 00:38:31.130 --> 00:38:33.380 align:middle line:84% rate, because it raises the price of the bonds 00:38:33.380 --> 00:38:35.470 align:middle line:90% that it's demanding. 00:38:35.470 --> 00:38:37.220 align:middle line:84% And when you raise the price of the bonds, 00:38:37.220 --> 00:38:38.595 align:middle line:84% then the interest rate goes down. 00:38:38.595 --> 00:38:49.700 align:middle line:90% 00:38:49.700 --> 00:38:52.570 align:middle line:84% So really, the only thing I really-- 00:38:52.570 --> 00:38:55.640 align:middle line:84% I want you to understand what I just said well 00:38:55.640 --> 00:38:57.920 align:middle line:90% because we're going to use it. 00:38:57.920 --> 00:39:02.260 align:middle line:84% I want you to understand what comes next ideally well, 00:39:02.260 --> 00:39:05.270 align:middle line:84% but it's OK if you don't understand it too well. 00:39:05.270 --> 00:39:07.270 align:middle line:84% And I'm going to tell you when you have to start 00:39:07.270 --> 00:39:09.340 align:middle line:90% understanding very well again. 00:39:09.340 --> 00:39:13.330 align:middle line:84% For now, this is a piece in which, what I'm doing here 00:39:13.330 --> 00:39:16.000 align:middle line:84% is making things a little bit more realistic. 00:39:16.000 --> 00:39:18.670 align:middle line:90% The message will be similar. 00:39:18.670 --> 00:39:21.310 align:middle line:84% But it's a little bit more complicated. 00:39:21.310 --> 00:39:25.690 align:middle line:84% That's the reason, substantively, 00:39:25.690 --> 00:39:28.090 align:middle line:84% I already told you what I wanted to tell you. 00:39:28.090 --> 00:39:29.995 align:middle line:84% What I'm going to tell you now will give you 00:39:29.995 --> 00:39:31.870 align:middle line:84% a little bit more realism, and therefore will 00:39:31.870 --> 00:39:33.370 align:middle line:84% allow you to understand a little bit 00:39:33.370 --> 00:39:37.960 align:middle line:84% better a technical description of monetary policy or something 00:39:37.960 --> 00:39:39.080 align:middle line:90% like that. 00:39:39.080 --> 00:39:43.600 align:middle line:84% So in practice in the economy I just described, 00:39:43.600 --> 00:39:47.650 align:middle line:84% you had sort of households and firms and the central bank. 00:39:47.650 --> 00:39:51.580 align:middle line:84% But in practice, there are lots of financial intermediaries. 00:39:51.580 --> 00:39:54.190 align:middle line:84% And in financial intermediaries, the most prominent of them, 00:39:54.190 --> 00:39:57.227 align:middle line:84% for especially for monetary policy, are the banks. 00:39:57.227 --> 00:39:58.810 align:middle line:84% And there are certain banks, actually, 00:39:58.810 --> 00:40:00.518 align:middle line:84% that are even more important than others. 00:40:00.518 --> 00:40:03.610 align:middle line:84% But banks are financial intermediaries. 00:40:03.610 --> 00:40:06.730 align:middle line:84% They take money from someone or they post it from someone 00:40:06.730 --> 00:40:09.940 align:middle line:84% and lend it to someone else, or buy some instruments. 00:40:09.940 --> 00:40:12.940 align:middle line:84% So the intermediate the funds of somebody 00:40:12.940 --> 00:40:16.780 align:middle line:84% that wants to save in the bank, a deposit and a deposit account 00:40:16.780 --> 00:40:20.910 align:middle line:84% or something, and they lend that money, 00:40:20.910 --> 00:40:26.340 align:middle line:84% effectively in the name of the other person, to someone else. 00:40:26.340 --> 00:40:32.700 align:middle line:84% So banks do two things to the model I just described. 00:40:32.700 --> 00:40:36.330 align:middle line:84% The first is that they produce money, as well. 00:40:36.330 --> 00:40:39.040 align:middle line:90% 00:40:39.040 --> 00:40:43.280 align:middle line:84% Because money is made of currency, 00:40:43.280 --> 00:40:45.370 align:middle line:84% which is issued by the central bank. 00:40:45.370 --> 00:40:49.390 align:middle line:84% But it's also made of checkable deposits. 00:40:49.390 --> 00:40:52.240 align:middle line:84% If you have a checking account, something 00:40:52.240 --> 00:40:56.380 align:middle line:84% you can have a debit card against or something like that, 00:40:56.380 --> 00:40:59.420 align:middle line:90% then that's money for you. 00:40:59.420 --> 00:41:05.950 align:middle line:84% If you deposit in a bank in a checking account, that's money. 00:41:05.950 --> 00:41:09.040 align:middle line:84% And so banks, the liabilities of banks, 00:41:09.040 --> 00:41:12.152 align:middle line:84% the deposits is part of money, is something 00:41:12.152 --> 00:41:13.360 align:middle line:90% you can use for transactions. 00:41:13.360 --> 00:41:14.235 align:middle line:90% You can write checks. 00:41:14.235 --> 00:41:16.930 align:middle line:84% You can use your debit card and stuff like that. 00:41:16.930 --> 00:41:20.490 align:middle line:84% So that's the first thing that banks do. 00:41:20.490 --> 00:41:27.300 align:middle line:84% The other thing the banks do is they, themselves, have a deposit 00:41:27.300 --> 00:41:28.950 align:middle line:90% account at the central bank. 00:41:28.950 --> 00:41:31.640 align:middle line:90% 00:41:31.640 --> 00:41:35.470 align:middle line:84% So they, themselves, take part of this deposit. 00:41:35.470 --> 00:41:37.150 align:middle line:90% They take the deposit. 00:41:37.150 --> 00:41:40.130 align:middle line:84% Part of the deposit they lend to other people. 00:41:40.130 --> 00:41:42.770 align:middle line:84% Another part they buy financial instruments, bonds, 00:41:42.770 --> 00:41:43.690 align:middle line:90% and stuff like that. 00:41:43.690 --> 00:41:45.910 align:middle line:84% In this economy would be only bonds. 00:41:45.910 --> 00:41:49.390 align:middle line:84% And the other part, smaller part, 10% or something 00:41:49.390 --> 00:41:54.330 align:middle line:84% like that, they deposit at the central bank. 00:41:54.330 --> 00:41:58.730 align:middle line:84% That deposit at the central bank is called reserves. 00:41:58.730 --> 00:42:02.550 align:middle line:84% So when you hear the word reserves or the banking sector, 00:42:02.550 --> 00:42:08.610 align:middle line:84% this is the deposits of the banks at the central bank. 00:42:08.610 --> 00:42:11.880 align:middle line:84% And that's also a liability for the central bank. 00:42:11.880 --> 00:42:14.160 align:middle line:84% The central bank is holding that deposit of the banks. 00:42:14.160 --> 00:42:15.810 align:middle line:84% It's not the central bank's money. 00:42:15.810 --> 00:42:17.932 align:middle line:90% It's the bank's money. 00:42:17.932 --> 00:42:19.140 align:middle line:90% And they're holding it there. 00:42:19.140 --> 00:42:20.505 align:middle line:90% It's a liability, as well. 00:42:20.505 --> 00:42:23.390 align:middle line:90% 00:42:23.390 --> 00:42:27.930 align:middle line:84% So now, if you look at how the balance sheets look, 00:42:27.930 --> 00:42:30.380 align:middle line:84% our central bank now has more things. 00:42:30.380 --> 00:42:31.865 align:middle line:90% It has assets. 00:42:31.865 --> 00:42:33.320 align:middle line:90% It's going to be bonds. 00:42:33.320 --> 00:42:35.570 align:middle line:84% In this economy, it's the only thing you can have. 00:42:35.570 --> 00:42:37.970 align:middle line:84% But now it will have the currency 00:42:37.970 --> 00:42:40.500 align:middle line:84% that it had before and in the liabilities, 00:42:40.500 --> 00:42:42.410 align:middle line:84% but also will have the reserves, the deposits 00:42:42.410 --> 00:42:44.330 align:middle line:90% of the banks themselves. 00:42:44.330 --> 00:42:49.800 align:middle line:90% 00:42:49.800 --> 00:42:52.170 align:middle line:84% OK, and this is called-- this stuff here 00:42:52.170 --> 00:42:54.150 align:middle line:90% is called central bank money. 00:42:54.150 --> 00:42:57.570 align:middle line:84% In contrast, it's called central bank-- has so many names-- 00:42:57.570 --> 00:43:00.120 align:middle line:84% it's called central bank money, high power 00:43:00.120 --> 00:43:03.480 align:middle line:90% money, some other name. 00:43:03.480 --> 00:43:04.380 align:middle line:90% They have it some. 00:43:04.380 --> 00:43:06.220 align:middle line:90% But it has several names. 00:43:06.220 --> 00:43:07.080 align:middle line:90% And what is it? 00:43:07.080 --> 00:43:08.850 align:middle line:84% I like the name central bank money 00:43:08.850 --> 00:43:12.220 align:middle line:84% because that's in contrast with this kind of money. 00:43:12.220 --> 00:43:14.370 align:middle line:84% It's the money that the banking sector produces, 00:43:14.370 --> 00:43:16.620 align:middle line:90% the checkable deposits. 00:43:16.620 --> 00:43:19.260 align:middle line:84% So this is the money produced by the central bank. 00:43:19.260 --> 00:43:23.340 align:middle line:84% And then through deposits, the financial system, the banks 00:43:23.340 --> 00:43:26.730 align:middle line:90% themselves produce more money. 00:43:26.730 --> 00:43:29.990 align:middle line:84% So the total money in the system is much more 00:43:29.990 --> 00:43:36.070 align:middle line:84% than the central bank money because deposits is a big thing. 00:43:36.070 --> 00:43:41.350 align:middle line:84% This is much larger than that in practice. 00:43:41.350 --> 00:43:42.200 align:middle line:90% Good. 00:43:42.200 --> 00:43:44.020 align:middle line:84% So how does this change our model? 00:43:44.020 --> 00:43:45.210 align:middle line:90% Not really much. 00:43:45.210 --> 00:43:48.160 align:middle line:84% And so that's the reason I don't care too much if you understand 00:43:48.160 --> 00:43:49.880 align:middle line:90% this last two slides. 00:43:49.880 --> 00:43:55.450 align:middle line:84% So let me rederive what we had with this approach, 00:43:55.450 --> 00:43:58.270 align:middle line:90% with this extension. 00:43:58.270 --> 00:44:00.792 align:middle line:84% So money, the money is the same as it used to be. 00:44:00.792 --> 00:44:02.500 align:middle line:84% What happens is you're going to demand it 00:44:02.500 --> 00:44:04.930 align:middle line:84% in the form of currency or checking accounts or something 00:44:04.930 --> 00:44:05.590 align:middle line:90% like that. 00:44:05.590 --> 00:44:10.590 align:middle line:84% But the total money demand is exactly as it used to be. 00:44:10.590 --> 00:44:14.470 align:middle line:90% Banks typically hold a share. 00:44:14.470 --> 00:44:16.860 align:middle line:84% And assume for now that there is no currency. 00:44:16.860 --> 00:44:19.350 align:middle line:84% So everything is in deposit, otherwise 00:44:19.350 --> 00:44:21.840 align:middle line:84% you get a more complicated formula. 00:44:21.840 --> 00:44:24.780 align:middle line:84% So no one holds cash, which is probably quite realistic 00:44:24.780 --> 00:44:25.710 align:middle line:90% nowadays. 00:44:25.710 --> 00:44:31.180 align:middle line:84% So everyone has a checking account, and that's it. 00:44:31.180 --> 00:44:40.280 align:middle line:84% So the banks typically hold, for regulatory reasons, 00:44:40.280 --> 00:44:42.110 align:middle line:90% a share of their deposit. 00:44:42.110 --> 00:44:44.300 align:middle line:84% They have a minimum for regulatory reasons, 00:44:44.300 --> 00:44:47.660 align:middle line:84% a minimum share of the deposit they have 00:44:47.660 --> 00:44:50.750 align:middle line:84% that they need to hold in the form of reserves. 00:44:50.750 --> 00:44:53.880 align:middle line:84% And I'm going to call that a fixed fraction, theta. 00:44:53.880 --> 00:44:58.040 align:middle line:84% So if all the money is held in the form of deposits, 00:44:58.040 --> 00:45:00.980 align:middle line:84% then theta, which is a number like 0.1, 00:45:00.980 --> 00:45:04.850 align:middle line:84% say, times the deposit, which is money demand, 00:45:04.850 --> 00:45:10.130 align:middle line:84% is equal to the reserves, is equal to the demand 00:45:10.130 --> 00:45:12.392 align:middle line:90% for central bank money. 00:45:12.392 --> 00:45:14.100 align:middle line:84% This is the demand for central bank money 00:45:14.100 --> 00:45:18.240 align:middle line:84% because these are the reserves that the banks want 00:45:18.240 --> 00:45:20.350 align:middle line:90% to have at the central bank. 00:45:20.350 --> 00:45:23.010 align:middle line:84% So the demand, they want to have this amount of deposits 00:45:23.010 --> 00:45:24.690 align:middle line:90% at the central bank. 00:45:24.690 --> 00:45:25.950 align:middle line:90% This we'll call Hd. 00:45:25.950 --> 00:45:28.390 align:middle line:90% It's theta times Md. 00:45:28.390 --> 00:45:31.278 align:middle line:84% And so now, rather than M, what the central bank controls 00:45:31.278 --> 00:45:33.820 align:middle line:84% really-- because it's the only thing you can really control-- 00:45:33.820 --> 00:45:39.070 align:middle line:84% is the money that it issues, which is the central bank money. 00:45:39.070 --> 00:45:41.540 align:middle line:84% Supplying M, which used to be currency. 00:45:41.540 --> 00:45:43.810 align:middle line:84% Now M is a bigger thing because of deposits 00:45:43.810 --> 00:45:45.110 align:middle line:90% and all sort of stuff. 00:45:45.110 --> 00:45:46.690 align:middle line:84% But the central bank is the one that 00:45:46.690 --> 00:45:49.840 align:middle line:84% controls how much high power money, how much central bank 00:45:49.840 --> 00:45:51.520 align:middle line:90% money, it issues. 00:45:51.520 --> 00:45:54.850 align:middle line:90% And we're going to call that H. 00:45:54.850 --> 00:45:58.450 align:middle line:84% So if you go back to my balance sheet here, 00:45:58.450 --> 00:46:01.150 align:middle line:84% the central bank cannot control total money because it cannot 00:46:01.150 --> 00:46:04.210 align:middle line:84% control the amount of checkable deposits in the economy. 00:46:04.210 --> 00:46:07.250 align:middle line:84% But it can control this money here. 00:46:07.250 --> 00:46:09.560 align:middle line:84% And since we have no currency in my example, 00:46:09.560 --> 00:46:14.180 align:middle line:84% it really can control how much supply of reserves it can do. 00:46:14.180 --> 00:46:16.100 align:middle line:84% And so now we have a demand for reserves, 00:46:16.100 --> 00:46:17.950 align:middle line:84% which is just proportional to money demand, 00:46:17.950 --> 00:46:20.410 align:middle line:84% equal to some fixed amount, H, which 00:46:20.410 --> 00:46:24.190 align:middle line:84% is the supply of high powered money by the central bank. 00:46:24.190 --> 00:46:28.038 align:middle line:84% And then the equilibrium looks exactly like before. 00:46:28.038 --> 00:46:29.830 align:middle line:84% It's going to be some-- remember, before we 00:46:29.830 --> 00:46:34.240 align:middle line:90% have M equal to dollar YLi. 00:46:34.240 --> 00:46:37.660 align:middle line:84% Now we're saying it's not M. It's theta times M, 00:46:37.660 --> 00:46:42.760 align:middle line:84% really, because it's a fraction only of total money. 00:46:42.760 --> 00:46:46.910 align:middle line:90% Has to be equal to money demand. 00:46:46.910 --> 00:46:48.250 align:middle line:90% It's not total money demand. 00:46:48.250 --> 00:46:49.840 align:middle line:84% It's the money that ends up being 00:46:49.840 --> 00:46:51.460 align:middle line:90% demand for central bank money. 00:46:51.460 --> 00:46:56.360 align:middle line:84% Because total money demand is the checking account. 00:46:56.360 --> 00:46:58.850 align:middle line:84% That leads to demand for central bank money 00:46:58.850 --> 00:47:02.930 align:middle line:84% by the banks, which is theta times those deposits, not 00:47:02.930 --> 00:47:03.797 align:middle line:90% the full deposits. 00:47:03.797 --> 00:47:06.380 align:middle line:84% They don't take all the deposits and deposit the central bank. 00:47:06.380 --> 00:47:08.330 align:middle line:84% They say only 10% of those deposits 00:47:08.330 --> 00:47:10.230 align:middle line:84% will keep them at the central bank. 00:47:10.230 --> 00:47:14.750 align:middle line:84% So $100 in deposit, if theta is 0.1, $100 in deposit 00:47:14.750 --> 00:47:16.760 align:middle line:84% leads to a demand for reserves, that 00:47:16.760 --> 00:47:19.730 align:middle line:84% is for deposits by the bank and the central bank, of $10. 00:47:19.730 --> 00:47:22.300 align:middle line:90% 00:47:22.300 --> 00:47:24.310 align:middle line:84% And that is the thing that the central bank 00:47:24.310 --> 00:47:26.330 align:middle line:90% can control very well. 00:47:26.330 --> 00:47:28.810 align:middle line:84% It's the demand that comes to me. 00:47:28.810 --> 00:47:30.400 align:middle line:90% The central bank is $10. 00:47:30.400 --> 00:47:33.700 align:middle line:84% And I decide whether we do $10 or not. 00:47:33.700 --> 00:47:36.910 align:middle line:84% We can do 5 and then we're going to have the interest rate sort 00:47:36.910 --> 00:47:39.850 align:middle line:90% out 5 to be an equilibrium. 00:47:39.850 --> 00:47:42.820 align:middle line:84% So if the banking sector wanted 10 00:47:42.820 --> 00:47:45.153 align:middle line:84% and I'm only going to supply 5, then something, 00:47:45.153 --> 00:47:46.570 align:middle line:84% the interest rate is going to have 00:47:46.570 --> 00:47:51.910 align:middle line:84% to rise so that the deposits decline, less demand for money, 00:47:51.910 --> 00:47:57.040 align:middle line:84% and the final demand that gets to me is 5, not 10. 00:47:57.040 --> 00:47:58.960 align:middle line:84% But the mechanism is exactly the same. 00:47:58.960 --> 00:48:00.910 align:middle line:84% I know this can be a little confusing. 00:48:00.910 --> 00:48:03.520 align:middle line:84% But the mechanism is exactly the same. 00:48:03.520 --> 00:48:05.980 align:middle line:90% This just illustrates-- 00:48:05.980 --> 00:48:11.080 align:middle line:84% I mean, this is important because it's 00:48:11.080 --> 00:48:14.080 align:middle line:84% institutional important, more than conceptually important. 00:48:14.080 --> 00:48:17.125 align:middle line:84% Because this is the market where really the interest rate is set. 00:48:17.125 --> 00:48:20.130 align:middle line:90% 00:48:20.130 --> 00:48:21.480 align:middle line:90% Okay? 00:48:21.480 --> 00:48:24.330 align:middle line:84% That market, the market for reserves, really, 00:48:24.330 --> 00:48:25.890 align:middle line:84% because what the banks do is they 00:48:25.890 --> 00:48:29.010 align:middle line:84% want reserves, deposit at the central bank. 00:48:29.010 --> 00:48:31.170 align:middle line:84% That market for reserves, the interest rate 00:48:31.170 --> 00:48:35.400 align:middle line:84% in that market for reserves, is called the Federal Funds Rate. 00:48:35.400 --> 00:48:37.420 align:middle line:84% And it's called the Federal Funds Rate 00:48:37.420 --> 00:48:39.850 align:middle line:84% because the federal reserves controls that rate. 00:48:39.850 --> 00:48:43.760 align:middle line:84% So when there is a meeting by the Fed or a policy announcement 00:48:43.760 --> 00:48:46.470 align:middle line:84% and it tell you that the Fed has increased the rate by 50 basis 00:48:46.470 --> 00:48:49.140 align:middle line:84% points, it means it has increased 00:48:49.140 --> 00:48:53.580 align:middle line:84% the interest rate in that market by 50 basis points. 00:48:53.580 --> 00:48:57.120 align:middle line:84% So the interest rate that the central bank controls directly 00:48:57.120 --> 00:48:58.980 align:middle line:84% is called the Federal Funds Rate. 00:48:58.980 --> 00:49:01.710 align:middle line:84% And the Federal Funds Rate is that market, 00:49:01.710 --> 00:49:04.180 align:middle line:84% is the market for reserve for high powered money. 00:49:04.180 --> 00:49:07.250 align:middle line:84% So all the operations happen there. 00:49:07.250 --> 00:49:09.685 align:middle line:84% They don't participate in the deposit 00:49:09.685 --> 00:49:10.810 align:middle line:90% market, anything like that. 00:49:10.810 --> 00:49:13.960 align:middle line:84% They participate in that market, which every night is 00:49:13.960 --> 00:49:15.790 align:middle line:90% a huge number of transactions. 00:49:15.790 --> 00:49:18.570 align:middle line:84% Every night because I put all the banks together. 00:49:18.570 --> 00:49:20.320 align:middle line:84% But what happens every night is some banks 00:49:20.320 --> 00:49:21.610 align:middle line:84% have more reserves than they need. 00:49:21.610 --> 00:49:23.735 align:middle line:84% Some other banks have less reserves than they need. 00:49:23.735 --> 00:49:27.970 align:middle line:84% So the supply and demand within the banking sector for reserves, 00:49:27.970 --> 00:49:30.340 align:middle line:84% and there is an interest rate that tends to equilibrate, 00:49:30.340 --> 00:49:32.212 align:middle line:84% if too many banks are short reserves, 00:49:32.212 --> 00:49:34.420 align:middle line:84% then there is going to be lots of demand for reserves 00:49:34.420 --> 00:49:36.503 align:middle line:84% and the interest rates are going to tend to go up. 00:49:36.503 --> 00:49:38.260 align:middle line:84% If the Fed doesn't want that interest rate 00:49:38.260 --> 00:49:40.610 align:middle line:84% to go up, then what it will do overnight, 00:49:40.610 --> 00:49:42.580 align:middle line:84% it will go there and inject reserves 00:49:42.580 --> 00:49:44.240 align:middle line:84% into the system, high power money. 00:49:44.240 --> 00:49:47.230 align:middle line:84% So the interest rate in that market comes down. 00:49:47.230 --> 00:49:49.840 align:middle line:84% And that's the way the Fed operates. 00:49:49.840 --> 00:49:51.190 align:middle line:90% That's the way it controls it. 00:49:51.190 --> 00:49:52.660 align:middle line:90% Participates in that market. 00:49:52.660 --> 00:49:54.160 align:middle line:84% Controls the amount of high power 00:49:54.160 --> 00:49:58.490 align:middle line:84% money, which regulates the rate in the reserves market. 00:49:58.490 --> 00:49:59.950 align:middle line:90% And here it's only-- 00:49:59.950 --> 00:50:07.070 align:middle line:84% and then so here you have the major banks participating here. 00:50:07.070 --> 00:50:10.070 align:middle line:84% And then this leaks into the other interest rates 00:50:10.070 --> 00:50:14.090 align:middle line:84% in the economy, into the deposit rates, to bond rates, and so on. 00:50:14.090 --> 00:50:16.220 align:middle line:84% But the real rate they control, the rate 00:50:16.220 --> 00:50:20.290 align:middle line:84% that they control most directly, is that right here. 00:50:20.290 --> 00:50:22.040 align:middle line:84% And that's the reason I wanted to give you 00:50:22.040 --> 00:50:24.440 align:middle line:90% a little bit of institutional-- 00:50:24.440 --> 00:50:30.640 align:middle line:84% I mean, to add complexity, so you 00:50:30.640 --> 00:50:33.500 align:middle line:84% could get to this word, Federal Funds Rate 00:50:33.500 --> 00:50:35.800 align:middle line:84% because that's what you want to read in the newspapers. 00:50:35.800 --> 00:50:38.800 align:middle line:84% The Fed increased the federal funds target, it's going to say. 00:50:38.800 --> 00:50:39.700 align:middle line:90% Because they target. 00:50:39.700 --> 00:50:41.680 align:middle line:84% They cannot guarantee there's going to be a target 00:50:41.680 --> 00:50:42.460 align:middle line:90% in an interest rate. 00:50:42.460 --> 00:50:44.030 align:middle line:84% And typically, they give you a range. 00:50:44.030 --> 00:50:45.310 align:middle line:90% It's a very narrow range. 00:50:45.310 --> 00:50:48.040 align:middle line:90% 00:50:48.040 --> 00:50:51.280 align:middle line:84% Let me just conclude by showing you how that rate has 00:50:51.280 --> 00:50:55.270 align:middle line:90% looked in the US recently. 00:50:55.270 --> 00:50:56.630 align:middle line:90% And I finish here. 00:50:56.630 --> 00:51:01.090 align:middle line:90% So here is before COVID. 00:51:01.090 --> 00:51:04.270 align:middle line:84% The interest rate, the Fed was already hiking interest rates. 00:51:04.270 --> 00:51:07.210 align:middle line:84% It had overdone it there so it was beginning to lower interest 00:51:07.210 --> 00:51:07.710 align:middle line:90% rates. 00:51:07.710 --> 00:51:11.520 align:middle line:84% And then COVID came and they cut interest rate very aggressively. 00:51:11.520 --> 00:51:13.145 align:middle line:84% This is the maximum they can cut it to. 00:51:13.145 --> 00:51:15.437 align:middle line:84% And we're going to talk about that briefly in the next, 00:51:15.437 --> 00:51:16.390 align:middle line:90% to zero. 00:51:16.390 --> 00:51:17.710 align:middle line:90% You cannot go below zero. 00:51:17.710 --> 00:51:20.830 align:middle line:84% You cannot pay negative interest rate because then I don't demand 00:51:20.830 --> 00:51:21.340 align:middle line:90% money. 00:51:21.340 --> 00:51:22.450 align:middle line:90% I don't demand bonds. 00:51:22.450 --> 00:51:24.400 align:middle line:84% Why should I hold a bond that pays me 00:51:24.400 --> 00:51:27.640 align:middle line:84% a negative interest rate when cash pays 0, always 0? 00:51:27.640 --> 00:51:30.183 align:middle line:84% I can keep it under the mattress and I 00:51:30.183 --> 00:51:31.350 align:middle line:90% don't pay anything negative. 00:51:31.350 --> 00:51:33.200 align:middle line:84% So the interest rate, the lowest can be 0. 00:51:33.200 --> 00:51:35.510 align:middle line:84% And you see that they did the maximum they could 00:51:35.510 --> 00:51:37.020 align:middle line:84% in terms of cutting interest rate. 00:51:37.020 --> 00:51:38.750 align:middle line:90% They went to 0, effectively 0. 00:51:38.750 --> 00:51:40.580 align:middle line:84% And now they have been trying to catch up 00:51:40.580 --> 00:51:41.910 align:middle line:90% because inflation is very high. 00:51:41.910 --> 00:51:44.060 align:middle line:84% And so they're trying to hike interest rates. 00:51:44.060 --> 00:51:45.920 align:middle line:90% And you see what they're doing. 00:51:45.920 --> 00:51:49.280 align:middle line:84% Well, all those interventions happen in the reserve market. 00:51:49.280 --> 00:51:50.450 align:middle line:90% That's what this is. 00:51:50.450 --> 00:51:54.960 align:middle line:84% That's the rate, is in that market over there. 00:51:54.960 --> 00:51:59.450 align:middle line:84% OK, so I think we're meeting on Tuesday next week. 00:51:59.450 --> 00:52:01.540 align:middle line:90% I think that's the plan. 00:52:01.540 --> 00:52:15.000 align:middle line:90%