WEBVTT 00:00:00.000 --> 00:00:02.485 align:middle line:90% [SQUEAKING] 00:00:02.485 --> 00:00:04.970 align:middle line:90% [RUSTLING] 00:00:04.970 --> 00:00:07.455 align:middle line:90% [CLICKING] 00:00:07.455 --> 00:00:16.420 align:middle line:90% 00:00:16.420 --> 00:00:20.760 align:middle line:84% PROFESSOR: So let me continue with the IS-LM-PC model. 00:00:20.760 --> 00:00:25.240 align:middle line:84% In fact, I want to rush a little bit because I was overexcited 00:00:25.240 --> 00:00:27.760 align:middle line:90% with the SVB bank event. 00:00:27.760 --> 00:00:33.700 align:middle line:84% And I want to make sure that you certainly understand this model. 00:00:33.700 --> 00:00:36.940 align:middle line:90% It's going to be very important. 00:00:36.940 --> 00:00:40.870 align:middle line:84% And I think it's one of the most important models in this course, 00:00:40.870 --> 00:00:42.550 align:middle line:90% as I said before. 00:00:42.550 --> 00:00:46.690 align:middle line:84% Also, I want to use it a little bit more, this model itself, 00:00:46.690 --> 00:00:48.590 align:middle line:84% to explain what is going on right now. 00:00:48.590 --> 00:00:52.250 align:middle line:84% Today, we got hit by a second shock from the financial system. 00:00:52.250 --> 00:00:57.920 align:middle line:84% And so it's getting exciting these days. 00:00:57.920 --> 00:01:01.870 align:middle line:84% So let me skip all this and remind you 00:01:01.870 --> 00:01:03.620 align:middle line:90% that that's where we were. 00:01:03.620 --> 00:01:06.190 align:middle line:84% That's the IS-LM-PC model, which I 00:01:06.190 --> 00:01:10.750 align:middle line:84% said is nothing else than just integrating the IS-LM analysis 00:01:10.750 --> 00:01:12.080 align:middle line:90% with the Phillips curve. 00:01:12.080 --> 00:01:13.520 align:middle line:90% This is the IS part. 00:01:13.520 --> 00:01:16.860 align:middle line:84% And I said at this point, I will follow the book 00:01:16.860 --> 00:01:20.180 align:middle line:84% and assume that the central bank can control the real interest 00:01:20.180 --> 00:01:22.910 align:middle line:84% rate, rather than the nominal interest rate, which is what 00:01:22.910 --> 00:01:24.980 align:middle line:90% really controls in practice. 00:01:24.980 --> 00:01:27.530 align:middle line:84% But I'm going to make that assumption so the pictures have 00:01:27.530 --> 00:01:29.990 align:middle line:84% less curves moving around when things are 00:01:29.990 --> 00:01:33.360 align:middle line:90% moving when we do the dynamics. 00:01:33.360 --> 00:01:38.120 align:middle line:84% But that's just a IS-LM, nothing different. 00:01:38.120 --> 00:01:42.740 align:middle line:84% And then we look at the Phillips curve. 00:01:42.740 --> 00:01:47.390 align:middle line:84% And I said, well, this is not very useful 00:01:47.390 --> 00:01:53.090 align:middle line:84% because in the IS part I have output here and in the Phillips 00:01:53.090 --> 00:01:55.550 align:middle line:84% curve, I have inflation but then I have unemployment 00:01:55.550 --> 00:01:58.250 align:middle line:84% and I don't want to be carrying around three variables, 00:01:58.250 --> 00:02:01.400 align:middle line:90% endogenous variables. 00:02:01.400 --> 00:02:06.338 align:middle line:84% And so it's difficult to diagram in three dimensions. 00:02:06.338 --> 00:02:07.380 align:middle line:90% Everything is less clear. 00:02:07.380 --> 00:02:13.383 align:middle line:84% So I'm going to replace this unemployment here for output. 00:02:13.383 --> 00:02:15.800 align:middle line:84% And it's very easy to do that with the production function 00:02:15.800 --> 00:02:19.340 align:middle line:84% we have because output is just equal to employment. 00:02:19.340 --> 00:02:23.060 align:middle line:84% And the employment is just equal to the labor force times 1 00:02:23.060 --> 00:02:24.810 align:middle line:90% minus the rate of unemployment. 00:02:24.810 --> 00:02:27.800 align:middle line:84% And we could define a concept of potential output 00:02:27.800 --> 00:02:30.380 align:middle line:84% as simply that output that happens when employment 00:02:30.380 --> 00:02:33.590 align:middle line:84% is equal to the natural level of employment, which 00:02:33.590 --> 00:02:35.600 align:middle line:84% is equal to the labor force times 1 00:02:35.600 --> 00:02:38.280 align:middle line:84% minus the natural rate of unemployment. 00:02:38.280 --> 00:02:40.940 align:middle line:84% And taking the difference, subtracting the second line 00:02:40.940 --> 00:02:42.920 align:middle line:84% from the first one, you get a concept 00:02:42.920 --> 00:02:45.850 align:middle line:84% that is used very frequently in macroeconomics, which is 00:02:45.850 --> 00:02:47.490 align:middle line:90% the concept of the output gap. 00:02:47.490 --> 00:02:50.870 align:middle line:84% An output gap refers to the difference between actual output 00:02:50.870 --> 00:02:53.750 align:middle line:84% and potential output, in which potential output is nothing 00:02:53.750 --> 00:02:55.550 align:middle line:84% else than the level of output that you 00:02:55.550 --> 00:03:00.390 align:middle line:84% get when unemployment is at the natural rate of unemployment. 00:03:00.390 --> 00:03:03.980 align:middle line:84% So we get the output gap is related to the employment gap. 00:03:03.980 --> 00:03:07.550 align:middle line:84% And now we can replace the employment gap from here 00:03:07.550 --> 00:03:10.670 align:middle line:90% with the output gap. 00:03:10.670 --> 00:03:12.350 align:middle line:84% And we end up with a Phillips curve 00:03:12.350 --> 00:03:14.780 align:middle line:84% in the space of inflation and output gap, 00:03:14.780 --> 00:03:17.390 align:middle line:84% which is something we can integrate 00:03:17.390 --> 00:03:21.090 align:middle line:84% very easily with the IS-LM model that has output in it. 00:03:21.090 --> 00:03:27.320 align:middle line:84% So the IS-LM model is really combining 00:03:27.320 --> 00:03:30.140 align:middle line:84% this equation with that equation, 00:03:30.140 --> 00:03:32.370 align:middle line:84% and some model about expected inflation. 00:03:32.370 --> 00:03:35.860 align:middle line:84% That's what the IS-LM-PC model is. 00:03:35.860 --> 00:03:38.780 align:middle line:84% So I gave you one example here, 1 mole of inflation. 00:03:38.780 --> 00:03:42.460 align:middle line:84% This is the case of the central banks do not like, 00:03:42.460 --> 00:03:44.920 align:middle line:90% an anchor inflation expectation. 00:03:44.920 --> 00:03:47.570 align:middle line:84% That's my model of expectation, then my Phillips curve. 00:03:47.570 --> 00:03:49.780 align:middle line:84% I plug this into my Phillips curve 00:03:49.780 --> 00:03:53.590 align:middle line:84% and I get this relationship between the change in inflation 00:03:53.590 --> 00:03:55.840 align:middle line:90% and the output gap. 00:03:55.840 --> 00:03:57.530 align:middle line:84% And it's an increasing relationship. 00:03:57.530 --> 00:03:59.170 align:middle line:84% And that's what I'm plotting here. 00:03:59.170 --> 00:04:03.430 align:middle line:84% For any given level, for any given level of Yn, 00:04:03.430 --> 00:04:06.760 align:middle line:84% then as I increase output, the Phillips curve-- 00:04:06.760 --> 00:04:09.010 align:middle line:84% the change in inflation, the left hand side, 00:04:09.010 --> 00:04:12.410 align:middle line:84% the difference between inflation and expected inflation rises. 00:04:12.410 --> 00:04:14.110 align:middle line:84% That's the reason this upward sloping. 00:04:14.110 --> 00:04:16.839 align:middle line:84% And the reason this rises has to do with all the things that 00:04:16.839 --> 00:04:19.480 align:middle line:90% happen in the labor market. 00:04:19.480 --> 00:04:22.550 align:middle line:84% If output rises, I mean, unemployment is falling. 00:04:22.550 --> 00:04:24.680 align:middle line:84% You need more employment to produce more output. 00:04:24.680 --> 00:04:26.770 align:middle line:84% If that's the case, it's more wage pressure 00:04:26.770 --> 00:04:29.590 align:middle line:84% that leads to a price pressure because there 00:04:29.590 --> 00:04:31.850 align:middle line:84% is a markup in between wages and prices. 00:04:31.850 --> 00:04:34.880 align:middle line:84% And that's the way you get into inflation. 00:04:34.880 --> 00:04:38.020 align:middle line:90% So I gave you one example. 00:04:38.020 --> 00:04:42.940 align:middle line:84% It says, OK, suppose that we have some equilibrium 00:04:42.940 --> 00:04:43.810 align:middle line:90% level of output. 00:04:43.810 --> 00:04:46.840 align:middle line:84% This, which is the result of this monetary policy, 00:04:46.840 --> 00:04:51.200 align:middle line:84% this rate set by the central bank. 00:04:51.200 --> 00:04:54.970 align:middle line:84% And that's the IS, which is a function of the fiscal policy 00:04:54.970 --> 00:04:56.980 align:middle line:84% of the country, how confident are consumers, 00:04:56.980 --> 00:04:58.310 align:middle line:90% and all these kind of things. 00:04:58.310 --> 00:05:03.370 align:middle line:84% So in quiz one, we really worry only about this top diagram. 00:05:03.370 --> 00:05:05.740 align:middle line:84% And all the shocks we had were shocks that 00:05:05.740 --> 00:05:07.400 align:middle line:90% happened in this top diagram. 00:05:07.400 --> 00:05:10.990 align:middle line:84% And we look at what happened to output, to equilibrium output 00:05:10.990 --> 00:05:12.610 align:middle line:90% as a result. 00:05:12.610 --> 00:05:15.050 align:middle line:90% Now, this hasn't changed. 00:05:15.050 --> 00:05:16.160 align:middle line:90% It hasn't changed. 00:05:16.160 --> 00:05:17.990 align:middle line:84% That block is the same as it used to be. 00:05:17.990 --> 00:05:20.020 align:middle line:84% The only difference that we have here 00:05:20.020 --> 00:05:23.170 align:middle line:84% is that this level of output, which 00:05:23.170 --> 00:05:25.780 align:middle line:84% is the equilibrium level of output at any point in time, 00:05:25.780 --> 00:05:28.038 align:middle line:84% needs not be equal to potential output. 00:05:28.038 --> 00:05:29.830 align:middle line:84% And if it is not equal to potential output, 00:05:29.830 --> 00:05:33.010 align:middle line:84% that will lead to something with inflation-- inflation, 00:05:33.010 --> 00:05:34.870 align:middle line:84% disinflation, or something of that kind. 00:05:34.870 --> 00:05:38.810 align:middle line:84% In this particular case, the equilibrium level of output, 00:05:38.810 --> 00:05:41.390 align:middle line:84% which is still determined as we used to determine, 00:05:41.390 --> 00:05:45.230 align:middle line:84% happens to be higher than the natural rate of output. 00:05:45.230 --> 00:05:48.800 align:middle line:84% And if output is higher than the rate of output, 00:05:48.800 --> 00:05:52.740 align:middle line:84% that means this is positive, which means inflation is rising. 00:05:52.740 --> 00:05:54.620 align:middle line:84% And that's exactly what we see here. 00:05:54.620 --> 00:05:57.450 align:middle line:84% It means inflation is above expected inflation. 00:05:57.450 --> 00:06:00.170 align:middle line:84% When expected inflation is equal to log inflation, 00:06:00.170 --> 00:06:02.900 align:middle line:84% then that means inflation is rising. 00:06:02.900 --> 00:06:06.470 align:middle line:90% And that's what we have here. 00:06:06.470 --> 00:06:08.400 align:middle line:90% So any question about that? 00:06:08.400 --> 00:06:10.430 align:middle line:84% So this is-- we just, what we did 00:06:10.430 --> 00:06:14.540 align:middle line:84% is kept analysis we used to have and now we added this diagram 00:06:14.540 --> 00:06:15.590 align:middle line:90% here at the bottom. 00:06:15.590 --> 00:06:19.010 align:middle line:84% Because it turns out that, yes, any equilibrium 00:06:19.010 --> 00:06:21.050 align:middle line:84% here, if I move the interest rate around, 00:06:21.050 --> 00:06:22.940 align:middle line:84% I'm going to change the level of output. 00:06:22.940 --> 00:06:24.900 align:middle line:84% All those are equilibrium levels output. 00:06:24.900 --> 00:06:27.440 align:middle line:84% But that doesn't mean that they're 00:06:27.440 --> 00:06:29.840 align:middle line:90% consistent with the natural-- 00:06:29.840 --> 00:06:31.160 align:middle line:90% with potential output. 00:06:31.160 --> 00:06:33.410 align:middle line:84% And if it's not equal to potential output, 00:06:33.410 --> 00:06:35.790 align:middle line:84% it's a valid equilibrium at any point in time. 00:06:35.790 --> 00:06:39.150 align:middle line:84% But it's going to lead to issues on the inflation front. 00:06:39.150 --> 00:06:39.800 align:middle line:90% That's all. 00:06:39.800 --> 00:06:42.380 align:middle line:84% The second diagram here tells you 00:06:42.380 --> 00:06:46.070 align:middle line:84% that we get issues on the inflation front 00:06:46.070 --> 00:06:49.130 align:middle line:84% with any equilibrium level of output that 00:06:49.130 --> 00:06:51.800 align:middle line:84% is different from the natural rate of output. 00:06:51.800 --> 00:06:53.380 align:middle line:90% That's what this diagram does. 00:06:53.380 --> 00:06:56.338 align:middle line:90% 00:06:56.338 --> 00:06:57.380 align:middle line:90% And that's what happened. 00:06:57.380 --> 00:06:58.963 align:middle line:84% In the short run, that's what it does. 00:06:58.963 --> 00:07:01.750 align:middle line:84% So we keep doing what we used to do in the first seven lectures 00:07:01.750 --> 00:07:02.440 align:middle line:90% or so. 00:07:02.440 --> 00:07:05.890 align:middle line:84% And this diagram just tells us what are 00:07:05.890 --> 00:07:07.420 align:middle line:90% the implications for inflation. 00:07:07.420 --> 00:07:08.810 align:middle line:90% That's in the short run. 00:07:08.810 --> 00:07:12.400 align:middle line:84% The medium run, we said, is when we start processing, 00:07:12.400 --> 00:07:16.240 align:middle line:84% which output converges back to the natural rate 00:07:16.240 --> 00:07:17.440 align:middle line:90% to potential output. 00:07:17.440 --> 00:07:19.010 align:middle line:90% How does that happen? 00:07:19.010 --> 00:07:21.700 align:middle line:84% Well, it involves the central bank. 00:07:21.700 --> 00:07:24.140 align:middle line:84% But it's not that the central bank is doing crazy things. 00:07:24.140 --> 00:07:26.860 align:middle line:84% The central bank is reacting to what the economy is 00:07:26.860 --> 00:07:28.340 align:middle line:90% telling it needs to do. 00:07:28.340 --> 00:07:33.640 align:middle line:84% Here is a central bank that was before doing whatever change 00:07:33.640 --> 00:07:36.550 align:middle line:84% in the interest rate or in the IS delivered the equilibrium 00:07:36.550 --> 00:07:37.420 align:middle line:90% output here. 00:07:37.420 --> 00:07:39.440 align:middle line:90% Had an inflation of around 2%. 00:07:39.440 --> 00:07:41.510 align:middle line:84% That was consistent with the target it had. 00:07:41.510 --> 00:07:43.900 align:middle line:84% Now suddenly it finds itself in a situation like this 00:07:43.900 --> 00:07:46.510 align:middle line:90% and inflation starts climbing. 00:07:46.510 --> 00:07:50.840 align:middle line:84% We get 3% one year, 4%, the next, 6, 9, 00:07:50.840 --> 00:07:52.450 align:middle line:90% in a situation like that. 00:07:52.450 --> 00:07:54.400 align:middle line:84% Well, it's very natural for that central bank, 00:07:54.400 --> 00:07:57.470 align:middle line:84% if it's a responsible central bank, to react to that. 00:07:57.470 --> 00:08:00.170 align:middle line:84% And the only reaction the central bank can have, 00:08:00.170 --> 00:08:03.120 align:middle line:84% the main reaction can have, is to raise interest rates. 00:08:03.120 --> 00:08:05.750 align:middle line:84% And that's exactly what starts happening. 00:08:05.750 --> 00:08:08.130 align:middle line:84% The central bank finds itself with inflation, 00:08:08.130 --> 00:08:10.260 align:middle line:84% in this case that is accelerating. 00:08:10.260 --> 00:08:12.510 align:middle line:84% It will start increasing interest rate. 00:08:12.510 --> 00:08:15.980 align:middle line:84% And this process of acceleration of inflation in this case 00:08:15.980 --> 00:08:20.090 align:middle line:84% would only stop when output is equal to the natural potential 00:08:20.090 --> 00:08:20.790 align:middle line:90% output. 00:08:20.790 --> 00:08:25.932 align:middle line:84% And we can define implicitly what that interest rate is. 00:08:25.932 --> 00:08:28.140 align:middle line:84% And we can call it the natural rate of interest rate. 00:08:28.140 --> 00:08:31.310 align:middle line:84% Sometimes we call it [INAUDIBLE] rate 00:08:31.310 --> 00:08:35.210 align:middle line:84% of interest rate, neutral interest rate, R star, 00:08:35.210 --> 00:08:36.783 align:middle line:84% lots of names for this interest rate. 00:08:36.783 --> 00:08:38.450 align:middle line:84% But this interest rate is simply the one 00:08:38.450 --> 00:08:41.570 align:middle line:84% that gives us an equilibrium output in our IS-LM diagram 00:08:41.570 --> 00:08:45.610 align:middle line:84% that is equal to potential output. 00:08:45.610 --> 00:08:47.990 align:middle line:84% Thus, that's all that this Rn means. 00:08:47.990 --> 00:08:52.540 align:middle line:84% And here I'm solving it as the rate that implicitly gives us 00:08:52.540 --> 00:08:55.150 align:middle line:84% an equilibrium output here that is 00:08:55.150 --> 00:08:58.330 align:middle line:84% equal to the natural rate of output that defines it 00:08:58.330 --> 00:08:59.690 align:middle line:90% implicitly. 00:08:59.690 --> 00:09:01.950 align:middle line:90% OK, there we are. 00:09:01.950 --> 00:09:05.150 align:middle line:90% Is all that clear? 00:09:05.150 --> 00:09:06.270 align:middle line:90% Yes, OK. 00:09:06.270 --> 00:09:09.890 align:middle line:84% I think you're going to have a big chunk of your current pset 00:09:09.890 --> 00:09:11.670 align:middle line:90% about this model and so on. 00:09:11.670 --> 00:09:12.990 align:middle line:90% And that's a good thing. 00:09:12.990 --> 00:09:14.990 align:middle line:84% And you'll see it also in the next one. 00:09:14.990 --> 00:09:17.290 align:middle line:84% Because, again, I think this is important. 00:09:17.290 --> 00:09:20.110 align:middle line:84% Then they talk about the difference between anchor 00:09:20.110 --> 00:09:21.590 align:middle line:90% and unanchor expectations. 00:09:21.590 --> 00:09:24.670 align:middle line:84% I said, look, here, we have a situation 00:09:24.670 --> 00:09:26.690 align:middle line:90% that suppose we started at 2%. 00:09:26.690 --> 00:09:29.570 align:middle line:84% And then we found ourselves in a situation like that. 00:09:29.570 --> 00:09:32.120 align:middle line:84% That means inflation starts building up. 00:09:32.120 --> 00:09:33.920 align:middle line:90% We go to 9% or so. 00:09:33.920 --> 00:09:36.010 align:middle line:84% So now the Fed gets scared and it 00:09:36.010 --> 00:09:37.460 align:middle line:90% starts raising interest rates. 00:09:37.460 --> 00:09:39.680 align:middle line:84% So that's moving up, lowering output. 00:09:39.680 --> 00:09:42.430 align:middle line:84% And as it lowers output, reduces the output gap. 00:09:42.430 --> 00:09:46.370 align:middle line:84% And therefore, reduces the change in inflation here. 00:09:46.370 --> 00:09:49.360 align:middle line:84% But inflation keeps rising in this particular model 00:09:49.360 --> 00:09:51.590 align:middle line:84% because expected inflation is an anchor. 00:09:51.590 --> 00:09:54.100 align:middle line:84% And I said, well, suppose that eventually the Fed gets 00:09:54.100 --> 00:09:55.900 align:middle line:90% to that interest rate here. 00:09:55.900 --> 00:09:58.030 align:middle line:84% So we get to a situation like that. 00:09:58.030 --> 00:10:02.170 align:middle line:84% And I ask the question, has the Fed solved the problem now? 00:10:02.170 --> 00:10:03.790 align:middle line:84% OK, finally we get to a situation 00:10:03.790 --> 00:10:07.300 align:middle line:84% where the interest rate is equal to the natural rate of interest 00:10:07.300 --> 00:10:07.850 align:middle line:90% rate. 00:10:07.850 --> 00:10:10.490 align:middle line:84% That tells me that output is equal to potential output. 00:10:10.490 --> 00:10:13.180 align:middle line:84% That tells me here that inflation is not changing. 00:10:13.180 --> 00:10:17.940 align:middle line:84% Problem is that we already had inflation of 9% at some point. 00:10:17.940 --> 00:10:22.040 align:middle line:84% So here, inflation stops rising in this particular model 00:10:22.040 --> 00:10:25.320 align:middle line:84% with expected inflation and anchor expected inflation. 00:10:25.320 --> 00:10:28.910 align:middle line:84% But stopping is not enough because that leaves us 00:10:28.910 --> 00:10:31.370 align:middle line:90% with a level of inflation of 9%. 00:10:31.370 --> 00:10:34.670 align:middle line:84% That means that the Fed, in order to bring back inflation 00:10:34.670 --> 00:10:38.180 align:middle line:84% to 2%, it needs to go into this region. 00:10:38.180 --> 00:10:44.490 align:middle line:84% So inflation starts coming down from 9%, 7%, 6%, 5% and so on. 00:10:44.490 --> 00:10:47.630 align:middle line:84% So if you have an anchor expectation, 00:10:47.630 --> 00:10:50.060 align:middle line:84% an inflation overshoots, you're going 00:10:50.060 --> 00:10:53.160 align:middle line:84% to have to cause a recession, and probably a severe recession. 00:10:53.160 --> 00:10:54.680 align:middle line:90% There is no way around that. 00:10:54.680 --> 00:10:57.470 align:middle line:84% And that's what the Fed has been struggling to do, 00:10:57.470 --> 00:10:58.760 align:middle line:90% is struggling not to. 00:10:58.760 --> 00:11:01.670 align:middle line:84% Because the Fed, we are in a situation-- not only in the US, 00:11:01.670 --> 00:11:04.340 align:middle line:84% but in the US in particular, where inflation 00:11:04.340 --> 00:11:06.830 align:middle line:90% is way above the target level. 00:11:06.830 --> 00:11:10.530 align:middle line:84% But expected inflation has been more or less stable. 00:11:10.530 --> 00:11:13.160 align:middle line:84% And so when people talk about being 00:11:13.160 --> 00:11:17.870 align:middle line:84% able to restore sort of reasonable levels of inflation 00:11:17.870 --> 00:11:21.020 align:middle line:84% in a soft landed manner, with a soft landing, 00:11:21.020 --> 00:11:24.710 align:middle line:84% that means that you don't need to cause a recession 00:11:24.710 --> 00:11:27.150 align:middle line:90% to bring inflation back to 2%. 00:11:27.150 --> 00:11:29.150 align:middle line:84% You just can bring it smoothly here. 00:11:29.150 --> 00:11:31.860 align:middle line:84% With this model of expected, inflation doesn't work. 00:11:31.860 --> 00:11:36.800 align:middle line:84% But if the bank, central bank, has credibility and inflation 00:11:36.800 --> 00:11:39.410 align:middle line:84% remain anchored, people continue to believe that the Fed will 00:11:39.410 --> 00:11:40.730 align:middle line:90% go back to 2%. 00:11:40.730 --> 00:11:42.750 align:middle line:84% Then you don't need to cause a big recession. 00:11:42.750 --> 00:11:46.220 align:middle line:84% Otherwise, you need to invest in bringing expectations down. 00:11:46.220 --> 00:11:48.200 align:middle line:84% And the only way you can invest in doing that 00:11:48.200 --> 00:11:49.760 align:middle line:90% is causing a recession. 00:11:49.760 --> 00:11:53.450 align:middle line:84% But that's the reason I said central banks worry so much 00:11:53.450 --> 00:11:56.090 align:middle line:84% about keeping inflation credibility, 00:11:56.090 --> 00:11:59.420 align:middle line:84% because otherwise they need to overshoot in order 00:11:59.420 --> 00:12:06.140 align:middle line:90% to restore a long run balance. 00:12:06.140 --> 00:12:08.550 align:middle line:90% Good. 00:12:08.550 --> 00:12:14.780 align:middle line:84% Now, you may wonder, well, I mean, this looks pretty simple. 00:12:14.780 --> 00:12:16.700 align:middle line:84% And just, if you have a problem like this, 00:12:16.700 --> 00:12:21.020 align:middle line:84% just go quickly to that point there. 00:12:21.020 --> 00:12:22.590 align:middle line:90% And then the problem is over. 00:12:22.590 --> 00:12:26.340 align:middle line:84% You don't let inflation build to 9%, or something like that. 00:12:26.340 --> 00:12:27.650 align:middle line:90% You react immediately. 00:12:27.650 --> 00:12:30.380 align:middle line:84% The problem is, there's a famous sentence that 00:12:30.380 --> 00:12:32.990 align:middle line:84% was coined by Milton Friedman, is 00:12:32.990 --> 00:12:34.940 align:middle line:84% that monetary policy acts on the economy 00:12:34.940 --> 00:12:37.100 align:middle line:90% with long and variable lags. 00:12:37.100 --> 00:12:40.580 align:middle line:84% So first of all, it's very difficult at any point in time 00:12:40.580 --> 00:12:42.710 align:middle line:84% to know where is potential output 00:12:42.710 --> 00:12:44.640 align:middle line:84% and what is a natural rate of unemployment. 00:12:44.640 --> 00:12:45.890 align:middle line:90% I mean, you sort of sense it. 00:12:45.890 --> 00:12:48.560 align:middle line:84% But the truth is that the only way you really know 00:12:48.560 --> 00:12:50.610 align:middle line:90% is by looking at inflation. 00:12:50.610 --> 00:12:52.880 align:middle line:84% So it's inflation that really tells you that you 00:12:52.880 --> 00:12:54.330 align:middle line:90% are on one side or the other. 00:12:54.330 --> 00:12:56.150 align:middle line:90% It's very difficult to-- 00:12:56.150 --> 00:12:58.470 align:middle line:84% you have some historical average and so on. 00:12:58.470 --> 00:12:59.812 align:middle line:90% But these things do move around. 00:12:59.812 --> 00:13:01.520 align:middle line:84% So it's difficult to at any point in time 00:13:01.520 --> 00:13:05.670 align:middle line:84% to know whether you are at our end or not. 00:13:05.670 --> 00:13:09.740 align:middle line:84% The second thing is that here everything happens immediately. 00:13:09.740 --> 00:13:12.540 align:middle line:84% If I move immediately, then output immediately jumps here. 00:13:12.540 --> 00:13:15.060 align:middle line:84% That's not the way monetary policy operates in practice. 00:13:15.060 --> 00:13:19.710 align:middle line:84% It takes time for monetary policy to affect the economy. 00:13:19.710 --> 00:13:24.620 align:middle line:84% And so the situation that happened, I would say, 00:13:24.620 --> 00:13:28.610 align:middle line:84% until last week, was the Fed knew that the inflation 00:13:28.610 --> 00:13:30.400 align:middle line:90% was still too high. 00:13:30.400 --> 00:13:32.810 align:middle line:84% But it also knew that it had done a lot. 00:13:32.810 --> 00:13:35.360 align:middle line:84% It had hiked rates very aggressively by a lot. 00:13:35.360 --> 00:13:40.090 align:middle line:84% And since there are lags between the increase in interest rate 00:13:40.090 --> 00:13:43.720 align:middle line:84% and the decline in output, the Fed's concern 00:13:43.720 --> 00:13:46.390 align:middle line:84% was, well, it's clear that I still have inflation. 00:13:46.390 --> 00:13:48.850 align:middle line:84% But it may well be the case that when this thing finally 00:13:48.850 --> 00:13:51.370 align:middle line:84% hits the economy, it hits it too much 00:13:51.370 --> 00:13:54.410 align:middle line:84% and we end up in a recession, and an unwanted recession. 00:13:54.410 --> 00:13:57.550 align:middle line:90% That was the concern. 00:13:57.550 --> 00:13:59.313 align:middle line:84% Now, what is happening right now, 00:13:59.313 --> 00:14:00.730 align:middle line:84% there is a little bit of a concern 00:14:00.730 --> 00:14:03.100 align:middle line:84% that we got to that point because things were very 00:14:03.100 --> 00:14:04.880 align:middle line:90% slow for a variety of reasons. 00:14:04.880 --> 00:14:06.820 align:middle line:90% But now something broke. 00:14:06.820 --> 00:14:10.510 align:middle line:84% And the question is, now that something has broken, 00:14:10.510 --> 00:14:13.930 align:middle line:84% will we sort of decelerate the economy very, very fast? 00:14:13.930 --> 00:14:15.010 align:middle line:90% And that's a concern. 00:14:15.010 --> 00:14:16.630 align:middle line:84% That's what is happening right now. 00:14:16.630 --> 00:14:20.780 align:middle line:84% But that's what makes monetary policy much more difficult 00:14:20.780 --> 00:14:22.610 align:middle line:84% than this little diagram, is that you 00:14:22.610 --> 00:14:25.400 align:middle line:84% have all these lags, these uncertainties, and all 00:14:25.400 --> 00:14:26.540 align:middle line:90% these non-linearities. 00:14:26.540 --> 00:14:28.180 align:middle line:90% And suddenly things happen. 00:14:28.180 --> 00:14:31.820 align:middle line:90% 00:14:31.820 --> 00:14:35.010 align:middle line:84% Let me tell you when things can go really, really wrong. 00:14:35.010 --> 00:14:36.630 align:middle line:90% It's not the issue now. 00:14:36.630 --> 00:14:40.890 align:middle line:84% But we were very close to that during the global recession. 00:14:40.890 --> 00:14:42.560 align:middle line:84% Japan has experienced several episodes 00:14:42.560 --> 00:14:44.760 align:middle line:84% like this, which is the following. 00:14:44.760 --> 00:14:50.747 align:middle line:84% Suppose you have a situation where your inflation is low. 00:14:50.747 --> 00:14:52.580 align:middle line:84% Typically, these things happen in situations 00:14:52.580 --> 00:14:54.600 align:middle line:90% where inflation is low. 00:14:54.600 --> 00:14:58.650 align:middle line:84% And for whatever reason, your natural rate of unemployment 00:14:58.650 --> 00:15:00.820 align:middle line:90% is negative. 00:15:00.820 --> 00:15:03.940 align:middle line:84% So you have inflation close to 0, say. 00:15:03.940 --> 00:15:09.150 align:middle line:84% And then the natural rate of interest rate is negative. 00:15:09.150 --> 00:15:10.530 align:middle line:90% What's the problem? 00:15:10.530 --> 00:15:13.230 align:middle line:84% Suppose you have a 0 lower bound. 00:15:13.230 --> 00:15:15.090 align:middle line:84% Well, you have a 0 lower bound means 00:15:15.090 --> 00:15:18.430 align:middle line:84% that you're not going to hit this rate. 00:15:18.430 --> 00:15:20.797 align:middle line:84% The best you can do with inflation is around 0. 00:15:20.797 --> 00:15:22.630 align:middle line:84% Then you set the nominal interest rate to 0. 00:15:22.630 --> 00:15:25.620 align:middle line:84% And then the real interest rate is around 0. 00:15:25.620 --> 00:15:34.330 align:middle line:84% Well, the problem is that at 0, you generate negative inflation. 00:15:34.330 --> 00:15:36.850 align:middle line:84% But if you generate negative inflation 00:15:36.850 --> 00:15:40.060 align:middle line:84% and the nominal interest rate is fixed at 0, then 00:15:40.060 --> 00:15:42.280 align:middle line:84% now you get a positive real interest rate 00:15:42.280 --> 00:15:44.980 align:middle line:84% because the real interest rate is equal to the nominal interest 00:15:44.980 --> 00:15:49.400 align:middle line:84% rate, which is 0, minus inflation, expected inflation. 00:15:49.400 --> 00:15:52.960 align:middle line:84% But if your expected inflation or inflation is negative, 00:15:52.960 --> 00:15:54.530 align:middle line:90% minus, minus is positive. 00:15:54.530 --> 00:15:57.610 align:middle line:84% So that means your real interest rate is actually positive. 00:15:57.610 --> 00:16:00.190 align:middle line:84% So you wanted something negative. 00:16:00.190 --> 00:16:02.980 align:middle line:84% But you end up with something positive. 00:16:02.980 --> 00:16:06.300 align:middle line:84% That means now you have a big gap here. 00:16:06.300 --> 00:16:09.760 align:middle line:84% So inflation, you get into deflation. 00:16:09.760 --> 00:16:11.630 align:middle line:90% Now inflation is very, very low. 00:16:11.630 --> 00:16:12.970 align:middle line:90% It gets very negative. 00:16:12.970 --> 00:16:16.290 align:middle line:84% Well, as inflation gets more and more negative, 00:16:16.290 --> 00:16:18.220 align:middle line:84% your real interest rate keeps climbing. 00:16:18.220 --> 00:16:20.370 align:middle line:84% So you keep moving further and further away 00:16:20.370 --> 00:16:23.730 align:middle line:84% from the natural rate of interest rate. 00:16:23.730 --> 00:16:26.730 align:middle line:84% Thus, something that is very scary for an economist, 00:16:26.730 --> 00:16:29.010 align:middle line:90% that deflationary trap. 00:16:29.010 --> 00:16:33.100 align:middle line:84% And that's the way you get into deep recessions. 00:16:33.100 --> 00:16:36.090 align:middle line:84% In fact, that's what happened during the Great Recession 00:16:36.090 --> 00:16:37.800 align:middle line:90% in the US. 00:16:37.800 --> 00:16:42.850 align:middle line:84% The no, during the Great Depression in the US. 00:16:42.850 --> 00:16:44.850 align:middle line:84% During the Great Recession, we were close to it, 00:16:44.850 --> 00:16:48.690 align:middle line:84% but we didn't get quite there because lots of things 00:16:48.690 --> 00:16:54.000 align:middle line:84% were done to prevent a repeat of the Great Depression. 00:16:54.000 --> 00:16:57.450 align:middle line:84% One of the biggest problems with the Great Depression 00:16:57.450 --> 00:17:02.610 align:middle line:84% was that monetary policy was not against the 0 lower bound. 00:17:02.610 --> 00:17:05.650 align:middle line:90% But it was very slow to react. 00:17:05.650 --> 00:17:08.840 align:middle line:84% They were in a situation like in this diagram here. 00:17:08.840 --> 00:17:11.720 align:middle line:90% 00:17:11.720 --> 00:17:14.000 align:middle line:84% But they kept the interest rate high. 00:17:14.000 --> 00:17:15.920 align:middle line:90% And they moved very slowly. 00:17:15.920 --> 00:17:18.740 align:middle line:84% And when they tried to catch up, well, they 00:17:18.740 --> 00:17:20.550 align:middle line:84% went into deflationary environment. 00:17:20.550 --> 00:17:22.970 align:middle line:84% So the real interest rate was moving away from them, 00:17:22.970 --> 00:17:25.428 align:middle line:84% despite the fact that they were moving the nominal interest 00:17:25.428 --> 00:17:26.240 align:middle line:90% rate down. 00:17:26.240 --> 00:17:27.960 align:middle line:90% And that you can see here. 00:17:27.960 --> 00:17:31.460 align:middle line:84% So the Great Depression starts around 1929. 00:17:31.460 --> 00:17:34.160 align:middle line:90% It starts really in 1929. 00:17:34.160 --> 00:17:36.350 align:middle line:90% Unemployment initially was low. 00:17:36.350 --> 00:17:39.110 align:middle line:84% The nominal interest rate was around 5%. 00:17:39.110 --> 00:17:42.860 align:middle line:84% And inflation rate, growth declined very rapidly. 00:17:42.860 --> 00:17:45.090 align:middle line:90% The inflation rate was around 0. 00:17:45.090 --> 00:17:46.520 align:middle line:90% So you had a one year-- 00:17:46.520 --> 00:17:50.300 align:middle line:84% the real interest rate was around 5%, as well. 00:17:50.300 --> 00:17:53.040 align:middle line:90% Well, things got worse. 00:17:53.040 --> 00:17:55.710 align:middle line:84% Unemployment began to climb very rapidly. 00:17:55.710 --> 00:17:59.630 align:middle line:84% And so the Fed began to lower interest rates, nominal interest 00:17:59.630 --> 00:18:00.470 align:middle line:90% rate. 00:18:00.470 --> 00:18:02.130 align:middle line:90% Went from 5% to 4%. 00:18:02.130 --> 00:18:06.030 align:middle line:84% Those were unusually low interest rates for the time. 00:18:06.030 --> 00:18:10.880 align:middle line:84% But the problem is that the inflation by then was -2.5%. 00:18:10.880 --> 00:18:12.987 align:middle line:84% So the real interest rate-- they were lowering 00:18:12.987 --> 00:18:14.070 align:middle line:90% the nominal interest rate. 00:18:14.070 --> 00:18:16.600 align:middle line:84% But the real interest rate was rising. 00:18:16.600 --> 00:18:20.560 align:middle line:84% And unemployment, accordingly, was rising, as well. 00:18:20.560 --> 00:18:22.720 align:middle line:90% It kept going. 00:18:22.720 --> 00:18:27.200 align:middle line:84% Then they began to cut the interest rate more aggressively. 00:18:27.200 --> 00:18:31.010 align:middle line:84% But we got into real deflation, -10% or so. 00:18:31.010 --> 00:18:34.200 align:middle line:84% So the real interest rate kept climbing. 00:18:34.200 --> 00:18:39.240 align:middle line:84% At that point was a very poor time interest rate hike, 00:18:39.240 --> 00:18:43.170 align:middle line:84% was a disaster for unemployment because it really 00:18:43.170 --> 00:18:45.510 align:middle line:84% hiked the interest rate, real interest rates even more. 00:18:45.510 --> 00:18:47.790 align:middle line:84% And eventually got out of it with a bunch 00:18:47.790 --> 00:18:49.840 align:middle line:84% of policies that were non-monetary policies. 00:18:49.840 --> 00:18:53.590 align:middle line:90% But that's what happened. 00:18:53.590 --> 00:18:55.470 align:middle line:84% So the Great Depression was very much 00:18:55.470 --> 00:19:01.110 align:middle line:84% a story of this kind in which essentially we 00:19:01.110 --> 00:19:04.740 align:middle line:84% fell into depression so that interest rate began to climb 00:19:04.740 --> 00:19:07.740 align:middle line:84% and got the economy deeper and deeper into recession 00:19:07.740 --> 00:19:09.640 align:middle line:84% and unemployment higher and higher and so on. 00:19:09.640 --> 00:19:12.090 align:middle line:84% And at some point, monetary policy just didn't work. 00:19:12.090 --> 00:19:14.340 align:middle line:84% So that's the reason you have to essentially do 00:19:14.340 --> 00:19:16.720 align:middle line:84% massive fiscal policy to get out of it. 00:19:16.720 --> 00:19:20.970 align:middle line:90% 00:19:20.970 --> 00:19:22.500 align:middle line:84% Let me talk about some of the shocks 00:19:22.500 --> 00:19:26.940 align:middle line:84% we have discussed in the context of this more complete model now. 00:19:26.940 --> 00:19:33.280 align:middle line:84% And actually-- OK, let me talk about two canonical type shocks. 00:19:33.280 --> 00:19:36.960 align:middle line:84% You can have two broad type of shocks or policies 00:19:36.960 --> 00:19:41.070 align:middle line:84% in these models that you want to analyze. 00:19:41.070 --> 00:19:43.530 align:middle line:84% Some of them are aggregate demand, either policies 00:19:43.530 --> 00:19:44.700 align:middle line:90% or shocks or whatever. 00:19:44.700 --> 00:19:46.470 align:middle line:90% Those are things that you know. 00:19:46.470 --> 00:19:50.440 align:middle line:84% Aggregate demand policies move the IS curve-- 00:19:50.440 --> 00:19:55.380 align:middle line:84% IS and LM, but moves operates in the goods market. 00:19:55.380 --> 00:19:59.760 align:middle line:84% So this is one case of a contractionary fiscal policy, 00:19:59.760 --> 00:20:01.390 align:middle line:90% a fiscal consolidation. 00:20:01.390 --> 00:20:02.590 align:middle line:90% So what happens here? 00:20:02.590 --> 00:20:06.060 align:middle line:84% Suppose you start an equilibrium level of output 00:20:06.060 --> 00:20:07.560 align:middle line:84% equal to the natural rate of output. 00:20:07.560 --> 00:20:08.820 align:middle line:84% But now, for whatever reason, we're 00:20:08.820 --> 00:20:10.510 align:middle line:84% running deficits that are very large. 00:20:10.510 --> 00:20:12.910 align:middle line:84% You want to reduce the size of the deficit. 00:20:12.910 --> 00:20:14.850 align:middle line:84% Well, you move the IS to the left. 00:20:14.850 --> 00:20:16.530 align:middle line:84% Now you cut government expenditure. 00:20:16.530 --> 00:20:17.770 align:middle line:90% You increase taxes. 00:20:17.770 --> 00:20:21.010 align:middle line:84% That will bring output below the natural rate of output. 00:20:21.010 --> 00:20:22.780 align:middle line:84% You go to the Phillips curve here. 00:20:22.780 --> 00:20:26.160 align:middle line:84% That means inflation now, you get into the deflationary forces 00:20:26.160 --> 00:20:28.170 align:middle line:90% or inflation starts declining. 00:20:28.170 --> 00:20:29.762 align:middle line:90% The result of that-- 00:20:29.762 --> 00:20:31.470 align:middle line:84% So in the short run, you get exactly what 00:20:31.470 --> 00:20:34.020 align:middle line:84% we had in lecture five, six or whatever. 00:20:34.020 --> 00:20:36.190 align:middle line:84% You get a contraction in real output. 00:20:36.190 --> 00:20:39.180 align:middle line:84% But on top of that, you start getting inflation 00:20:39.180 --> 00:20:41.380 align:middle line:84% coming down, or even going negative. 00:20:41.380 --> 00:20:44.910 align:middle line:84% And as a result of that, the central bank will react. 00:20:44.910 --> 00:20:46.140 align:middle line:90% And it will react. 00:20:46.140 --> 00:20:49.080 align:middle line:84% And that reaction will stop when in the long run 00:20:49.080 --> 00:20:52.110 align:middle line:84% when output goes back to the initial level of output, 00:20:52.110 --> 00:20:53.500 align:middle line:90% its natural rate of output. 00:20:53.500 --> 00:20:56.940 align:middle line:84% So the point of this picture that 00:20:56.940 --> 00:20:59.040 align:middle line:84% is new relative to things you already knew 00:20:59.040 --> 00:21:01.830 align:middle line:84% is that in the short run, you get very much the type 00:21:01.830 --> 00:21:03.850 align:middle line:90% of responses we had early on. 00:21:03.850 --> 00:21:07.680 align:middle line:84% In the medium run, in the medium run, you don't get that. 00:21:07.680 --> 00:21:10.950 align:middle line:84% A fiscal consolidation does not reduce output in the medium run. 00:21:10.950 --> 00:21:15.270 align:middle line:84% The fiscal consolidation does is reduces the real interest rate 00:21:15.270 --> 00:21:17.320 align:middle line:90% in the medium run. 00:21:17.320 --> 00:21:19.890 align:middle line:84% So you see here, output eventually 00:21:19.890 --> 00:21:24.130 align:middle line:84% goes back to that level with a much lower real interest rate. 00:21:24.130 --> 00:21:26.670 align:middle line:90% 00:21:26.670 --> 00:21:30.480 align:middle line:84% The point is sometimes this path, 00:21:30.480 --> 00:21:33.650 align:middle line:84% this path takes your output down initially and then comes back, 00:21:33.650 --> 00:21:34.810 align:middle line:90% can be very painful. 00:21:34.810 --> 00:21:38.200 align:middle line:84% It can take a long time to generate a procession and so on. 00:21:38.200 --> 00:21:41.670 align:middle line:84% And sometimes it can happen in any sort of conditions 00:21:41.670 --> 00:21:43.190 align:middle line:90% and be faster and so on. 00:21:43.190 --> 00:21:46.560 align:middle line:84% Many of the policies, agreements that people have, 00:21:46.560 --> 00:21:48.900 align:middle line:84% people that understand what they're talking about, 00:21:48.900 --> 00:21:51.550 align:middle line:84% had to do with the speed at which these things happen. 00:21:51.550 --> 00:21:53.790 align:middle line:84% So sometimes people can agree that you 00:21:53.790 --> 00:21:54.960 align:middle line:90% need a fiscal consolidation. 00:21:54.960 --> 00:21:57.880 align:middle line:84% But someone may think, no, this stuff is going to be very slow. 00:21:57.880 --> 00:22:00.713 align:middle line:84% And so I don't want to incur in a very deep recession for very 00:22:00.713 --> 00:22:02.880 align:middle line:84% long just to adjust a little bit the fiscal deficit. 00:22:02.880 --> 00:22:05.070 align:middle line:84% And others may think the opposite. 00:22:05.070 --> 00:22:06.660 align:middle line:90% It's mostly about the speed. 00:22:06.660 --> 00:22:10.590 align:middle line:84% But shorter response to a fiscal consolidation 00:22:10.590 --> 00:22:12.270 align:middle line:84% or to any aggregate demand contraction 00:22:12.270 --> 00:22:15.523 align:middle line:84% is different than the medium term response. 00:22:15.523 --> 00:22:19.110 align:middle line:90% 00:22:19.110 --> 00:22:21.480 align:middle line:84% And again, the signals for the central bank 00:22:21.480 --> 00:22:22.980 align:middle line:84% that it needs to move interest rate, 00:22:22.980 --> 00:22:25.630 align:middle line:84% they all come from this block here-- inflation falling. 00:22:25.630 --> 00:22:27.990 align:middle line:84% That tells the central bank, oops, 00:22:27.990 --> 00:22:30.910 align:middle line:84% we may have a problem, and so on. 00:22:30.910 --> 00:22:35.290 align:middle line:84% Another kind of shock that is more complicated 00:22:35.290 --> 00:22:37.300 align:middle line:84% and that has played a role actually 00:22:37.300 --> 00:22:39.400 align:middle line:84% very much in the recovery from COVID 00:22:39.400 --> 00:22:42.040 align:middle line:84% is some sort of supply side shock-- 00:22:42.040 --> 00:22:44.230 align:middle line:90% for example, an oil shock. 00:22:44.230 --> 00:22:47.090 align:middle line:84% The price of energy goes up or something like that. 00:22:47.090 --> 00:22:50.630 align:middle line:84% Well, that one, how do you analyze that? 00:22:50.630 --> 00:22:53.180 align:middle line:84% A supply side shock is not something that comes from, 00:22:53.180 --> 00:22:56.900 align:middle line:84% that would go to the IS-LM part of the model. 00:22:56.900 --> 00:22:58.550 align:middle line:84% A supply side shock, remember, we 00:22:58.550 --> 00:23:02.690 align:middle line:84% analyze it when we analyze the natural rate of unemployment. 00:23:02.690 --> 00:23:05.600 align:middle line:84% It's something that affects the supply side of the economy. 00:23:05.600 --> 00:23:09.200 align:middle line:84% We can model that as an increase in the markup. 00:23:09.200 --> 00:23:11.810 align:middle line:84% And we know that an increase in the markup 00:23:11.810 --> 00:23:14.930 align:middle line:84% will increase the natural rate of unemployment. 00:23:14.930 --> 00:23:21.130 align:middle line:84% That means that this shock will do what to potential output? 00:23:21.130 --> 00:23:25.150 align:middle line:90% 00:23:25.150 --> 00:23:29.350 align:middle line:84% So an energy shock, especially if it's a persistent one, 00:23:29.350 --> 00:23:32.080 align:middle line:84% will operate like a markup shock. 00:23:32.080 --> 00:23:35.980 align:middle line:84% And that we know will increase the natural rate 00:23:35.980 --> 00:23:37.510 align:middle line:90% of unemployment. 00:23:37.510 --> 00:23:42.290 align:middle line:84% So what happens to the potential output? 00:23:42.290 --> 00:23:44.690 align:middle line:90% Goes down, of course. 00:23:44.690 --> 00:23:47.052 align:middle line:84% Output is equal to employment, to labor force 00:23:47.052 --> 00:23:49.010 align:middle line:84% times 1 minus the natural rate of unemployment. 00:23:49.010 --> 00:23:50.843 align:middle line:84% If the natural rate of unemployment goes up, 00:23:50.843 --> 00:23:53.000 align:middle line:84% then the potential output goes down. 00:23:53.000 --> 00:23:55.950 align:middle line:84% So that is not a shift in the top diagram. 00:23:55.950 --> 00:23:57.740 align:middle line:84% It's a shift in the lower diagram. 00:23:57.740 --> 00:24:00.840 align:middle line:84% It says, we used to have this Phillips curve. 00:24:00.840 --> 00:24:04.560 align:middle line:84% And now the Phillips curve has shifted to the left. 00:24:04.560 --> 00:24:07.243 align:middle line:84% Because we have a new natural rate of an output. 00:24:07.243 --> 00:24:08.910 align:middle line:84% And remember, the natural rate of output 00:24:08.910 --> 00:24:14.630 align:middle line:84% is at that point when output equal to the natural rate 00:24:14.630 --> 00:24:19.620 align:middle line:84% of output does not produce inflationary forces. 00:24:19.620 --> 00:24:21.500 align:middle line:84% What happened with this shock here? 00:24:21.500 --> 00:24:24.240 align:middle line:84% So suppose the economy was in this equilibrium here 00:24:24.240 --> 00:24:29.110 align:middle line:84% and now it gets hit by an oil shock. 00:24:29.110 --> 00:24:31.150 align:middle line:84% In the short run, if no one reacts, 00:24:31.150 --> 00:24:33.410 align:middle line:90% nothing happens to output. 00:24:33.410 --> 00:24:34.730 align:middle line:90% Doesn't move much. 00:24:34.730 --> 00:24:35.725 align:middle line:90% But what happens? 00:24:35.725 --> 00:24:42.440 align:middle line:90% 00:24:42.440 --> 00:24:44.240 align:middle line:84% You see, if I don't move something 00:24:44.240 --> 00:24:47.310 align:middle line:84% in this part of the diagram, I'm not moving equilibrium output. 00:24:47.310 --> 00:24:48.920 align:middle line:84% In the short run, equilibrium output 00:24:48.920 --> 00:24:50.480 align:middle line:84% is determined exactly in the same way 00:24:50.480 --> 00:24:52.100 align:middle line:90% we have determined up to now. 00:24:52.100 --> 00:24:57.980 align:middle line:84% So if we get a markup shock, nothing happens to output. 00:24:57.980 --> 00:25:02.150 align:middle line:84% If nobody moves, nothing happens to output in the short run. 00:25:02.150 --> 00:25:07.590 align:middle line:84% But what happens that we may not like? 00:25:07.590 --> 00:25:08.670 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:25:08.670 --> 00:25:09.790 align:middle line:90% PROFESSOR: Exactly. 00:25:09.790 --> 00:25:11.970 align:middle line:84% What happens is the Phillips curve went up. 00:25:11.970 --> 00:25:16.410 align:middle line:84% Before, that level of output was consistent with no changes 00:25:16.410 --> 00:25:17.580 align:middle line:90% in inflation. 00:25:17.580 --> 00:25:19.320 align:middle line:90% Now, it's not. 00:25:19.320 --> 00:25:21.640 align:middle line:90% We get an increase in inflation. 00:25:21.640 --> 00:25:27.210 align:middle line:84% So the first place where you'll see the effect of the oil shock 00:25:27.210 --> 00:25:28.617 align:middle line:90% here is inflation will pick up. 00:25:28.617 --> 00:25:31.200 align:middle line:84% Remember, the price of gasoline going up and all those things. 00:25:31.200 --> 00:25:33.180 align:middle line:84% Well, that's where you see it first. 00:25:33.180 --> 00:25:36.000 align:middle line:84% Before activity falls, you see it there. 00:25:36.000 --> 00:25:38.190 align:middle line:84% That's what makes up the Phillips curve also, 00:25:38.190 --> 00:25:39.480 align:middle line:90% in the '70s and '80s. 00:25:39.480 --> 00:25:41.820 align:middle line:84% You can see lots of shocks of this kind. 00:25:41.820 --> 00:25:44.310 align:middle line:84% Initially, unemployment didn't move much, 00:25:44.310 --> 00:25:47.190 align:middle line:90% but inflation kept climbing. 00:25:47.190 --> 00:25:48.252 align:middle line:90% So that's what happens. 00:25:48.252 --> 00:25:49.710 align:middle line:84% Well, obviously, when that happens, 00:25:49.710 --> 00:25:51.593 align:middle line:84% if it persists-- and typically central banks, 00:25:51.593 --> 00:25:53.010 align:middle line:84% if they think is very short lived, 00:25:53.010 --> 00:25:54.718 align:middle line:84% they're not going to react to this stuff. 00:25:54.718 --> 00:25:57.420 align:middle line:84% But if it is persistent and they think it's persistent, 00:25:57.420 --> 00:25:59.540 align:middle line:90% then the reaction is what? 00:25:59.540 --> 00:26:00.820 align:middle line:90% Well, they need to-- 00:26:00.820 --> 00:26:06.210 align:middle line:84% this only means that the natural rate of interest 00:26:06.210 --> 00:26:09.960 align:middle line:84% has gone up because I need, for that same IS, 00:26:09.960 --> 00:26:12.510 align:middle line:84% I need to bring down equilibrium output. 00:26:12.510 --> 00:26:16.230 align:middle line:84% That means I need a higher natural rate of interest rate, 00:26:16.230 --> 00:26:17.893 align:middle line:90% or a higher R star. 00:26:17.893 --> 00:26:20.310 align:middle line:84% So what the Fed needs to do, the central bank needs to do, 00:26:20.310 --> 00:26:22.250 align:middle line:84% is just start increasing interest rates. 00:26:22.250 --> 00:26:24.620 align:middle line:90% That's a natural response. 00:26:24.620 --> 00:26:26.300 align:middle line:84% A lot of what happened during the COVID, 00:26:26.300 --> 00:26:29.150 align:middle line:84% why inflation picked up so much in COVID 00:26:29.150 --> 00:26:31.970 align:middle line:84% is because we had a shock of this kind. 00:26:31.970 --> 00:26:33.200 align:middle line:90% It was not energy. 00:26:33.200 --> 00:26:34.880 align:middle line:90% The energy shock came later. 00:26:34.880 --> 00:26:38.660 align:middle line:84% But it was supply side, transport costs, and stuff 00:26:38.660 --> 00:26:41.660 align:middle line:84% like that, the network, the production network and things 00:26:41.660 --> 00:26:43.020 align:middle line:90% like that broke down. 00:26:43.020 --> 00:26:46.230 align:middle line:84% But they thought it was going to be very temporary. 00:26:46.230 --> 00:26:49.550 align:middle line:84% So understanding this model, they thought, OK, look, this, 00:26:49.550 --> 00:26:53.670 align:middle line:84% this curve will come back by itself, 00:26:53.670 --> 00:26:55.290 align:middle line:90% so better not react right now. 00:26:55.290 --> 00:26:55.790 align:middle line:90% Why? 00:26:55.790 --> 00:26:57.920 align:middle line:84% Because a recession is really, this curve 00:26:57.920 --> 00:27:01.480 align:middle line:84% will come down, back down by itself. 00:27:01.480 --> 00:27:03.580 align:middle line:84% Well, the problem is that it didn't come back 00:27:03.580 --> 00:27:05.610 align:middle line:90% by itself that fast. 00:27:05.610 --> 00:27:07.600 align:middle line:90% Some things came up fairly fast. 00:27:07.600 --> 00:27:09.020 align:middle line:90% Some others did not. 00:27:09.020 --> 00:27:11.500 align:middle line:84% In particular, labor force participation 00:27:11.500 --> 00:27:14.810 align:middle line:84% did not come sufficiently fast back. 00:27:14.810 --> 00:27:17.470 align:middle line:84% And so that's the reason we stayed too long 00:27:17.470 --> 00:27:19.130 align:middle line:90% in a situation like this. 00:27:19.130 --> 00:27:23.650 align:middle line:84% And that's one of the main reasons inflation sort crept up 00:27:23.650 --> 00:27:26.560 align:middle line:84% in the US, and also in other places in the world. 00:27:26.560 --> 00:27:31.270 align:middle line:84% In Europe, the big reason for why inflation picked up there 00:27:31.270 --> 00:27:33.670 align:middle line:84% is because this curve moved a lot up. 00:27:33.670 --> 00:27:34.470 align:middle line:90% Why is that? 00:27:34.470 --> 00:27:39.941 align:middle line:90% 00:27:39.941 --> 00:27:41.360 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:27:41.360 --> 00:27:42.320 align:middle line:90% PROFESSOR: Exactly. 00:27:42.320 --> 00:27:44.720 align:middle line:90% They had a massive energy shock. 00:27:44.720 --> 00:27:49.410 align:middle line:84% And so that moved that curve up a lot. 00:27:49.410 --> 00:27:49.910 align:middle line:90% Good. 00:27:49.910 --> 00:27:52.530 align:middle line:90% 00:27:52.530 --> 00:27:55.235 align:middle line:84% I want to now return to what is going on right now. 00:27:55.235 --> 00:27:57.842 align:middle line:90% 00:27:57.842 --> 00:27:59.800 align:middle line:84% Actually first, I'm going to-- yeah, right now, 00:27:59.800 --> 00:28:01.570 align:middle line:90% meaning the last few days. 00:28:01.570 --> 00:28:04.010 align:middle line:84% So it turns out that this diagram 00:28:04.010 --> 00:28:06.970 align:middle line:84% that I used for the fiscal consolidation shock 00:28:06.970 --> 00:28:09.790 align:middle line:84% can also be used to understand a little bit what 00:28:09.790 --> 00:28:16.840 align:middle line:84% happens with the Silicon Valley Bank event. 00:28:16.840 --> 00:28:19.150 align:middle line:84% Remember, we model that as a credit shock. 00:28:19.150 --> 00:28:22.260 align:middle line:84% We said that x we had is like x going up. 00:28:22.260 --> 00:28:25.400 align:middle line:84% Well, x going up does exactly that. 00:28:25.400 --> 00:28:27.730 align:middle line:90% It moves IS to the left. 00:28:27.730 --> 00:28:36.340 align:middle line:84% So a shock to x, a panic of the kind that we saw, is that. 00:28:36.340 --> 00:28:37.490 align:middle line:90% It moves IS to the left. 00:28:37.490 --> 00:28:39.370 align:middle line:90% Why is that? 00:28:39.370 --> 00:28:43.060 align:middle line:84% So for any given level, the safe, real interest rate, 00:28:43.060 --> 00:28:47.510 align:middle line:84% a panic, a shock to credit and so on, moves the IS to the left. 00:28:47.510 --> 00:28:50.248 align:middle line:90% Why is that? 00:28:50.248 --> 00:28:52.590 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:28:52.590 --> 00:28:53.718 align:middle line:90% 00:28:53.718 --> 00:28:54.510 align:middle line:90% PROFESSOR: Exactly. 00:28:54.510 --> 00:28:57.340 align:middle line:84% So the safe interest rate doesn't go up. 00:28:57.340 --> 00:29:04.110 align:middle line:84% But what goes up is the cost of borrowing because firms need 00:29:04.110 --> 00:29:06.850 align:middle line:90% to pay this extra risk premium. 00:29:06.850 --> 00:29:10.020 align:middle line:84% And then for any given safe interest rate, the real interest 00:29:10.020 --> 00:29:13.590 align:middle line:84% rate, firms have to pay more, which 00:29:13.590 --> 00:29:15.780 align:middle line:84% means there is less investment for any given level 00:29:15.780 --> 00:29:16.930 align:middle line:90% of the real interest rate. 00:29:16.930 --> 00:29:18.760 align:middle line:90% And so the IS moves to the left. 00:29:18.760 --> 00:29:21.210 align:middle line:84% And if that happens, then you start 00:29:21.210 --> 00:29:22.655 align:middle line:90% getting deflationary forces. 00:29:22.655 --> 00:29:25.190 align:middle line:90% 00:29:25.190 --> 00:29:28.760 align:middle line:84% So again, all this happens very quickly here. 00:29:28.760 --> 00:29:32.330 align:middle line:84% In reality, I told you there are lots of lags and so on. 00:29:32.330 --> 00:29:35.425 align:middle line:84% But markets begin to anticipate what will happen. 00:29:35.425 --> 00:29:38.560 align:middle line:90% 00:29:38.560 --> 00:29:40.360 align:middle line:90% So markets begin to anticipate. 00:29:40.360 --> 00:29:43.450 align:middle line:84% So in the immediate, output doesn't collapse 00:29:43.450 --> 00:29:44.720 align:middle line:90% immediately or anything. 00:29:44.720 --> 00:29:47.660 align:middle line:84% And inflation doesn't collapse immediately. 00:29:47.660 --> 00:29:51.290 align:middle line:84% But markets realized that there are long lags. 00:29:51.290 --> 00:29:53.750 align:middle line:90% But there is a shock already. 00:29:53.750 --> 00:29:56.920 align:middle line:84% So it's likely that these things will happen. 00:29:56.920 --> 00:30:00.560 align:middle line:84% And it's likely that this will happen. 00:30:00.560 --> 00:30:04.880 align:middle line:84% And it's also likely that the Fed will react to that. 00:30:04.880 --> 00:30:06.590 align:middle line:84% What should be the reaction of the Fed 00:30:06.590 --> 00:30:08.446 align:middle line:84% if this stuff gets to be persistent? 00:30:08.446 --> 00:30:12.850 align:middle line:90% 00:30:12.850 --> 00:30:14.580 align:middle line:84% How do you get out of a shock like that 00:30:14.580 --> 00:30:16.080 align:middle line:84% if you really want to go back there? 00:30:16.080 --> 00:30:18.940 align:middle line:90% 00:30:18.940 --> 00:30:21.280 align:middle line:90% You cut interest rates. 00:30:21.280 --> 00:30:24.130 align:middle line:84% In the case of the US, they were hiking interest rates 00:30:24.130 --> 00:30:26.630 align:middle line:84% because we dealing with high inflation. 00:30:26.630 --> 00:30:31.300 align:middle line:84% This tells you, well, you should slow down the pace of hiking. 00:30:31.300 --> 00:30:32.810 align:middle line:84% Again, they don't do it immediately. 00:30:32.810 --> 00:30:34.120 align:middle line:90% They meet next week. 00:30:34.120 --> 00:30:36.420 align:middle line:84% But the markets don't need to wait for the Fed. 00:30:36.420 --> 00:30:39.490 align:middle line:84% They anticipate what the Fed is likely to do 00:30:39.490 --> 00:30:41.180 align:middle line:90% and they start betting on that. 00:30:41.180 --> 00:30:44.980 align:middle line:84% So let me show you next a bunch of charts 00:30:44.980 --> 00:30:47.770 align:middle line:84% that show you that someone in the market 00:30:47.770 --> 00:30:49.762 align:middle line:90% understands these mechanics-- 00:30:49.762 --> 00:30:51.220 align:middle line:84% a lot of people, because the prices 00:30:51.220 --> 00:30:53.790 align:middle line:90% are moving exactly that way. 00:30:53.790 --> 00:30:58.220 align:middle line:90% 00:30:58.220 --> 00:31:04.220 align:middle line:84% This is something-- this is the one year ahead inflation 00:31:04.220 --> 00:31:06.530 align:middle line:84% expectation, as traded in the market. 00:31:06.530 --> 00:31:09.450 align:middle line:84% It's called Inflation breakeven, the one year inflation break. 00:31:09.450 --> 00:31:12.680 align:middle line:84% So these things are traded in the market. 00:31:12.680 --> 00:31:15.020 align:middle line:84% And you can trade expected inflation 00:31:15.020 --> 00:31:16.740 align:middle line:90% all the maturities you want. 00:31:16.740 --> 00:31:21.940 align:middle line:84% So this is what the market was expecting before this shock. 00:31:21.940 --> 00:31:23.820 align:middle line:84% We're getting hotter and hotter numbers. 00:31:23.820 --> 00:31:27.470 align:middle line:84% So the economy was-- inflation, expected inflation, as price 00:31:27.470 --> 00:31:32.330 align:middle line:84% in the market, was climbing one year out. 00:31:32.330 --> 00:31:34.410 align:middle line:90% And then the shock came. 00:31:34.410 --> 00:31:36.480 align:middle line:84% And look what had happened to expected inflation. 00:31:36.480 --> 00:31:36.980 align:middle line:90% Boom. 00:31:36.980 --> 00:31:40.120 align:middle line:90% It collapsed. 00:31:40.120 --> 00:31:42.400 align:middle line:90% OK, why is that? 00:31:42.400 --> 00:31:49.330 align:middle line:84% Well, people thought this shock, that leads to that. 00:31:49.330 --> 00:31:50.440 align:middle line:90% That's what they thought. 00:31:50.440 --> 00:31:54.700 align:middle line:84% This bounce was markets got a little excited yesterday. 00:31:54.700 --> 00:31:56.590 align:middle line:84% It was a little risk on environment. 00:31:56.590 --> 00:32:00.935 align:middle line:84% Today they lost all that already for a shock 00:32:00.935 --> 00:32:02.810 align:middle line:84% I'm going to tell you about in a few minutes. 00:32:02.810 --> 00:32:06.310 align:middle line:84% But anyways, the point I wanted to highlight 00:32:06.310 --> 00:32:09.340 align:middle line:84% is, again, expected inflation was getting 00:32:09.340 --> 00:32:10.820 align:middle line:90% a little out of control. 00:32:10.820 --> 00:32:14.230 align:middle line:84% And then this x shock came, the panic shock, 00:32:14.230 --> 00:32:16.000 align:middle line:84% and then immediately expected inflation 00:32:16.000 --> 00:32:20.530 align:middle line:84% declined because people anticipated something like this. 00:32:20.530 --> 00:32:22.920 align:middle line:84% The market anticipates something like that. 00:32:22.920 --> 00:32:24.950 align:middle line:90% What is that? 00:32:24.950 --> 00:32:33.730 align:middle line:84% This is the market's expected next hike. 00:32:33.730 --> 00:32:37.500 align:middle line:84% So March 22nd, the Fed will decide on the increase 00:32:37.500 --> 00:32:39.240 align:middle line:90% in interest rate. 00:32:39.240 --> 00:32:40.770 align:middle line:84% Remember, the Fed had decided, as I 00:32:40.770 --> 00:32:44.220 align:middle line:84% said in the previous lecture, to go for a path of 50 basis points 00:32:44.220 --> 00:32:45.450 align:middle line:90% initially, very high. 00:32:45.450 --> 00:32:47.280 align:middle line:84% But since a couple of meetings ago, 00:32:47.280 --> 00:32:49.380 align:middle line:84% they decided to slow down to 25 basis points, 00:32:49.380 --> 00:32:52.700 align:middle line:84% precisely because they want to wait and see a bit what 00:32:52.700 --> 00:32:53.902 align:middle line:90% [INAUDIBLE] do we have? 00:32:53.902 --> 00:32:55.360 align:middle line:84% I mean, there's long variable lags. 00:32:55.360 --> 00:32:58.060 align:middle line:84% They have increased rates a lot and so on. 00:32:58.060 --> 00:33:00.760 align:middle line:84% So they have gone back to a pace of 25. 00:33:00.760 --> 00:33:04.800 align:middle line:84% So if you see somewhere here, in February 22, 00:33:04.800 --> 00:33:09.510 align:middle line:84% if you ask the market, what do you think will be the next hike? 00:33:09.510 --> 00:33:11.130 align:middle line:90% There will be lots of answers-- 00:33:11.130 --> 00:33:12.400 align:middle line:90% trades, and so on. 00:33:12.400 --> 00:33:18.240 align:middle line:84% But when I say answers, I mean what is price, what is traded, 00:33:18.240 --> 00:33:19.650 align:middle line:90% these financial instruments. 00:33:19.650 --> 00:33:22.840 align:middle line:84% The average answer was 30 basis points. 00:33:22.840 --> 00:33:25.332 align:middle line:84% 30 basis point is that most of the people 00:33:25.332 --> 00:33:27.540 align:middle line:84% thought that they were going to increase the interest 00:33:27.540 --> 00:33:28.912 align:middle line:90% rate by 25 basis points. 00:33:28.912 --> 00:33:30.370 align:middle line:84% And there were a few guys out there 00:33:30.370 --> 00:33:32.560 align:middle line:84% that thought the Fed doesn't increase the interest 00:33:32.560 --> 00:33:34.520 align:middle line:90% rate by 33 basis points. 00:33:34.520 --> 00:33:37.010 align:middle line:90% That's 25, 50, 75. 00:33:37.010 --> 00:33:40.768 align:middle line:84% So this 30 meant that almost everyone thought 00:33:40.768 --> 00:33:42.310 align:middle line:84% it was going to be 25, but there were 00:33:42.310 --> 00:33:44.643 align:middle line:84% a few people that were concerned that it could be higher 00:33:44.643 --> 00:33:45.580 align:middle line:90% than that. 00:33:45.580 --> 00:33:46.820 align:middle line:90% What happened here? 00:33:46.820 --> 00:33:49.510 align:middle line:84% We started getting very hot numbers on inflation. 00:33:49.510 --> 00:33:52.510 align:middle line:84% And so all of a sudden the equilibrium changed dramatically 00:33:52.510 --> 00:33:55.780 align:middle line:84% and we went to 45, which means most people then 00:33:55.780 --> 00:34:01.030 align:middle line:84% thought in the market that the next hike on March 22 00:34:01.030 --> 00:34:02.780 align:middle line:90% was going to be 50 basis points. 00:34:02.780 --> 00:34:05.960 align:middle line:84% And a few people said stay at 25. 00:34:05.960 --> 00:34:09.739 align:middle line:90% That's the reason this is 0.5. 00:34:09.739 --> 00:34:12.100 align:middle line:84% But it was almost priced in that. 00:34:12.100 --> 00:34:14.739 align:middle line:84% When people say pricing, they are talking about this. 00:34:14.739 --> 00:34:16.520 align:middle line:84% What is the hike that's priced in? 00:34:16.520 --> 00:34:18.340 align:middle line:90% It's this statistic. 00:34:18.340 --> 00:34:24.730 align:middle line:84% Look, that's what happened with the Silicon Valley bank event, 00:34:24.730 --> 00:34:27.460 align:middle line:90% a collapse in this thing. 00:34:27.460 --> 00:34:31.610 align:middle line:84% Now, it's trading at around 13 basis points. 00:34:31.610 --> 00:34:36.070 align:middle line:84% That means most of the people think, the traders here think, 00:34:36.070 --> 00:34:39.219 align:middle line:84% that there will be no hike at all. 00:34:39.219 --> 00:34:42.130 align:middle line:84% So a few days ago, they all thought 00:34:42.130 --> 00:34:45.610 align:middle line:84% there was going to be 50 basis points, which is a big hike. 00:34:45.610 --> 00:34:48.800 align:middle line:84% And now most people think there will be no hike whatsoever. 00:34:48.800 --> 00:34:51.370 align:middle line:84% But a few think that it's going to be 25. 00:34:51.370 --> 00:34:53.820 align:middle line:90% Actually, it's almost 50/50. 00:34:53.820 --> 00:34:55.570 align:middle line:84% I think today is a little lower than that. 00:34:55.570 --> 00:34:58.820 align:middle line:84% But it's almost 50/50 that it's 25 or 0. 00:34:58.820 --> 00:35:00.740 align:middle line:90% That's what it is. 00:35:00.740 --> 00:35:03.160 align:middle line:84% But had you asked anyone around here, 00:35:03.160 --> 00:35:06.130 align:middle line:84% and certainly around here, is there any chance of 0, 00:35:06.130 --> 00:35:08.380 align:middle line:84% and there will be no one, literally. 00:35:08.380 --> 00:35:10.360 align:middle line:90% That contract was not traded. 00:35:10.360 --> 00:35:13.300 align:middle line:90% OK well, you see things happen. 00:35:13.300 --> 00:35:14.300 align:middle line:90% Accidents happen. 00:35:14.300 --> 00:35:17.710 align:middle line:90% So now that's where we are at. 00:35:17.710 --> 00:35:25.670 align:middle line:84% Now, if this all lasts a week and everything gets resolved, 00:35:25.670 --> 00:35:29.420 align:middle line:84% it doesn't have a lot of macroeconomic consequences. 00:35:29.420 --> 00:35:30.505 align:middle line:90% It's just a little panic. 00:35:30.505 --> 00:35:31.880 align:middle line:84% You know, some people make money. 00:35:31.880 --> 00:35:35.300 align:middle line:84% Some people lose money, and so on. 00:35:35.300 --> 00:35:38.150 align:middle line:84% But this can be a very problematic shock, actually, 00:35:38.150 --> 00:35:42.540 align:middle line:84% Because what you see here, this is the size, 00:35:42.540 --> 00:35:45.040 align:middle line:90% this is Silicon Valley Bank. 00:35:45.040 --> 00:35:50.180 align:middle line:84% These are all the banks smaller than that. 00:35:50.180 --> 00:35:52.790 align:middle line:84% It turns out that all this bank at this moment 00:35:52.790 --> 00:35:54.290 align:middle line:84% are reshuffling their portfolios, 00:35:54.290 --> 00:35:55.850 align:middle line:90% are becoming very conservative. 00:35:55.850 --> 00:35:58.260 align:middle line:84% Because they don't want to be exposed to similar risks. 00:35:58.260 --> 00:35:59.635 align:middle line:84% They realize that the environment 00:35:59.635 --> 00:36:01.760 align:middle line:90% became very unfriendly to-- 00:36:01.760 --> 00:36:03.830 align:middle line:84% there can be ransomed banks in any moment, 00:36:03.830 --> 00:36:06.270 align:middle line:84% despite the fact that it's a big policy package out there. 00:36:06.270 --> 00:36:08.330 align:middle line:84% But people are still withdrawing lots of deposits 00:36:08.330 --> 00:36:10.820 align:middle line:84% from small banks, small and regional banks. 00:36:10.820 --> 00:36:14.340 align:middle line:84% And they all deposited it in JP Morgan, you know, the big banks. 00:36:14.340 --> 00:36:19.160 align:middle line:84% So there's lots of deposits that, despite the insurance, 00:36:19.160 --> 00:36:22.830 align:middle line:84% the blanket insurance that is implicit, 00:36:22.830 --> 00:36:25.550 align:middle line:84% at least at the moment, lots of deposits from these sectors 00:36:25.550 --> 00:36:28.700 align:middle line:84% are moving to these major banks here. 00:36:28.700 --> 00:36:31.910 align:middle line:84% That's called a flight to quality. 00:36:31.910 --> 00:36:35.690 align:middle line:84% Now, the problem of that for the economy as a whole 00:36:35.690 --> 00:36:38.570 align:middle line:84% is that small banks and regional banks 00:36:38.570 --> 00:36:43.400 align:middle line:90% play a huge role in lending. 00:36:43.400 --> 00:36:48.420 align:middle line:84% I think a little more than 50%, for example, 00:36:48.420 --> 00:36:52.650 align:middle line:84% of the commercial and industrial loans are made by small banks. 00:36:52.650 --> 00:36:55.720 align:middle line:84% 80% of the mortgages are given by a small bank. 00:36:55.720 --> 00:36:59.100 align:middle line:84% So it has a big potential consequence. 00:36:59.100 --> 00:37:01.350 align:middle line:84% What I'm trying to say is that x may stay high 00:37:01.350 --> 00:37:03.040 align:middle line:90% for quite a bit of time. 00:37:03.040 --> 00:37:08.790 align:middle line:84% And that's the reason, there is anticipation 00:37:08.790 --> 00:37:10.870 align:middle line:84% that this will have macroeconomic consequences. 00:37:10.870 --> 00:37:13.440 align:middle line:84% And as a result of that, that the Fed will react, 00:37:13.440 --> 00:37:15.305 align:middle line:84% that inflation will change, and all that. 00:37:15.305 --> 00:37:18.280 align:middle line:90% 00:37:18.280 --> 00:37:20.175 align:middle line:84% So that's where we were at on Monday. 00:37:20.175 --> 00:37:21.550 align:middle line:84% Remember when we had the lecture, 00:37:21.550 --> 00:37:25.640 align:middle line:84% I was telling you more or less that the story. 00:37:25.640 --> 00:37:27.970 align:middle line:90% What is this? 00:37:27.970 --> 00:37:31.670 align:middle line:84% You can read it there, but it may not mean much to you. 00:37:31.670 --> 00:37:34.270 align:middle line:84% But what I'm highlighting is this. 00:37:34.270 --> 00:37:36.370 align:middle line:90% This is pretty big. 00:37:36.370 --> 00:37:38.000 align:middle line:90% 35% decline. 00:37:38.000 --> 00:37:39.040 align:middle line:90% This is an equity. 00:37:39.040 --> 00:37:40.420 align:middle line:90% It's a share. 00:37:40.420 --> 00:37:46.830 align:middle line:84% So this is the value of the equity of a pretty major bank, 00:37:46.830 --> 00:37:49.710 align:middle line:90% Credit Suisse. 00:37:49.710 --> 00:37:53.460 align:middle line:84% So Credit Suisse has been in trouble for a while. 00:37:53.460 --> 00:37:56.910 align:middle line:84% But today got into really big trouble 00:37:56.910 --> 00:38:01.570 align:middle line:84% and saw a massive collapse in the equity shares. 00:38:01.570 --> 00:38:04.960 align:middle line:84% In fact, they stopped trading for a while and so on. 00:38:04.960 --> 00:38:11.420 align:middle line:84% This thing here-- you know, I updated your slides many times 00:38:11.420 --> 00:38:15.860 align:middle line:84% today because I began to look at this event around here. 00:38:15.860 --> 00:38:18.490 align:middle line:84% And then the thing kept going and they stopped, kept going, 00:38:18.490 --> 00:38:18.990 align:middle line:90% and so on. 00:38:18.990 --> 00:38:20.820 align:middle line:84% And I'm not sure where he's at now. 00:38:20.820 --> 00:38:22.790 align:middle line:84% I stopped-- at what time did I stop? 00:38:22.790 --> 00:38:23.840 align:middle line:90% 9:00 in the morning. 00:38:23.840 --> 00:38:26.310 align:middle line:90% And I was awake at 4:45 today. 00:38:26.310 --> 00:38:31.730 align:middle line:84% So they tell you this was pretty intense. 00:38:31.730 --> 00:38:37.160 align:middle line:84% But what this is is the credit default swaps on Credit Suisse. 00:38:37.160 --> 00:38:41.180 align:middle line:84% Credit default swap is whenever it's a bond issued by a bank, 00:38:41.180 --> 00:38:43.820 align:middle line:84% you can buy an insurance on that bond. 00:38:43.820 --> 00:38:48.920 align:middle line:84% So if the bond defaults on you, you then use the insurance 00:38:48.920 --> 00:38:50.720 align:middle line:90% and you get paid. 00:38:50.720 --> 00:38:52.970 align:middle line:84% So these things for banks normally 00:38:52.970 --> 00:38:55.842 align:middle line:84% are very small numbers, but for Credit Suisse, 00:38:55.842 --> 00:38:57.800 align:middle line:84% bigger than for other big banks because they've 00:38:57.800 --> 00:39:00.840 align:middle line:84% been in trouble for a while, all sorts of trouble. 00:39:00.840 --> 00:39:02.730 align:middle line:90% But look at that spike there. 00:39:02.730 --> 00:39:04.970 align:middle line:84% I mean, that's pretty big for these kind of things. 00:39:04.970 --> 00:39:08.490 align:middle line:90% It's not Lehman yet, but big. 00:39:08.490 --> 00:39:10.535 align:middle line:84% So anyway, that caused a little panic today. 00:39:10.535 --> 00:39:13.890 align:middle line:90% 00:39:13.890 --> 00:39:19.030 align:middle line:84% This is the stock prices of the main European banks. 00:39:19.030 --> 00:39:21.090 align:middle line:90% It's sold today. 00:39:21.090 --> 00:39:22.900 align:middle line:90% So look at this. 00:39:22.900 --> 00:39:24.880 align:middle line:84% It was a little rally yesterday and so on. 00:39:24.880 --> 00:39:29.530 align:middle line:84% I mean, this is the decline as a result of the US problem, 00:39:29.530 --> 00:39:31.200 align:middle line:90% the Silicon Valley Bank's. 00:39:31.200 --> 00:39:33.120 align:middle line:90% Then a rally yesterday. 00:39:33.120 --> 00:39:35.130 align:middle line:90% And then Credit Suisse happened. 00:39:35.130 --> 00:39:43.350 align:middle line:84% And you had a big decline in all the major banks in Europe. 00:39:43.350 --> 00:39:45.460 align:middle line:90% The US banks are also declining. 00:39:45.460 --> 00:39:50.130 align:middle line:84% But that was bigger for the major banks. 00:39:50.130 --> 00:39:52.590 align:middle line:84% The Vix, remember I told you last week, 00:39:52.590 --> 00:39:55.050 align:middle line:84% last Monday, about this indicator of 00:39:55.050 --> 00:39:58.300 align:middle line:84% fear in the market, which is really the price of put options? 00:39:58.300 --> 00:39:59.760 align:middle line:90% I'm simplifying things. 00:39:59.760 --> 00:40:04.650 align:middle line:84% I mean, protection for big declines on the equity market. 00:40:04.650 --> 00:40:10.020 align:middle line:84% Again, it began to spike very, very sharply as a result. 00:40:10.020 --> 00:40:12.490 align:middle line:84% This is what happened with the US event. 00:40:12.490 --> 00:40:15.390 align:middle line:84% Then yesterday we got a rally, risk on type thing. 00:40:15.390 --> 00:40:19.720 align:middle line:84% And then today we got a new event. 00:40:19.720 --> 00:40:20.890 align:middle line:90% Look at this. 00:40:20.890 --> 00:40:22.900 align:middle line:90% I like this picture. 00:40:22.900 --> 00:40:23.890 align:middle line:90% What this is. 00:40:23.890 --> 00:40:28.690 align:middle line:84% Let me tell you what the blue line is. 00:40:28.690 --> 00:40:38.020 align:middle line:84% The blue line is the market expected federal funds rate 00:40:38.020 --> 00:40:39.480 align:middle line:84% at different dates in the future. 00:40:39.480 --> 00:40:42.310 align:middle line:90% 00:40:42.310 --> 00:40:46.480 align:middle line:84% Today the federal funds rate is around 4 and 1/2. 00:40:46.480 --> 00:40:49.535 align:middle line:84% And this is what the market expects. 00:40:49.535 --> 00:40:52.120 align:middle line:90% 00:40:52.120 --> 00:40:55.810 align:middle line:84% So they expected the Fed to continue to hike interest rates 00:40:55.810 --> 00:41:02.020 align:middle line:84% and to reach a peak around in June 14 in that meeting 00:41:02.020 --> 00:41:05.350 align:middle line:90% of the order of 5.3% or so. 00:41:05.350 --> 00:41:07.375 align:middle line:90% That's what's the average. 00:41:07.375 --> 00:41:08.500 align:middle line:90% There's lots of dispersion. 00:41:08.500 --> 00:41:11.570 align:middle line:84% That people are betting on 6%, but that's the average. 00:41:11.570 --> 00:41:12.920 align:middle line:90% That's what people expected. 00:41:12.920 --> 00:41:15.430 align:middle line:84% The yellow things is the number of hikes 00:41:15.430 --> 00:41:16.730 align:middle line:90% that you're likely to see. 00:41:16.730 --> 00:41:19.960 align:middle line:84% So you're likely to see one hike in the next meeting, 00:41:19.960 --> 00:41:22.390 align:middle line:84% another one in the next meeting, and another one 00:41:22.390 --> 00:41:23.950 align:middle line:90% in the next meeting. 00:41:23.950 --> 00:41:27.470 align:middle line:84% And then stop and begin sort of cutting rates. 00:41:27.470 --> 00:41:31.180 align:middle line:84% That was expected path on Friday-- 00:41:31.180 --> 00:41:32.197 align:middle line:90% 10th was Friday. 00:41:32.197 --> 00:41:33.280 align:middle line:90% More or less around there. 00:41:33.280 --> 00:41:35.080 align:middle line:84% Maybe Thursday, I don't remember. 00:41:35.080 --> 00:41:37.350 align:middle line:84% But anyway, that was expected path. 00:41:37.350 --> 00:41:40.730 align:middle line:84% So still, hike rates reach a peak 00:41:40.730 --> 00:41:44.960 align:middle line:84% of 5.3% and still pretty high interest rates 00:41:44.960 --> 00:41:47.810 align:middle line:90% by the end of the year. 00:41:47.810 --> 00:41:49.195 align:middle line:90% That was expected path. 00:41:49.195 --> 00:41:52.270 align:middle line:90% 00:41:52.270 --> 00:41:55.370 align:middle line:90% That's the way it looks now. 00:41:55.370 --> 00:41:56.780 align:middle line:90% Very different. 00:41:56.780 --> 00:42:00.950 align:middle line:84% Now people are expecting very small changes now, I showed you. 00:42:00.950 --> 00:42:05.330 align:middle line:84% It's like 13 basis points what people expect. 00:42:05.330 --> 00:42:09.020 align:middle line:84% Still people expect sort of a hike, but small one. 00:42:09.020 --> 00:42:14.750 align:middle line:84% Now they expect the peak to be sort of in May and then the Fed 00:42:14.750 --> 00:42:16.700 align:middle line:84% to start cutting very aggressively 00:42:16.700 --> 00:42:18.140 align:middle line:84% to at the end of the year, end up 00:42:18.140 --> 00:42:21.520 align:middle line:84% with much lower rates than today. 00:42:21.520 --> 00:42:25.430 align:middle line:84% So this is exactly what I was telling you before. 00:42:25.430 --> 00:42:27.700 align:middle line:84% The market is anticipating that we 00:42:27.700 --> 00:42:33.550 align:middle line:84% had a huge contraction in the IS because x went up a lot. 00:42:33.550 --> 00:42:37.250 align:middle line:84% The major consequences, that is going to be lower inflation. 00:42:37.250 --> 00:42:38.920 align:middle line:90% Yes, we have a problem. 00:42:38.920 --> 00:42:45.780 align:middle line:84% I mean, if the US did not have 5.5% of inflation today, 00:42:45.780 --> 00:42:48.280 align:middle line:84% I can assure you that the Fed would have come out and said, 00:42:48.280 --> 00:42:50.230 align:middle line:90% we cut the rates right now. 00:42:50.230 --> 00:42:52.600 align:middle line:84% The only reason they're not cutting right now 00:42:52.600 --> 00:42:54.560 align:middle line:90% is because we have two problems. 00:42:54.560 --> 00:42:56.298 align:middle line:84% We have the financial panic on one side 00:42:56.298 --> 00:42:58.340 align:middle line:84% and we have the high inflation on the other side. 00:42:58.340 --> 00:43:01.430 align:middle line:84% So they have to balance these two forces. 00:43:01.430 --> 00:43:03.655 align:middle line:84% But the expectation of the market 00:43:03.655 --> 00:43:05.030 align:middle line:84% is that the balance of two forces 00:43:05.030 --> 00:43:08.090 align:middle line:84% is going to be dominated by the contraction in aggregate demand 00:43:08.090 --> 00:43:10.960 align:middle line:84% much sooner than people were expecting. 00:43:10.960 --> 00:43:13.390 align:middle line:84% So that's what the market is pricing at the moment. 00:43:13.390 --> 00:43:14.890 align:middle line:84% And what I'm saying is, I was trying 00:43:14.890 --> 00:43:24.410 align:middle line:84% to highlight that this is very consistent with that. 00:43:24.410 --> 00:43:26.330 align:middle line:84% It's just the market looking ahead, 00:43:26.330 --> 00:43:28.510 align:middle line:90% but what is likely to happen. 00:43:28.510 --> 00:43:29.950 align:middle line:84% It started from a situation which 00:43:29.950 --> 00:43:32.075 align:middle line:84% is a little bit more complicated, again, because we 00:43:32.075 --> 00:43:33.650 align:middle line:90% already had high inflation. 00:43:33.650 --> 00:43:35.270 align:middle line:90% Well, I do not know, really. 00:43:35.270 --> 00:43:39.370 align:middle line:84% I mean, it is on one hand, more complicated 00:43:39.370 --> 00:43:42.670 align:middle line:84% because we have a problem of high inflation. 00:43:42.670 --> 00:43:45.897 align:middle line:84% On the other hand, having high inflation 00:43:45.897 --> 00:43:47.980 align:middle line:84% allows you to cut the real interest rate much more 00:43:47.980 --> 00:43:48.700 align:middle line:90% aggressively. 00:43:48.700 --> 00:43:50.920 align:middle line:84% Because if you bring the nominal interest rate to 0 00:43:50.920 --> 00:43:53.200 align:middle line:84% and you have inflation of 5%, that 00:43:53.200 --> 00:43:55.940 align:middle line:84% allows you to cut the real interest rate to -5%. 00:43:55.940 --> 00:43:57.430 align:middle line:84% Well, if you start with a situation 00:43:57.430 --> 00:44:00.360 align:middle line:84% where your inflation is 0, you don't have any space 00:44:00.360 --> 00:44:01.610 align:middle line:90% to cut the real interest rate. 00:44:01.610 --> 00:44:04.377 align:middle line:84% So the Fed can be very aggressive here. 00:44:04.377 --> 00:44:06.710 align:middle line:84% And the only reason is not being very, very aggressive-- 00:44:06.710 --> 00:44:09.085 align:middle line:84% They were very aggressive in terms of supporting deposits 00:44:09.085 --> 00:44:09.950 align:middle line:90% and all that. 00:44:09.950 --> 00:44:15.790 align:middle line:84% But they can be very aggressive in terms of interest rate cuts 00:44:15.790 --> 00:44:17.270 align:middle line:90% if the need arises. 00:44:17.270 --> 00:44:18.200 align:middle line:90% Hopefully we won't. 00:44:18.200 --> 00:44:20.140 align:middle line:84% But they have a space because we're 00:44:20.140 --> 00:44:22.150 align:middle line:84% starting from a much higher level of inflation. 00:44:22.150 --> 00:44:23.680 align:middle line:90% That helps. 00:44:23.680 --> 00:44:27.070 align:middle line:84% It hurts in the sense that it will delay the reaction. 00:44:27.070 --> 00:44:28.810 align:middle line:84% But it helps in the sense that they have 00:44:28.810 --> 00:44:31.245 align:middle line:90% much more space for policy. 00:44:31.245 --> 00:44:35.640 align:middle line:90% 00:44:35.640 --> 00:44:36.455 align:middle line:90% What is this? 00:44:36.455 --> 00:44:40.720 align:middle line:90% 00:44:40.720 --> 00:44:43.910 align:middle line:84% This is just one year interest rates. 00:44:43.910 --> 00:44:47.600 align:middle line:84% That reflects the previous picture, as well. 00:44:47.600 --> 00:44:50.110 align:middle line:90% 00:44:50.110 --> 00:44:57.340 align:middle line:84% One year out rates were over 5% a few days ago and now are 00:44:57.340 --> 00:44:59.530 align:middle line:90% in the low 4s. 00:44:59.530 --> 00:45:02.860 align:middle line:84% And this picture I kept updating, as you can see. 00:45:02.860 --> 00:45:04.335 align:middle line:90% It was really dropping fast. 00:45:04.335 --> 00:45:07.330 align:middle line:90% 00:45:07.330 --> 00:45:08.890 align:middle line:90% That's a big change. 00:45:08.890 --> 00:45:12.195 align:middle line:84% The one year rate, 60 basis points, that's a big change. 00:45:12.195 --> 00:45:15.680 align:middle line:90% 00:45:15.680 --> 00:45:18.080 align:middle line:90% So that's where we're at. 00:45:18.080 --> 00:45:20.610 align:middle line:84% And from the next lecture, I'm going to start with growth. 00:45:20.610 --> 00:45:21.950 align:middle line:90% But any questions about this? 00:45:21.950 --> 00:45:25.780 align:middle line:90% 00:45:25.780 --> 00:45:26.280 align:middle line:90% OK. 00:45:26.280 --> 00:45:28.510 align:middle line:84% I don't want to start growth now in four minutes. 00:45:28.510 --> 00:45:31.020 align:middle line:84% But so the set of topics we're going 00:45:31.020 --> 00:45:35.310 align:middle line:84% to discuss from the next lecture are very different, 00:45:35.310 --> 00:45:37.660 align:middle line:84% subject to not having any major events. 00:45:37.660 --> 00:45:40.590 align:middle line:84% If there is a major event, I'm going to reshuffle things 00:45:40.590 --> 00:45:44.550 align:middle line:84% so we can talk about financial panics and things of that kind. 00:45:44.550 --> 00:45:46.440 align:middle line:84% Let's hope that it can stick to the program 00:45:46.440 --> 00:45:50.020 align:middle line:90% and do growth in the next week. 00:45:50.020 --> 00:45:51.600 align:middle line:90% OK, good. 00:45:51.600 --> 00:45:53.450 align:middle line:90% Have a good weekend. 00:45:53.450 --> 00:46:05.000 align:middle line:90%