Lecture on Measuring Aggregate Output and Introduction to IS-LM Model

um so we started with the something a little boring basic definitions and the first thing we had to do is to understand how do we measure output at the aggregate level it's very easy to understand what output is at the level of an Factory but but at the AG level is a little tricky and so we had an example of a very simple economy with two companies one that produces steel and the other one that produces cars and in this particular example the steel company doesn't sell anything to the final consumers it sells all its production to the car company and we ask a question where is the GDP of this economy H the simplest answer would have been well 300 no I some what the the the output of the two companies and that could be one answer but then I show you through three different methods that that's the wrong answer and um method one H was h a definition is um GDP is the value of final goods only okay and final goods in this simple example is well this company is not producing anything as a final good because all its sales are going to as an input into other companies production and so this one doesn't count at all in our simple example this one counts and then the answer is $200 okay not 3300 but $200 method two was to count only the value added in each company and value added is the difference between the final output that is the revenue from sales minus whatever that company spends on intermediate inputs in this simple example this company the steel company is not spending anything on intermediate inputs it's a strange production of a steel but anyways it is what it is in example and so this is entire this $100 is is value added completely value added there's no expenses on intermediate inputs for the car company however the revenue from C is 200 but the company spends 100 on intermediate input therefore the value out of this company is 200 minus 100 so you get 100 value out from this one 100 value out from that one total value added 200 so same answer and the third method these are the two method that I just described are production methods no you're measuring the production side the alternative is to look at the income side okay and the income side let's says just let's sum all the incomes in the economy and the incomes are income to workers wages and income to the owners of capital profits ER income to way to workers is $80 plus 70 is 100 50 income to owners of capital is 20 + 30 that's 50 so 150 plus 50 is again 200 okay so these are three equivalent ways of er er measuring output and I said ER you know and one of the features I I I I show you of of of of this method is that they are immune to organizational structure within the economy so for example if these two companies were to merge no clearly the sum of incomes would not change would still be 100 it would be 200 ER this one would not change because if they were to merge then the whole production of the revenues from sales of the car company would be value added everything would be produced in house and still the answer would be 200 then no because this company would disappear it would emerge inside here and you would get still get 200 and the same happen with h method one because still the sales of final goods is only 200 the naive approach of just summing output you know would be terrible because once you merge it output would collapse from 300 to 200 that tells you that's not the right way of doing things okay so while the three methods we propose do H work are immune to to this organiz changes in organization structure The Next Step was to H highlight that when we say out output we're really after real output and there's a distinction between nominal output and real output nominal output is simply the quantity of final goods measured at current prices while real output is measured at some fixed set of prices okay of one fixed year and I think I gave you an example this is example I gave you and then in the in the in the pets you had more complicated examples with multiple Goods here you have an economy that produces only one good cars and that PES 10 cars here 12 cars here 13 cars here the price of the cars is rising so the nominal GDP is rising a lot while the real GDP is rising less how do we measure real GDP here we use to to 12 in this particular example we use the prices here 12 10 times the price of the car in 2012 is 24,000 that's 240 obviously for the base year nominal GDP is the same as real GDP and then 12 13 is 13 not time 26,000 but times 24,000 and we get that now in this particular example of only one e one good ER you can pick any any base year and you'll get exactly the same rate of growth of real output if you have multiple Goods that's not true because the relative prices of goods are moving over time okay but uh but that's the basic idea so I mean again you should know these things they're not going to be tremendously important in the quiz but they will show up in your quiz [Music] okay and then we went some some definitions the unemployment rate know being the number of unemployed over the labor force not population that's important H we talked about inflation rate as well that's the rate of change of prices and there are different prices in the economy one of them is the deflator the other one is CPI and so on so forth that's it so that was the first uh lecture relevant for the quiz any question about that good keep moving okay then we move to when then we began to really get serious because we began to construct sort of a foundation for the islm model okay and the first thing we did is we look at the Goods Market uh no and and what we did here is just was say we describ the different components of of aggregate demand and we said in this econ for for now at least we're going to make this economy close so we we remove exports and imports and for your quiz absolutely you not going to see anything about exports or Imports okay so this is your aggregate demand ER we wanted to build a little more so we had to have some behavioral assumptions H we made it initially very simple we assumed this was exogenous the Govern expension was exogenous taxes were also exogenous t h and the only behavioral equation we had was this consumption function we said consumption is increasing disposable income okay so and we we assume something linear like this disposable income is just income minus taxes and remember income remember from the from the alternative ways of measuring GDP income is the same as output no so when I say income because as is relevant for the consump consumer well but it's the same as output so that's was our consumption function it had an upward slope it was upward sloping because there's a marginal propensity to consume C1 H and then then a key Assumption of this part of the course is that that H output is aggregate demand determined prices were completely fixed H and and we said well but you know output is whatever demand wants that's what output is so this is an equilibrium condition okay this is the aggregate demand this is an equilibrium condition so we can solve out because I can say in equilibrium Z is equal to Y and I can solve for equilibrium output from that equation okay and that's exactly what we did in this slide and you got to an expression like this knowing how to do that is very important for you okay so you you better be sure that you know how to find equilibrium output in in in this model I mean it's going to be very difficult to do I M if you don't know these steps so so you better know this stuff H and remember something we call this guy here in the simple economy the multiplier why the multiplier well because given certain sort of something we call exogenous expenditure the 1 minus C1 multiplies that if the marginal to consume is very high say it's close to one then the multipli is very very high if the marginal Pro to consume say is 05 then how much is the multiplier two okay good so the multiplier is two okay good and that was our equilibrium now we had the aggregate demand the slope was less than the 45 degree line because C1 is a number less than one and so you have some equilibrium output there that's equilibrium output at this point aggregate demand is equal to well agre demand is equal to agre supply that's that's always true uh but that's consistent also with aggregate demand okay with the with the function of aggregate demand and and the important for for this equilibrium output is that that equilibrium output is a function of a lot of things that we took as parameters in this aggregate demand curve what did we take as parameters in the agregate bank care just give examples well investment government expenditure and taxes at the very least tax also parameters like autonomous consumption that c0 were taking as given anything if any of those things move this the position of this aggregate demand curve will shift around okay and that was one example suppose autonomous consumption C zero goes up so suddenly consumers decide to spend more okay well then then what we had is is that aggregate demand shift up and equilibrium output ends up changing by more than the initial change in c z why is that so this is the change in c0 but uh but the change in output and so the initial change c0 leads to an initial change in output which is equal to c0 that's up to here but then we end up with final equilibrium output is is is higher than the initial response all this happens infinitely fast in this model why is this change greater than c0 there is a multiplier in front exactly we change c0 by one but then you have to multiply by 1/ 1 minus C1 and that's what we Illustrated in this picture there okay good and so you should move anything you you can move here around no move G up T up or stuff like that and see what happens the last thing I did in this section is is uh I show you an alternative way entirely equivalent way of of illustrating equilibrium which was saving equal to investment H remember and I derive this and I got to an expression like that that's exactly the same as aggregate demand equal to aggregate supply no a investment which in this particular basic model is fixed is equal to saving by the government which is also in this basic model is fixed because it's G minus t which is fixed H sorry it's T minus G which is fixed and then private saving and and then I show you a an interesting result which is called known the Paradox of savings which says the following if for whatever reason consumers decide to save more say for example because c z now comes down okay so now out they have certain income out of that same income they want to save more then from this very simple equation I know that what happens to Output why because savings go up consum Dem goes down and then also investment suppos to go down and then no investment doesn't go down here because it's fixed in this this B Bas basic example not islm yes but that's that's that's an explanation which is is the right explanation but it's is it's the explanation in the other space output and and and and the income I want it in the space of saving an investment so let me give it to you very quickly but your answer is correct but but but it's not what I wanted here because what I wanted to say is the following if for whatever reason for any given level of income savings go up then we have an imbalance saving total saving is greater than investment the only variable that can adjust here so we restore equilibrium investment equal to saving is for output to bring come down because if output comes down savings come down and that's the way you restore equilibrium I told you this way of looking at thing is entirely equivalent as we had already done so I can also do what you wanted to do which is represent that in the space of output and aggregate demand and and output or or income and and the an increase in c0 a reduction in c0 would lead to a decline in aggregate demand and then through the multiply larger increase in output so this is the way we characteriz it before this is a slightly different way of of characterizing which is is what gives rise to what is called the Paradox of saving because suddenly you decide to save more supposed to be good well in the short run it's not really good it causes a recession okay anyway it's cute but it may show up in your future so I wanted to remind you so that was the Goods Market side oops then we look at financial markets and we we trivialized financial markets really we said let's assume the financial markets are very very simple money and bonds that's it nothing else ER and the first sort of behavior the the only behavioral equation we really had here was money demand and we say well money demand is increasing in nomal GDP because if nominal GDP is larger then you need to do more transactions you need more money more cash ER cash or deposit but here we're looking only at cash but it's decreasing in the interest rate money money is decreasing the Reon why it's decreasing in interest rate interest rate is the return on the bonds no why is money demand decreasing in the interest rate yeah the opportunity cost of holding cash in your pocket is higher you didn't care about this stuff you know a year ago but now you know it cost you 5% to hold cash that's what you get in a in a one year certificate Bond you treasury bond at this moment so it's more significant maybe it's not that relevant for you but Corporation makes a big difference I guarantee you right than keeping the thing in the checking account now they're really buying short-term treasuries and stuff like that okay um good so so that's the reason this is downward sloping um and uh and that's the concept here so then what the Central Bank controls is money how much money it injects in the economy that is how much H you know when okay how much money it injects into the economy how does let me say just that for now and so that's like money supply so the equilibrium interest rate is simply uh the point in which money demand is equal to the money exogenous money supply and I said in the modern world the central banks don't tell you Ms they tell you this is the interest rate we want and then they provide whatever M they need in order to get the interest rate they have told you that the they want to have okay so that's the case of an expansionary monetary policy suppose the FED wants to lower the interest rate from here to here well what it needs to do is increase money and increase money means it goes out there and open market operation and and and the buys bonds from the private sector okay buys bonds takes Bonds in and gives them Cash Money okay that's an expansion in monetary policy an expansionary monetary policy will lower the interest rate that's an open market operation so that's what we just saw was exactly that the the FED wants to lower the interest rate what it does is it goes out there it buys bonds from the private sector so it's balance sheet on the asset side has more bonds now but it has more liabilities because it gives cash to people and that's the liability of the central banks okay so that's that's an open market operation that's an expansionary open market operation which is designed to lower the interest rate okay then I talked about the relationship between the interest rate and the price of the bond okay and that's that's a return on a bond no is is is the face value of the bond what you get in when the bond matures say it's 100 it's a B for 100 minus whatever you pay divided by whatever you pay so say if you pay today $95 for a bond that will pay you $100 a year from now that's approximately a 5% interest rate no it's a little more but but that's about it okay H which is also helps in the understand a little bit what what what happens during an open market operation in an open market operation an expansion in monetary policy the Central Bank goes out there and buys bonds what typically happens to a price of a good that is a good or an asset that is been bought by somebody big that has goes up or down now we have a big buyer out there that goes and buys Bond do you think the price of bonds will go up or down up no big guy buyer got into the market to buy bonds the price of bonds go up but if the P price of bonds goes up that means the interest rate goes down that's an intuitive way of understanding how monetary policy lowers interest rate it's a big buyer buying bonds the price of bonds will go up but the interest rate and the price of the bond are inversely related you you can see that now suppose that the initial price of the bond was 95 and now the price of the bone goes to 100 the interest rate goes from a little more than 5% to zero good then I we talk about intermediaries forget it for now so then we got into two lectures about the islm about the basic islm model and then we did one more on on the extended islm model and I told you that at least two third of your quiz will be about this so and and I I I already know what is in the quiz and I guarantee you that I honor my my commitment okay so so you better understand the slm mod very very well now understanding the slm mod also me understanding the previous two lectures because we're building the islm model there ER so the first thing we did here is said well to make this stuff a little more interest we already had a model in which we could find equilibrium output remember that was in in lecture three we had that that but we said but but we took many things as exogenous there that are really not exogenous in practice in particular private investment private investment certainly something that responds to aggregate activity and to the cost of borrowing and things of that nature so what we did the first thing we did here is we we changed the investment function for some constant for something that was a function of output and the interest rate that component here this this the fact that was increasing in output just increased the multiplier but it didn't change anything qualitatively in the analysis but the fact that it depends on the interest rate is important because now we have as a parameter in the in in the goods Mar in the aggregate demand curve the interest rate okay when you solve out the whole thing the interest rate is one of the things that can move agregate demand around and and and that's important because now you can begin to see the connection between what the Central Bank does and how it affects aggregate activity because what the Central Bank does affect the interest rate the Central Bank cannot go out there and buy hamburgers as I said it can go out there and buy bonds and with that it affects the interest rate and and for that to matter for the economy not only to bond holders it better be the case that that interest rate matters for the equilibrium level of output and it does so by affecting real investment okay so that's a mechanism through which monetary policy affect real activity is through the cost of borrowing we simply in in in reality consumers are also affected by that by interest rate and so on but the but let's keep things simple and have only investment as a function of the interest rate and and very importantly it's a decreasing function of the interest rate the higher interest rates the lower is investment for any given of output because it's more costly to borrow to fund that investment so that gave us our a curve which is a the combinations of output and interest rate that are consistent with equilibrium in the Market that is when output is equal to aggregate demand okay so I say yes so that point belongs to one is for one interest rate here okay so how do we construct the is well we start moving the interest rate no so uh suppose we start from this this is one point in the the point I just showed you supposing that we now we increase the interest rate we look at the new equilibrium output well that Al belongs to this is okay and you can keep moving the interest rate around so you move ZZ around only by moving the interest rate don't move g t anything else only by moving the interest rate and then you can trace an is curve okay if you move other parameter than the interest rate then it's a move it's a shift in the curve it's not a movement along the curve so if for example if I increase G what happens with this curve the curve shift to the right okay because now for any given level of interest rate output will be higher because aggregate demand moves up and so that's a shift to the right of theare good that's an example of the opposite is an increasing taxes well it will shift the yes to the left the L relationship is we already described it is is no equilibrium in financial markets but we said the way monetary policies conducted is the Fed sets the interest rate and then money is whatever the market needs in order for that to be the equilibrium interest rate so the mod LM if you will is horizontal it's like that okay so now we're set because once the FED decides to set this interest rate we can find not only the equilibrium combinations of interest rate and output that are consistent with equilibrium in the Goods Market but the particular equilibrium level of output that is consistent with that interest rate and that's exactly equilibrium out okay so given the LM now I looked at intersection with my is and that gives me equilibrium output for that level of the interest rate which has been set by the FED okay and then you can use this model this is a very powerful little model because now you can do lots of things with it no for example H that's a contractionary fiscal policy that's what happens when you reduce G or when you you increase T what happens if you reduce G and T by the same amount you see what I'm doing and maybe if you that that's often done is okay you can increase govern expend but then you find a source of Revenue or or or reduced govern expenditure but then you don't need to generate fiscal Surplus so on so when I'm saying this is a Balan Balan budget fiscal policy that's what it's called okay what if I move G and T by the same amount does that curve move yeah because the multip next to T is c0 in the equation original equation so c0 C1 okay perfect yeah yeah so in which direction does it move so if I reduce G and reduce T by the same amount what happens to the I moves to the left or to the right yeah it moves to the left left because why is that I can always go back to my basic Goods market equilibrium mod if I reduce G by one that reduces aggregate demand one by one one for one and then the multiplier sort of kicks in if I REM but the initial change shift down is one if I if I reduce taxes I increase aggregate demand but by C1 times one no and so I had a reduction in a demand of one and I had an increas in aggre demand of C1 1 minus C1 is greater than zero that's the reason you have a net a reduction in in agre demand hint this is not a random thought I have okay so so do understand it okay good okay that's monetary policy ER so um we that's an expansion in monetary policy and in equilibrium why is spary so cutting interest rate course it will increase equilibrium output that's a case in which the FED probably is unhappy with this low level of output maybe it's a recession so one of the main policy tools we have to fight a recession is to lower the interest rate and you can see here how lowering the interest rate will increase equilibrium output how does it happen why is it that this happen why is it that equilibrium output Rises exactly it's because increasing investment that gives us the first kick and once equilibrium starts Rising then consumption Rises and we get the whole the whole multiply but the initial impulse is exactly because there increase in in in investment H how does it Implement that open market operation so what the FED will do if it wants to cut the interest rate it goes out there buys bonds from the public and gives him money in exchange okay and that's what happens here and then I talk about different policy mixes no this this is what typically when an economy is deep into recession you're going to see both policies that work at the same time that's very powerful that's a case in which in which you know we have a very we cut we have an expansionary monetary policy that shift is down and an expansionary fiscal policy and uh you know that's definitely what we did during covid was massive and during the global financial crisis so typically big recessions will lead to any recession will lead to something like that obviously if it is Big you're going to have to a bigger combination of this kind of stuff some problems that that monetary policy May face is that you know sometimes you hit a Zer lower bound and then when you hit a zero lower bound is you just can't lower the interest rate more you lose monetary policy you need to do other stuff and typically fiscal policy then becomes very very active okay and this is not just a the theoretical curiosity I mean we have been against zero lower Bound for a sustain amount of time during the last 20 years or so oh that's another policy mix as well that suppose that you need to do a fiscal adjustment I said so you want to reduce the deficit reduce G but you don't want to have a recession as a result of that one way you can do that is by you know you have a a contraction in G or increase in taxes that's contra actionary but you can offset it with an expansion in monetary policy I think in the quiz somewhere you have a question not I don't think there specific to this but in which you're asked to compensate for something with something and something like that okay so some curve move and then you are asked to offset that effect on output okay so you should understand these kind of things The Next Step was to extend a little bit our eslm model and by extension we said well look at this moment we have only a um prices are completely fixed but in reality we have inflation and so the nominal interest rate is not really the effective cost of capital for a company a company that wants to fund a real investment is more concerned with the real interest rate is pain not the nominal interest rate so with prices that are constant There's no distinction but if you have positive inflation then then then the distinction makes a makes a difference that's the reason we wanted to talk about that and the second thing is that the same firms are are very unlikely to pay the same that the treasury pays for borrowing pay it's a risky proposition to invest in bonds issued by a corporation and therefore they're going to have to pay a risk premium for that okay and so the importance of these two things is that ER we ended up with an islm M that have now had something a little more complicated here because it didn't have only the nominal interest rate but also had expected inflation if for any given nominal interest rate if if uh we expect a higher inflation that means a lower real interest rate okay so so for any given nominal interest rate if expected inflation goes up that's expansionary really for firms okay it's like it's cheaper in a sense to borrow okay conversely if x goes up the great spread goes up that's contractionary because it's now more expensive for the firms to borrow for any given real interest rate okay so we can we can this is called extended islm model simply because it has been extended to incorporate this these add additional factors and now you have two more parameters in your in your model which is expected inflation and the credit spreads okay so if you move either of these you're going to going to move your aggregate demand curve in the Goods Market no and it's going to move for exactly the same reasons that that aggregate demand move when you move the interest rate it enters symmetrically in this model these guys here enter completely symmetrically with then the interest rate so whatever was the comparative Statics you had with respect to the nominal interest rate before they appli to x minus Pi what I'm trying to say is if I if you know how what is the change in equilibrium output as a response as a result of an increase in 100 basis points on the nominal interest rate then you know what is a response of equilibrium output to an increasing credit spreads of 100 basis points or to a reduction or or to a reduction in expected inflation of 100 basis points the entire symmetric okay because that's a that's a channel is the it's the real it's a cost of capital Channel you know for the firm that's they're all entering exactly through the same the same place but the but the the FED doesn't control this guy it controls only the nominal interest rate okay so anyways so these are new parameters here so this is an example here that's an example in which credit spreads or respected inflation went up sorry whether CR spreads went down or expected inflation went up up okay and that's expansionary that will increase aggregate demand because for any given level of output now there will be more investment okay cre spreads are lower or expected inflation is higher mean the real interest rate is lower for any given nominal interest rate so if the if if the FED doesn't react to that that's going to lead to an expansion in output of course the FED could react to that suppose the FED is okay with the level of output we have okay suppose it's a level of output and the F seeing credit spreads falling so output is expanding but the FED says no no no the level of output y z was what I needed I don't want y1 what would the FED do increase the interest rate exactly and it's very easy to see in this expression here that that if you don't want this guy the total sum to move then if this guy moves down or or this guy moves up then I need to move I exactly to offset that and that's it it's very easy to calculate I don't need to solve my whole model actually you know you tell me this thing in net went down by 100 basis points if I don't want to change output then I need to increase the interest rate by 100 basis points so I don't change the cost of borrowing the effective cost of borrowing for corporations okay in fact this is exactly what is going on right now in the US economy you know every time markets get very excited credit specs are compressed the stock market goes up the FED comes out and say come on guys I mean we have inflation problem I'm going to need to keep hiking interest rates because I need to offset Your Enthusiasm they don't use those words but that's exactly what happened I mean chairman pow was testifying in Congress yesterday and today and that's what he said I me just giving you a summary of what he said okay now a problem that the Central Bank May face suppose you have the opposite situation is that one in which credit spreads are going up a lot and expected inflation is declining a lot and the FED doesn't want output to the client because that combination will lead to reduction in output so the FED wants to cut interest rate what problem may it face it's zero lower bound it may not be able to bring interest rate as much as because suppose that the the interest rate today is is a is a 50 basis point it's not the case today but it was two years ago 50 basis point 25 basis points and cre spreads go up by 200 basis points well there's no way the FED can upset that no because he has maximum 25 basis points to lower and cre the spread went up by 100 basis points and that's when you start seeing all these more exotic policies quantitive eing and other things to offset the negative impact of the of the increase in the greater spreads in the economy and the last thing we we did was to begin a a our transitions to medium run issues and and the whole thing began from the labor market now you're going to get a little bit in the quiz of that but it's not going to be as important as what I just described but a little bit you're going to have and the basic uh well definitions you should should know the basic definitions well this was the first a a important equation we have a a wage setting equation that says essentially that wages are increasing in expected prices obviously the nominal wage the workers are going to demand is going to be higher if they expect the price level to be higher in the future but important is decreasing in unemployment and increasing in this in this variable that represents sort of their bargaining power and so on H then we look at what happened on the on the product on the price setting side meaning what firms do and for that we had to start with the production function we had a very simple production function which said if you want to produce one more unit of the good you need to have one more worker that means that the marginal cost of production is the wage so it's very simple and then we said we're going to have a very simple model in which the the firms charge their marginal cost which is the wage times a marup 1 plus M so m is a number like say2 okay so if the wage is 100 the markup is 20% they want the price of they're want to charge a price of 120 we can rearrange this in terms of wages and you can say well the firm the maximum real wage that firms collectively are willing to pay is really one over one plus the market okay that's just from that so then we look at a concept that that is important which is the natural rate of unemployment and we said the natural rate of unemployment has nothing of natural it just means that is the level of unemployment when the price is equal to expected price or expected price equal to the price you pick okay so all that we did was to replacing the weight setting equation the expected price for the actual price and then we divided both sides and now we have this real wage Demand by by workers when the price is equal to expected price and we also had a price set in equation we can and I said when we replace P for p then I get the right to put an n superscript n there that's the natural rate of unemployment because that's my definition of the natural rate ofemployment what happens when I can replace in the weight setting equation H the the expected price for the price and we look at the at the natural rate of unemployment what is equilibrium here of the price setting equation has an imply real wage of 1 over 1 plus M and that's a wage setting equation which is obviously decreasing unemployment because the higher is unemployment the lower the wage Demand by the workers okay and that's one natural rate of unemployment again nothing natural is a function of parameters which parameters well it's a function of that markup parameter it's a function of this institutional variable Z for example okay so that's in equations that's an example in which Z goes up so suppose that somehow you know unions go up or something like unionization goes up something of that kind or an employment benefits go up something of that kind which in in principle is supportive of workers well in this model that will immediately lead to an increasing wage demand for at this level of unemployment there going to be a a higher demand higher real wage Demand by the workers because they have more bargaining power now in this particular model that that cannot happen because the real wage that firms can are willing to pay is only this one one plus M so in order to restore equilibrium in the in the labor market what has to happen is unemployment natural rate of unemployment will go up and and that that will restore equilibrium here because well workers the the the bargaining power workers gain through those benefits in Z they end up losing by an increas in the equilibrium level of unemployment okay so that's the reason hear this stuff backfiring as to the workers because you know you end up with higher natural rate of unemployment so Europe for example has much higher labor protection than the US well they typically have a much higher unemployment rate than the US okay so that tradeoffs all these things that's a case of increaseing the markup and increasing the markup means effectively that the firms are going offering a lower real wage well at this level of unemployment workers are not going to take that lower real wage so what will have to happen for workers to take that low lower real wage is for unemployment to rise okay so those are the two canonical experiments you can have here it's what happens when markets go up and that can go they can go up for for the wrong reason it could be for oil shocks and stuff like that it could be because the market becomes less competitive allistic firms and so on but the final outcome here is that we end up with a higher natural rate of unemployment which again highlights the idea that this is not a g given unemployment rate so it's not it's not good in any sense it's it's just whatever it is the equilibri okay uh anyway so you should understand well what these two type of shocks do to the natur rate of unemployment I think that's because then lecture nine is not for this this quiz that's all I want to say any any questions no y this I think so I think is that the same a as next to the yeah this is the C you you want me to explain this this this yeah yeah it is a CR spread I said that's the way you calculate this CR spread here it's um remember there are two reasons why why um do you really want to know in anyway let me let me say so there are two reasons why the credit Express really happen one is the actual probability of the fault of a bond which the treasury has a very low priority def fall corporations depending on the ratings they may have higher or lower and the other one which is very significant is how risk averse investors are and that risk aversion changes a lot over the business cycle H we capture everything through just that X spread which we we capture it through this probability of theault but you can think that prity of the fault as being the perceived priority of the fault and when you're very scared you perceive that terrible things can happen so so it's a subjective priority of the fault so when that priority of the fault is different from zero then you start getting a positive spread how impactful is the actual def I know there were some recent defaults in at least the European like real estate markets yeah um like how I guess is there a difference between like a fear of a default and like an actual implications as oh this is all about perceived risk so it's because this is this determines the the borrowing that firms can do the cost for firms of borrowing if you already defaulted you cannot borrow so that's that's over that that has other consequences it may have impact on the balance sheet of the banks it's destruction of wealth it may lead to other problems but the problem we're highlighting here in this model is the cost of borrowing and that is something that happens only before you default yeah I mean actual defaults especially typically in developers and stuff like that can and that's what happen in the Great Recession ER can have consequences especially for the banks that typically lend to this developers and so on but I I may do something about financial crisis but much later in the course at the end okay well good luck enjoy it if you understood what I said today you're you're in good shape for

um so we started with the something a little boring basic definitions and the first thing we had to do is to understand how do we measure output at the aggregate level it&#39;s very easy to understand what output is at the level of an Factory but but at the AG level is a little tricky and so we had an example of a very simple economy with two companies one that produces steel and the other one that produces cars and in this particular example the steel company doesn&#39;t sell anything to the final consumers it sells all its production to the car company and we ask a question where is the GDP of this economy H the simplest answer would have been well 300 no I some what the the the output of the two companies and that could be one answer but then I show you through three different methods that that&#39;s the wrong answer and um method one H was h a definition is um GDP is the value of final goods only okay and final goods in this simple example is well this company is not producing anything as a final good because all its sales are going to as an input into other companies production and so this one doesn&#39;t count at all in our simple example this one counts and then the answer is $200 okay not 3300 but $200 method two was to count only the value added in each company and value added is the difference between the final output that is the revenue from sales minus whatever that company spends on intermediate inputs in this simple example this company the steel company is not spending anything on intermediate inputs it&#39;s a strange production of a steel but anyways it is what it is in example and so this is entire this $100 is is value added completely value added there&#39;s no expenses on intermediate inputs for the car company however the revenue from C is 200 but the company spends 100 on intermediate input therefore the value out of this company is 200 minus 100 so you get 100 value out from this one 100 value out from that one total value added 200 so same answer and the third method these are the two method that I just described are production methods no you&#39;re measuring the production side the alternative is to look at the income side okay and the income side let&#39;s says just let&#39;s sum all the incomes in the economy and the incomes are income to workers wages and income to the owners of capital profits ER income to way to workers is $80 plus 70 is 100 50 income to owners of capital is 20 + 30 that&#39;s 50 so 150 plus 50 is again 200 okay so these are three equivalent ways of er er measuring output and I said ER you know and one of the features I I I I show you of of of of this method is that they are immune to organizational structure within the economy so for example if these two companies were to merge no clearly the sum of incomes would not change would still be 100 it would be 200 ER this one would not change because if they were to merge then the whole production of the revenues from sales of the car company would be value added everything would be produced in house and still the answer would be 200 then no because this company would disappear it would emerge inside here and you would get still get 200 and the same happen with h method one because still the sales of final goods is only 200 the naive approach of just summing output you know would be terrible because once you merge it output would collapse from 300 to 200 that tells you that&#39;s not the right way of doing things okay so while the three methods we propose do H work are immune to to this organiz changes in organization structure The Next Step was to H highlight that when we say out output we&#39;re really after real output and there&#39;s a distinction between nominal output and real output nominal output is simply the quantity of final goods measured at current prices while real output is measured at some fixed set of prices okay of one fixed year and I think I gave you an example this is example I gave you and then in the in the in the pets you had more complicated examples with multiple Goods here you have an economy that produces only one good cars and that PES 10 cars here 12 cars here 13 cars here the price of the cars is rising so the nominal GDP is rising a lot while the real GDP is rising less how do we measure real GDP here we use to to 12 in this particular example we use the prices here 12 10 times the price of the car in 2012 is 24,000 that&#39;s 240 obviously for the base year nominal GDP is the same as real GDP and then 12 13 is 13 not time 26,000 but times 24,000 and we get that now in this particular example of only one e one good ER you can pick any any base year and you&#39;ll get exactly the same rate of growth of real output if you have multiple Goods that&#39;s not true because the relative prices of goods are moving over time okay but uh but that&#39;s the basic idea so I mean again you should know these things they&#39;re not going to be tremendously important in the quiz but they will show up in your quiz [Music] okay and then we went some some definitions the unemployment rate know being the number of unemployed over the labor force not population that&#39;s important H we talked about inflation rate as well that&#39;s the rate of change of prices and there are different prices in the economy one of them is the deflator the other one is CPI and so on so forth that&#39;s it so that was the first uh lecture relevant for the quiz any question about that good keep moving okay then we move to when then we began to really get serious because we began to construct sort of a foundation for the islm model okay and the first thing we did is we look at the Goods Market uh no and and what we did here is just was say we describ the different components of of aggregate demand and we said in this econ for for now at least we&#39;re going to make this economy close so we we remove exports and imports and for your quiz absolutely you not going to see anything about exports or Imports okay so this is your aggregate demand ER we wanted to build a little more so we had to have some behavioral assumptions H we made it initially very simple we assumed this was exogenous the Govern expension was exogenous taxes were also exogenous t h and the only behavioral equation we had was this consumption function we said consumption is increasing disposable income okay so and we we assume something linear like this disposable income is just income minus taxes and remember income remember from the from the alternative ways of measuring GDP income is the same as output no so when I say income because as is relevant for the consump consumer well but it&#39;s the same as output so that&#39;s was our consumption function it had an upward slope it was upward sloping because there&#39;s a marginal propensity to consume C1 H and then then a key Assumption of this part of the course is that that H output is aggregate demand determined prices were completely fixed H and and we said well but you know output is whatever demand wants that&#39;s what output is so this is an equilibrium condition okay this is the aggregate demand this is an equilibrium condition so we can solve out because I can say in equilibrium Z is equal to Y and I can solve for equilibrium output from that equation okay and that&#39;s exactly what we did in this slide and you got to an expression like this knowing how to do that is very important for you okay so you you better be sure that you know how to find equilibrium output in in in this model I mean it&#39;s going to be very difficult to do I M if you don&#39;t know these steps so so you better know this stuff H and remember something we call this guy here in the simple economy the multiplier why the multiplier well because given certain sort of something we call exogenous expenditure the 1 minus C1 multiplies that if the marginal to consume is very high say it&#39;s close to one then the multipli is very very high if the marginal Pro to consume say is 05 then how much is the multiplier two okay good so the multiplier is two okay good and that was our equilibrium now we had the aggregate demand the slope was less than the 45 degree line because C1 is a number less than one and so you have some equilibrium output there that&#39;s equilibrium output at this point aggregate demand is equal to well agre demand is equal to agre supply that&#39;s that&#39;s always true uh but that&#39;s consistent also with aggregate demand okay with the with the function of aggregate demand and and the important for for this equilibrium output is that that equilibrium output is a function of a lot of things that we took as parameters in this aggregate demand curve what did we take as parameters in the agregate bank care just give examples well investment government expenditure and taxes at the very least tax also parameters like autonomous consumption that c0 were taking as given anything if any of those things move this the position of this aggregate demand curve will shift around okay and that was one example suppose autonomous consumption C zero goes up so suddenly consumers decide to spend more okay well then then what we had is is that aggregate demand shift up and equilibrium output ends up changing by more than the initial change in c z why is that so this is the change in c0 but uh but the change in output and so the initial change c0 leads to an initial change in output which is equal to c0 that&#39;s up to here but then we end up with final equilibrium output is is is higher than the initial response all this happens infinitely fast in this model why is this change greater than c0 there is a multiplier in front exactly we change c0 by one but then you have to multiply by 1/ 1 minus C1 and that&#39;s what we Illustrated in this picture there okay good and so you should move anything you you can move here around no move G up T up or stuff like that and see what happens the last thing I did in this section is is uh I show you an alternative way entirely equivalent way of of illustrating equilibrium which was saving equal to investment H remember and I derive this and I got to an expression like that that&#39;s exactly the same as aggregate demand equal to aggregate supply no a investment which in this particular basic model is fixed is equal to saving by the government which is also in this basic model is fixed because it&#39;s G minus t which is fixed H sorry it&#39;s T minus G which is fixed and then private saving and and then I show you a an interesting result which is called known the Paradox of savings which says the following if for whatever reason consumers decide to save more say for example because c z now comes down okay so now out they have certain income out of that same income they want to save more then from this very simple equation I know that what happens to Output why because savings go up consum Dem goes down and then also investment suppos to go down and then no investment doesn&#39;t go down here because it&#39;s fixed in this this B Bas basic example not islm yes but that&#39;s that&#39;s that&#39;s an explanation which is is the right explanation but it&#39;s is it&#39;s the explanation in the other space output and and and and the income I want it in the space of saving an investment so let me give it to you very quickly but your answer is correct but but but it&#39;s not what I wanted here because what I wanted to say is the following if for whatever reason for any given level of income savings go up then we have an imbalance saving total saving is greater than investment the only variable that can adjust here so we restore equilibrium investment equal to saving is for output to bring come down because if output comes down savings come down and that&#39;s the way you restore equilibrium I told you this way of looking at thing is entirely equivalent as we had already done so I can also do what you wanted to do which is represent that in the space of output and aggregate demand and and output or or income and and the an increase in c0 a reduction in c0 would lead to a decline in aggregate demand and then through the multiply larger increase in output so this is the way we characteriz it before this is a slightly different way of of characterizing which is is what gives rise to what is called the Paradox of saving because suddenly you decide to save more supposed to be good well in the short run it&#39;s not really good it causes a recession okay anyway it&#39;s cute but it may show up in your future so I wanted to remind you so that was the Goods Market side oops then we look at financial markets and we we trivialized financial markets really we said let&#39;s assume the financial markets are very very simple money and bonds that&#39;s it nothing else ER and the first sort of behavior the the only behavioral equation we really had here was money demand and we say well money demand is increasing in nomal GDP because if nominal GDP is larger then you need to do more transactions you need more money more cash ER cash or deposit but here we&#39;re looking only at cash but it&#39;s decreasing in the interest rate money money is decreasing the Reon why it&#39;s decreasing in interest rate interest rate is the return on the bonds no why is money demand decreasing in the interest rate yeah the opportunity cost of holding cash in your pocket is higher you didn&#39;t care about this stuff you know a year ago but now you know it cost you 5% to hold cash that&#39;s what you get in a in a one year certificate Bond you treasury bond at this moment so it&#39;s more significant maybe it&#39;s not that relevant for you but Corporation makes a big difference I guarantee you right than keeping the thing in the checking account now they&#39;re really buying short-term treasuries and stuff like that okay um good so so that&#39;s the reason this is downward sloping um and uh and that&#39;s the concept here so then what the Central Bank controls is money how much money it injects in the economy that is how much H you know when okay how much money it injects into the economy how does let me say just that for now and so that&#39;s like money supply so the equilibrium interest rate is simply uh the point in which money demand is equal to the money exogenous money supply and I said in the modern world the central banks don&#39;t tell you Ms they tell you this is the interest rate we want and then they provide whatever M they need in order to get the interest rate they have told you that the they want to have okay so that&#39;s the case of an expansionary monetary policy suppose the FED wants to lower the interest rate from here to here well what it needs to do is increase money and increase money means it goes out there and open market operation and and and the buys bonds from the private sector okay buys bonds takes Bonds in and gives them Cash Money okay that&#39;s an expansion in monetary policy an expansionary monetary policy will lower the interest rate that&#39;s an open market operation so that&#39;s what we just saw was exactly that the the FED wants to lower the interest rate what it does is it goes out there it buys bonds from the private sector so it&#39;s balance sheet on the asset side has more bonds now but it has more liabilities because it gives cash to people and that&#39;s the liability of the central banks okay so that&#39;s that&#39;s an open market operation that&#39;s an expansionary open market operation which is designed to lower the interest rate okay then I talked about the relationship between the interest rate and the price of the bond okay and that&#39;s that&#39;s a return on a bond no is is is the face value of the bond what you get in when the bond matures say it&#39;s 100 it&#39;s a B for 100 minus whatever you pay divided by whatever you pay so say if you pay today $95 for a bond that will pay you $100 a year from now that&#39;s approximately a 5% interest rate no it&#39;s a little more but but that&#39;s about it okay H which is also helps in the understand a little bit what what what happens during an open market operation in an open market operation an expansion in monetary policy the Central Bank goes out there and buys bonds what typically happens to a price of a good that is a good or an asset that is been bought by somebody big that has goes up or down now we have a big buyer out there that goes and buys Bond do you think the price of bonds will go up or down up no big guy buyer got into the market to buy bonds the price of bonds go up but if the P price of bonds goes up that means the interest rate goes down that&#39;s an intuitive way of understanding how monetary policy lowers interest rate it&#39;s a big buyer buying bonds the price of bonds will go up but the interest rate and the price of the bond are inversely related you you can see that now suppose that the initial price of the bond was 95 and now the price of the bone goes to 100 the interest rate goes from a little more than 5% to zero good then I we talk about intermediaries forget it for now so then we got into two lectures about the islm about the basic islm model and then we did one more on on the extended islm model and I told you that at least two third of your quiz will be about this so and and I I I already know what is in the quiz and I guarantee you that I honor my my commitment okay so so you better understand the slm mod very very well now understanding the slm mod also me understanding the previous two lectures because we&#39;re building the islm model there ER so the first thing we did here is said well to make this stuff a little more interest we already had a model in which we could find equilibrium output remember that was in in lecture three we had that that but we said but but we took many things as exogenous there that are really not exogenous in practice in particular private investment private investment certainly something that responds to aggregate activity and to the cost of borrowing and things of that nature so what we did the first thing we did here is we we changed the investment function for some constant for something that was a function of output and the interest rate that component here this this the fact that was increasing in output just increased the multiplier but it didn&#39;t change anything qualitatively in the analysis but the fact that it depends on the interest rate is important because now we have as a parameter in the in in the goods Mar in the aggregate demand curve the interest rate okay when you solve out the whole thing the interest rate is one of the things that can move agregate demand around and and and that&#39;s important because now you can begin to see the connection between what the Central Bank does and how it affects aggregate activity because what the Central Bank does affect the interest rate the Central Bank cannot go out there and buy hamburgers as I said it can go out there and buy bonds and with that it affects the interest rate and and for that to matter for the economy not only to bond holders it better be the case that that interest rate matters for the equilibrium level of output and it does so by affecting real investment okay so that&#39;s a mechanism through which monetary policy affect real activity is through the cost of borrowing we simply in in in reality consumers are also affected by that by interest rate and so on but the but let&#39;s keep things simple and have only investment as a function of the interest rate and and very importantly it&#39;s a decreasing function of the interest rate the higher interest rates the lower is investment for any given of output because it&#39;s more costly to borrow to fund that investment so that gave us our a curve which is a the combinations of output and interest rate that are consistent with equilibrium in the Market that is when output is equal to aggregate demand okay so I say yes so that point belongs to one is for one interest rate here okay so how do we construct the is well we start moving the interest rate no so uh suppose we start from this this is one point in the the point I just showed you supposing that we now we increase the interest rate we look at the new equilibrium output well that Al belongs to this is okay and you can keep moving the interest rate around so you move ZZ around only by moving the interest rate don&#39;t move g t anything else only by moving the interest rate and then you can trace an is curve okay if you move other parameter than the interest rate then it&#39;s a move it&#39;s a shift in the curve it&#39;s not a movement along the curve so if for example if I increase G what happens with this curve the curve shift to the right okay because now for any given level of interest rate output will be higher because aggregate demand moves up and so that&#39;s a shift to the right of theare good that&#39;s an example of the opposite is an increasing taxes well it will shift the yes to the left the L relationship is we already described it is is no equilibrium in financial markets but we said the way monetary policies conducted is the Fed sets the interest rate and then money is whatever the market needs in order for that to be the equilibrium interest rate so the mod LM if you will is horizontal it&#39;s like that okay so now we&#39;re set because once the FED decides to set this interest rate we can find not only the equilibrium combinations of interest rate and output that are consistent with equilibrium in the Goods Market but the particular equilibrium level of output that is consistent with that interest rate and that&#39;s exactly equilibrium out okay so given the LM now I looked at intersection with my is and that gives me equilibrium output for that level of the interest rate which has been set by the FED okay and then you can use this model this is a very powerful little model because now you can do lots of things with it no for example H that&#39;s a contractionary fiscal policy that&#39;s what happens when you reduce G or when you you increase T what happens if you reduce G and T by the same amount you see what I&#39;m doing and maybe if you that that&#39;s often done is okay you can increase govern expend but then you find a source of Revenue or or or reduced govern expenditure but then you don&#39;t need to generate fiscal Surplus so on so when I&#39;m saying this is a Balan Balan budget fiscal policy that&#39;s what it&#39;s called okay what if I move G and T by the same amount does that curve move yeah because the multip next to T is c0 in the equation original equation so c0 C1 okay perfect yeah yeah so in which direction does it move so if I reduce G and reduce T by the same amount what happens to the I moves to the left or to the right yeah it moves to the left left because why is that I can always go back to my basic Goods market equilibrium mod if I reduce G by one that reduces aggregate demand one by one one for one and then the multiplier sort of kicks in if I REM but the initial change shift down is one if I if I reduce taxes I increase aggregate demand but by C1 times one no and so I had a reduction in a demand of one and I had an increas in aggre demand of C1 1 minus C1 is greater than zero that&#39;s the reason you have a net a reduction in in agre demand hint this is not a random thought I have okay so so do understand it okay good okay that&#39;s monetary policy ER so um we that&#39;s an expansion in monetary policy and in equilibrium why is spary so cutting interest rate course it will increase equilibrium output that&#39;s a case in which the FED probably is unhappy with this low level of output maybe it&#39;s a recession so one of the main policy tools we have to fight a recession is to lower the interest rate and you can see here how lowering the interest rate will increase equilibrium output how does it happen why is it that this happen why is it that equilibrium output Rises exactly it&#39;s because increasing investment that gives us the first kick and once equilibrium starts Rising then consumption Rises and we get the whole the whole multiply but the initial impulse is exactly because there increase in in in investment H how does it Implement that open market operation so what the FED will do if it wants to cut the interest rate it goes out there buys bonds from the public and gives him money in exchange okay and that&#39;s what happens here and then I talk about different policy mixes no this this is what typically when an economy is deep into recession you&#39;re going to see both policies that work at the same time that&#39;s very powerful that&#39;s a case in which in which you know we have a very we cut we have an expansionary monetary policy that shift is down and an expansionary fiscal policy and uh you know that&#39;s definitely what we did during covid was massive and during the global financial crisis so typically big recessions will lead to any recession will lead to something like that obviously if it is Big you&#39;re going to have to a bigger combination of this kind of stuff some problems that that monetary policy May face is that you know sometimes you hit a Zer lower bound and then when you hit a zero lower bound is you just can&#39;t lower the interest rate more you lose monetary policy you need to do other stuff and typically fiscal policy then becomes very very active okay and this is not just a the theoretical curiosity I mean we have been against zero lower Bound for a sustain amount of time during the last 20 years or so oh that&#39;s another policy mix as well that suppose that you need to do a fiscal adjustment I said so you want to reduce the deficit reduce G but you don&#39;t want to have a recession as a result of that one way you can do that is by you know you have a a contraction in G or increase in taxes that&#39;s contra actionary but you can offset it with an expansion in monetary policy I think in the quiz somewhere you have a question not I don&#39;t think there specific to this but in which you&#39;re asked to compensate for something with something and something like that okay so some curve move and then you are asked to offset that effect on output okay so you should understand these kind of things The Next Step was to extend a little bit our eslm model and by extension we said well look at this moment we have only a um prices are completely fixed but in reality we have inflation and so the nominal interest rate is not really the effective cost of capital for a company a company that wants to fund a real investment is more concerned with the real interest rate is pain not the nominal interest rate so with prices that are constant There&#39;s no distinction but if you have positive inflation then then then the distinction makes a makes a difference that&#39;s the reason we wanted to talk about that and the second thing is that the same firms are are very unlikely to pay the same that the treasury pays for borrowing pay it&#39;s a risky proposition to invest in bonds issued by a corporation and therefore they&#39;re going to have to pay a risk premium for that okay and so the importance of these two things is that ER we ended up with an islm M that have now had something a little more complicated here because it didn&#39;t have only the nominal interest rate but also had expected inflation if for any given nominal interest rate if if uh we expect a higher inflation that means a lower real interest rate okay so so for any given nominal interest rate if expected inflation goes up that&#39;s expansionary really for firms okay it&#39;s like it&#39;s cheaper in a sense to borrow okay conversely if x goes up the great spread goes up that&#39;s contractionary because it&#39;s now more expensive for the firms to borrow for any given real interest rate okay so we can we can this is called extended islm model simply because it has been extended to incorporate this these add additional factors and now you have two more parameters in your in your model which is expected inflation and the credit spreads okay so if you move either of these you&#39;re going to going to move your aggregate demand curve in the Goods Market no and it&#39;s going to move for exactly the same reasons that that aggregate demand move when you move the interest rate it enters symmetrically in this model these guys here enter completely symmetrically with then the interest rate so whatever was the comparative Statics you had with respect to the nominal interest rate before they appli to x minus Pi what I&#39;m trying to say is if I if you know how what is the change in equilibrium output as a response as a result of an increase in 100 basis points on the nominal interest rate then you know what is a response of equilibrium output to an increasing credit spreads of 100 basis points or to a reduction or or to a reduction in expected inflation of 100 basis points the entire symmetric okay because that&#39;s a that&#39;s a channel is the it&#39;s the real it&#39;s a cost of capital Channel you know for the firm that&#39;s they&#39;re all entering exactly through the same the same place but the but the the FED doesn&#39;t control this guy it controls only the nominal interest rate okay so anyways so these are new parameters here so this is an example here that&#39;s an example in which credit spreads or respected inflation went up sorry whether CR spreads went down or expected inflation went up up okay and that&#39;s expansionary that will increase aggregate demand because for any given level of output now there will be more investment okay cre spreads are lower or expected inflation is higher mean the real interest rate is lower for any given nominal interest rate so if the if if the FED doesn&#39;t react to that that&#39;s going to lead to an expansion in output of course the FED could react to that suppose the FED is okay with the level of output we have okay suppose it&#39;s a level of output and the F seeing credit spreads falling so output is expanding but the FED says no no no the level of output y z was what I needed I don&#39;t want y1 what would the FED do increase the interest rate exactly and it&#39;s very easy to see in this expression here that that if you don&#39;t want this guy the total sum to move then if this guy moves down or or this guy moves up then I need to move I exactly to offset that and that&#39;s it it&#39;s very easy to calculate I don&#39;t need to solve my whole model actually you know you tell me this thing in net went down by 100 basis points if I don&#39;t want to change output then I need to increase the interest rate by 100 basis points so I don&#39;t change the cost of borrowing the effective cost of borrowing for corporations okay in fact this is exactly what is going on right now in the US economy you know every time markets get very excited credit specs are compressed the stock market goes up the FED comes out and say come on guys I mean we have inflation problem I&#39;m going to need to keep hiking interest rates because I need to offset Your Enthusiasm they don&#39;t use those words but that&#39;s exactly what happened I mean chairman pow was testifying in Congress yesterday and today and that&#39;s what he said I me just giving you a summary of what he said okay now a problem that the Central Bank May face suppose you have the opposite situation is that one in which credit spreads are going up a lot and expected inflation is declining a lot and the FED doesn&#39;t want output to the client because that combination will lead to reduction in output so the FED wants to cut interest rate what problem may it face it&#39;s zero lower bound it may not be able to bring interest rate as much as because suppose that the the interest rate today is is a is a 50 basis point it&#39;s not the case today but it was two years ago 50 basis point 25 basis points and cre spreads go up by 200 basis points well there&#39;s no way the FED can upset that no because he has maximum 25 basis points to lower and cre the spread went up by 100 basis points and that&#39;s when you start seeing all these more exotic policies quantitive eing and other things to offset the negative impact of the of the increase in the greater spreads in the economy and the last thing we we did was to begin a a our transitions to medium run issues and and the whole thing began from the labor market now you&#39;re going to get a little bit in the quiz of that but it&#39;s not going to be as important as what I just described but a little bit you&#39;re going to have and the basic uh well definitions you should should know the basic definitions well this was the first a a important equation we have a a wage setting equation that says essentially that wages are increasing in expected prices obviously the nominal wage the workers are going to demand is going to be higher if they expect the price level to be higher in the future but important is decreasing in unemployment and increasing in this in this variable that represents sort of their bargaining power and so on H then we look at what happened on the on the product on the price setting side meaning what firms do and for that we had to start with the production function we had a very simple production function which said if you want to produce one more unit of the good you need to have one more worker that means that the marginal cost of production is the wage so it&#39;s very simple and then we said we&#39;re going to have a very simple model in which the the firms charge their marginal cost which is the wage times a marup 1 plus M so m is a number like say2 okay so if the wage is 100 the markup is 20% they want the price of they&#39;re want to charge a price of 120 we can rearrange this in terms of wages and you can say well the firm the maximum real wage that firms collectively are willing to pay is really one over one plus the market okay that&#39;s just from that so then we look at a concept that that is important which is the natural rate of unemployment and we said the natural rate of unemployment has nothing of natural it just means that is the level of unemployment when the price is equal to expected price or expected price equal to the price you pick okay so all that we did was to replacing the weight setting equation the expected price for the actual price and then we divided both sides and now we have this real wage Demand by by workers when the price is equal to expected price and we also had a price set in equation we can and I said when we replace P for p then I get the right to put an n superscript n there that&#39;s the natural rate of unemployment because that&#39;s my definition of the natural rate ofemployment what happens when I can replace in the weight setting equation H the the expected price for the price and we look at the at the natural rate of unemployment what is equilibrium here of the price setting equation has an imply real wage of 1 over 1 plus M and that&#39;s a wage setting equation which is obviously decreasing unemployment because the higher is unemployment the lower the wage Demand by the workers okay and that&#39;s one natural rate of unemployment again nothing natural is a function of parameters which parameters well it&#39;s a function of that markup parameter it&#39;s a function of this institutional variable Z for example okay so that&#39;s in equations that&#39;s an example in which Z goes up so suppose that somehow you know unions go up or something like unionization goes up something of that kind or an employment benefits go up something of that kind which in in principle is supportive of workers well in this model that will immediately lead to an increasing wage demand for at this level of unemployment there going to be a a higher demand higher real wage Demand by the workers because they have more bargaining power now in this particular model that that cannot happen because the real wage that firms can are willing to pay is only this one one plus M so in order to restore equilibrium in the in the labor market what has to happen is unemployment natural rate of unemployment will go up and and that that will restore equilibrium here because well workers the the the bargaining power workers gain through those benefits in Z they end up losing by an increas in the equilibrium level of unemployment okay so that&#39;s the reason hear this stuff backfiring as to the workers because you know you end up with higher natural rate of unemployment so Europe for example has much higher labor protection than the US well they typically have a much higher unemployment rate than the US okay so that tradeoffs all these things that&#39;s a case of increaseing the markup and increasing the markup means effectively that the firms are going offering a lower real wage well at this level of unemployment workers are not going to take that lower real wage so what will have to happen for workers to take that low lower real wage is for unemployment to rise okay so those are the two canonical experiments you can have here it&#39;s what happens when markets go up and that can go they can go up for for the wrong reason it could be for oil shocks and stuff like that it could be because the market becomes less competitive allistic firms and so on but the final outcome here is that we end up with a higher natural rate of unemployment which again highlights the idea that this is not a g given unemployment rate so it&#39;s not it&#39;s not good in any sense it&#39;s it&#39;s just whatever it is the equilibri okay uh anyway so you should understand well what these two type of shocks do to the natur rate of unemployment I think that&#39;s because then lecture nine is not for this this quiz that&#39;s all I want to say any any questions no y this I think so I think is that the same a as next to the yeah this is the C you you want me to explain this this this yeah yeah it is a CR spread I said that&#39;s the way you calculate this CR spread here it&#39;s um remember there are two reasons why why um do you really want to know in anyway let me let me say so there are two reasons why the credit Express really happen one is the actual probability of the fault of a bond which the treasury has a very low priority def fall corporations depending on the ratings they may have higher or lower and the other one which is very significant is how risk averse investors are and that risk aversion changes a lot over the business cycle H we capture everything through just that X spread which we we capture it through this probability of theault but you can think that prity of the fault as being the perceived priority of the fault and when you&#39;re very scared you perceive that terrible things can happen so so it&#39;s a subjective priority of the fault so when that priority of the fault is different from zero then you start getting a positive spread how impactful is the actual def I know there were some recent defaults in at least the European like real estate markets yeah um like how I guess is there a difference between like a fear of a default and like an actual implications as oh this is all about perceived risk so it&#39;s because this is this determines the the borrowing that firms can do the cost for firms of borrowing if you already defaulted you cannot borrow so that&#39;s that&#39;s over that that has other consequences it may have impact on the balance sheet of the banks it&#39;s destruction of wealth it may lead to other problems but the problem we&#39;re highlighting here in this model is the cost of borrowing and that is something that happens only before you default yeah I mean actual defaults especially typically in developers and stuff like that can and that&#39;s what happen in the Great Recession ER can have consequences especially for the banks that typically lend to this developers and so on but I I may do something about financial crisis but much later in the course at the end okay well good luck enjoy it if you understood what I said today you&#39;re you&#39;re in good shape for

Transcript for:Lecture on Measuring Aggregate Output and Introduction to IS-LM Model

Transcript for:
Lecture on Measuring Aggregate Output and Introduction to IS-LM Model