today we're going to talk about um perhaps the most important model in this class the ISL MPC model which puts together all that we have done up to now but before we do that uh let's talk a little bit about the current events uh who knows what that is is this a exam week or what Silicon Valley Bank exactly no so Silicon Valley Bank the 16th Bank in size asset size in the US ER went essentially under last Friday was shut down by the FD last last Friday so that's the decline in in the stock value uh during Thursday Friday and uh and then it was shut down and you see that it's not being traded anymore um so that's a pretty significant event and the the weekend was pretty stressful for anyone involved in in in this event the treasury the FDIC the Federal Reserve and so on um it's first it was a large I mean it's not one of the big systemic Banks if you will it's not JP Morgan City Bank of America one of those Banks which are regulated even differently from these Banks but still is a pretty large Bank you see by asset size $29 billion H which is you know comparable to Washington Mutual which was the largest bank that went under during the global financial crisis Great Recession at that time there were lots of other banks that went under H but the largest was comparable to this one and in fact all the things that were done over the weekend and that still being done today is to prevent something like this happening here as well okay and so it was a a pretty significant event now what happened to Silicon Valley Bank um well in the the immediate cause of of of of the failure is what always kills a bank which is a r by this depositors okay and what you see here is is the following this is this this Bank actually grew enormously over the last two three years essentially doubl its asset size um but it began to have sort of outflow net outflows of deposits during 2022 and the reason for that is not because the business was doing poorly anything it was simply because this is a bank that service primarily of the high the tech sector startups companies and things like that and those sectors were having hard time raising new capital in an environment that was not very friendly towards the tech sector so so so they began to withdraw on their deposits and and that's what led to these flows here now eventually ER because of this and and something I'll explain in a few minutes ER this the they decided svb Bank decided to issue new Equity ER issue new Equity to cover certain losses they had incurrent and today in the mod of social in the world of social media that immediately led to sort of massive spread that this bank was in trouble and then you saw enormous attempts to withdraw deposits now not all of these these were fulfilled but there was a massive pressure to withdraw deposits and and and and that's the end always for a bank that doesn't find an alternative source of funding and often for withdrawals of that size the only alternative source of funding is either that some other bank buys you or that the FED comes in and gives you a line anyway so what is the that was immediate and it's always whenever you ask you hear about the bank run the immediate cost of the problem is a run from of the depositors from deposits in that that bank now why did this happen in this in this particular bank again I explain why is that you saw those small withdrawals of deposits but but what happens to this to them is actually there as I said before their deposits grew very rapidly over the last two three years and then rather than being very risky lenders rather than investing you know sometimes when Banks grow very rapidly they do lots of crazy things you know they in they make lots of loans without going doing the D diligent process and all that that's not what they did they bought treasury bonds the safest as as you can imagine they bought 10 year treasury bonds lots of them but they bought them at the wrong time they bought them right before the hike in interest rates that we began to see in 2022 and we already looked at the relation between interest rates and price of bonds well you have a 10-year bond and the interest starts going up the price of that Bond starts declining now that is not is problematic for a bank but not entirely the end of the story because that means that the the the market value of the bonds you're holding among your assets starts declining but Banks do not need to recognize that loss unless they sell the bonds because the the the logic is that well if the guy just sits on the bond the bond hasn't really lost any value in the sense that it will get the same coupons that he was planning to get and so on this is us treasuries us treasuries are not going to default in the coupons let's hope it's not going to happen in a few months from now but but typically they don't default on coupons so so the logic the regul regulation is assigned in such a way perhaps is a failure I think there is a problem there but that they don't need to recognize the losses unless they sell the bonds so they look pretty healthy because they had massive amount of Treasury bonds they did not need to recognize that problem is that when this small W relatively small withdrawals start at some point they needed to find a substitute for those funds they need to honor the deposits that that were being withdrawn and at that point they had to sell assets and when they sold assets they made the loss because at that point you have to recognize the loss because you're not going to hold the the bond until expiration and clip all the coupons that come from it so you have to recognize the loss that's a loss that led the CEO to announce that they needed a fundraising to cover a $2.5 billion hold they had as a result of the losses okay now okay so now we have a we know why where the losses came from now if you notice the losses are not that big I mean this is a bank with $200 billion and and the losses were relatively small where is the other leg of the problem it's here you know in in the US deposits are ured up to $250,000 that means no matter what happens to the bank where you have the money if that bank goes under and you have deposits for below $250,000 the FDIC comes and gives you a check okay so there's no risk so if you have deposit under $250,000 you don't need to worry about this you may go you don't need to read the news about this bank because you will get your funds in fact when when the bank was shut down on Friday the FDIC announc immediately every depositor under $250,000 can come on Monday and get his money okay so there's no issue there and most banks have a large share of depositors that are small depositor that means they are covered by this Deposit Insurance mechanism which was designed precisely to prevent runs because if you don't need to worry about where you get your money know you don't need to run on the bank the problem is that this bank was very different in the composition of depositors he had primarily business deposits meaning it was all these startup companies and so on in the tech sector they had their their deposits there and those deposits were much larger than $250,000 if you see it's about I think it's close to 95% of the deposits were not covered by the insurance by the fdac insurance okay that means it's a very different calculation when you have a deposit that's not covered by insurance and then you start feeling that the bank Mak may go under what do you do you take your money out you know put it some you send it to JP Morgan where there's no risk and wait until this thing is resolved now in this case and that's what typically happens in this case it happens even faster than normally why because many of the depositors the business that were deposited in there were were a startups that were being seeded by some Venture Capital funds and Venture Capital funds as soon as they noticed that there was a problem here began to call all the startups and tell him hey take that money out of there because you know they may run into travel so it was a venture capital world that caused the Run effectively and and and and and that's what happened okay now so that's that's what happened that's the reason for the run and and and the and so there was a a problem the problem was not that big but but the problem is that the deposits were very un safe they were not covered and moving deposits out is very easy I mean you just you know you just wire your money to another bank so so so why wait there why risk it and that's that's what happened it's called in economics coordination failure when I mean if everyone freezes and say okay nobody takes the money out and so on this stuff is when I pass then we're safe but but but since we don't call each other and we don't trust each other to really leave the money there we we we we make the call only after we have taken our money out and since we all think the same way then you get a run on the bank now let me start connecting this a little bit with uh with the kind of things we have done in in this course I I I I may actually discuss runs later in the course as a as a as a topic crisis speculative attacks and things like that but for now here what you have is an indicator of essentially is this is the vix a is a is an indicator of Supply volatility something is extracted from the price of options you don't need to know the details but the point is that that is one of the main indicators of of fear of of how afraid are investors in a moment in the market and and uh and what you can see here is that that this indicator the vixs essentially Spike Thursday and and Thursday and Friday went up Friday went up very very rapidly and then it got stabilized a little now ER it turned out that it turns out that over the weekend ER H you may have heard the government the Consolidated Government came up with a very massive package to to prevent runs on the remaining Banks and and also to prevent the fact that I mean all of these were business deposits of a small companies that used even this bank for the payroll and so on so so what was done of this weakness that all the deposit not only the ones under $250,000 were guarantee by the FDIC there are mechanism under which you can activate that so that means now all the depositors were made whole and but the idea was not it was part partly the reason to do that it was to prevent a mess in the pay roles of the small companies and all that that had their account in in in this bank but it was also to prevent on other Banks you know and uh and so on top of this the FED now has a line of credit ER for banks to not have to sell their assets for small Banks they can just pledge the assets to the central bank and get an exchange for that the cash they need okay and they can do that without recognizing the implicit loss so without marking to market the price of the bonds okay so how this mechanism existed before the pl of svb we would not have seen anything like that but the whole idea was to prevent that other Banks run into into that kind of trouble now the markets reacted well to all that overnight and so on but the vi kept going up this morning now it's coming down again I mean there's still a lot of stress and if you see the shares of First Republic Bank for example had declined by 60% today and things like that so so there's a still Panic going on okay and as a result of that ER all these indicators of stress sort of are very stressed out remember credit spreads I told you about that X that we had Le several lectures ago the probability of the fault of a bone the perceived probability of the fault all those things went up a lot I mean the Riser the bonds the closer you are to the financial system particular to small Banks the larger those spreads have become so X went up a lot this picture that comes next I find it very interesting from the point of view of this course what this is is the following this is the market expectation of the next hike by the fed the FED next announcement on policy rate happens on the 22nd March 22nd so remember what has been happening is that that that ER since the US has been running sort of very hot with lots of inflation interest rate were increased very rapidly at clips of 50 basis points a CLI that's very large changes in policy rate for a country as large as the US and and so we had this big 25 basis points increases and a few meetings ago they decided to lower the pace of the increases to 25 basis points rather than 50 Bas points per meeting okay so they said we're going to keep raising interest rate but we're going to go out to 25 basis points now it turns out so this is 25 basis points the data has becoming very hot remember we said inflation looked to have Peak and now it's beginning sort of to turn around again it's beginning to rise so what has been happening is that the market say Okay 25% basis point is the most likely next hike but you see the expectation of that is it was sort of a steady around 30 basis points some people expected some major players expected the FED to hike by 50 basis points not 25 basis points by early last week data came very hot so there was indication that clearly inflation was picking up again the labor market Market was very strong and so on so look what happened to the bets immediately expected value went up this is all traded it went up and and the expectation was for the next meeting was up north of of 40 basis points so essentially most of the market thought that the next hike would be 50 basis points okay but look what happened and then the problems of this with this Bank began and look how this pleted today is 15 basis point is expected value that means very few people are expecting 50 basis point A lot of people are thinking 25 still but about an equal size expecting zero so a POS in the interest rate hike by the FED okay and all that is a result of the events of the last two three days Y what is there to learn from this I guess in like the bigger structure or who's at fault is it the people who got really scared all these depositors that got potentially scared or or fearmonger in that capacity is it that the banks don't necessarily have I mean I can't feel like it's an unre there are many good questions and and and you're going to see a lot of that and politicians are going to talk a lot about that in the next few days and so on it's very clear that there was some sort of regulatory failure here the regulator it was pretty obvious that I mean this this bank had doubled the asset size in in in a year that's already a red flag and and these guys are regulated by the Fed so the the s Francisco fed should have been worried about this Bank ER there is issues conventional issues of diversification I mean it's pretty crazy to have all your savings in One Bank especially if you're not insure there is issues there's also remember after the global financial crisis there's there was a bill designed to legislation designed to strengthen the balance sheet of the banks it made them hold a lot more cas Capital they are subject see if they're systemic they are consider they're subject to stress test where sort of regulators go in there and check whether portfolios can survive major micros shcks and so on H and that's that's called The Dot Frank Bill okay so that was done in 2018 that got partially undone and partially andone precisely for these type of Banks and these guys were actually loving for that they said okay why don't you because to be sort of really stress test and so on by the regular you have to be big enough to really be able to live a a big mess and and and and so what these guys and and Banks like them did is they Lobby a lot so they got the the the threshold of asset that you need to have in order to be stress stress tested and so on raise dramatically so they were right below the level that you need to be really sort of monitored very very closely by the regulator by the by the FED if you're a systemic bank then the FED regulates you these guys were lightly regulated by the FED because they were below that threshold so there regulatory failures it's clear that the regulator fail what it did depositors didn't diversify enough ER they didn't diversify enough the bank itself didn't diversify enough the the source of funding I mean what is very special of this bank and that's what gives us hope that this stuff is not going to spread all around is that their funding was very sort of you know was all coming from the same sector large saver large depositors and so on the typical bank doesn't have that they have a much broader source of funding which is what you need because you know otherwise so so there are lots of lessons for Bankers for Regulators ER for microeconomist as well I mean to tell you the truth one of the concerns with with the pace at which the FED has been hik in interest rates is that people were wondering well do we we know whe something will break at some point and there was a lot of concern that something could break well something broke now and this broke entirely the part of the the loss comes entirely from interest rate highs essentially they got into a portfolio of long that was very long rat when rates began to rise so they they had losses entirely from that and that's a risk I mean when you do monetary policy is that some people will be stretch out there and and and if you sort of sometimes miss one that is important that that's very costly and I think was that's one of the reasons they wanted to lower the the interest R hikes from 50 basis points to 25 basis points because they knew that something could be fragile out there and and and this was one of those things so those are those are lessons now I was about to connect with the things we did in a few lectures ago I said look so this is telling you the markets when they saw this x going up and started betting that the that the FED will not hike interest rate as much and in fact that they may even pause rather than raise the interest rate as was planned they may even pause interest rates we talked about this lecture seven remember in lecture seven when we talk about the expanded islm model we had this x variable and we said look if x goes up that measure of riskiness and so on that increases the cost of borrowing for the private sector that is like a shift in the yes to the left for any given safe interest rate saved by the central bank now all of the sudden the cost of borrowing for companies is higher and therefore this is contractionary okay and then we went on remember we went on and said well here it is the question what should the Central Bank do in this case in which X went up that's was the next slide inide of fact you know lower the interest rate because there's one component of cost of borrowing that's going up for for ER for firms which is the X well the FED can offset that by lowering the interest rate now here they're not planning yet to lower the interest rate they were planning to raise interest and now they're slowing down that that's a bet so the market knows some basic and expanded islm model because that's that's what you know explains exactly what you should anticipate that that's what is likely to to happen anyways that's where we are at this moment any questions about this otherwise I'm going to move to the lecture really but I thought we had to talk about it well in anyways if it gets a lot Messier I'm hoping that it won but if it gets a lot Messier then we can another section at the end I can replace something for for something on banking crisis and something like that okay which is what I teach in one of my graduate courses so would be would be fine anyway so now what I want to do is start this islm PC model and sort of the number the name is not very creative it's pretty obvious what we're going to do here no is going to combine the aslm with with the Philips curve and what this this will do for us is it will allow us to think not only about the impact of a policy or a shock but also think about what happens over time with that shock okay ER not to the long run but we call this analysis sort of the short run which is what happens in the very few early weeks months and what happens in the medium run say a year a year and a half from now and so this model will allow us to put all of the together um so and But but so so so you don't get lost on this so the analysis of the short run essentially will remain unchanged it's is our islm mod it's just that give it a little time and you start seeing other certain effects get undone and some others get exacerbated and so on okay but but the short one is still islm is your basic mod but then we're going to see that things happen over time so remember the slm model was essentially this is equilibrium in the Goods Market and then we had an LM which said I equal to I bar no and so I'm going to replace the LM already inside this and I get my islm mod so for any given I bar I could solve out for equilibrium output now here I'm going to do I'm going to adopt the the the I didn't want to do it before but I think at this point is useful because of will simplify the diagrams when we draw them to really think of the FED as setting the real interest rate okay so I'm going to assume now and then I'm going to explain what happens when that's a bad assumption but but I'm going to assume for now that rather than the FED setting the nominal interest rate that the FED is set in the real interest rate okay so it's setting this and then we're going to talk about problems I mean in principle if the interest rate is not against the zero lower bound the FED can always do that say okay I'm going to give them them I'm going to give you the nominal interest rate that given this expected inflation gives me the real interest rate I want okay that's what the FED is really trying to do all the time the FED is not trying to figure out what is the equilibrium nominal interest rate he's always trying to figure out whether the real interest rate is at the right level or not for the economy now the tool they have is a nominal interest rate but they are thinking thinking always about the real interest rate and and and and sometimes there's a problem because it's a when you against a zero lower bound then you can't affect the real interest in the same way but but most of the time you can and so I'm going to think I'm going to rewrite the slm mo now but I'm going to call this our bar and the bar is there just to tell you remind you that there something that the FED is setting okay so that's our aslm remember the Philips curve part the Philips that was our Philips curve remember the last once we replace the natural rate of unemployment in there we had the inflation minus expected inflation was a decreasing function of the unemployment Gap okay so if unemployment was above the natural rate of unemployment inflation was lower than expected inflation and conversely if the unemployment rate was lower than the unemployment rate and I said one the situation of the US today is that everything seems to point towards toward a situation where U is below un that's the reason we're seeing sort of high inflation okay now what I'm going to do next is I'm going to go from an employment to Output so I can put you see I don't have an employment anywhere here I have output so what I want to do is play with the Philips curve and until I write it in the space of inflation and output not inflation and unemployment so I can put the two curves together that's what I want to remember I want to merge here the slm with the PC so I want to put them in the the same variable so remember we have operated with a very simple production function in which output is equal to employment remember that's what we assume employment we call it n well I can rewrite n employment as the labor force times one minus the unemployment rate that's employment okay so that's I can think of output as that similar I can define a what we call we don't call it natur output we call it potential output no and potential output is defined as as the output that you get when unemployment is at the natural rate of unemployment okay so that's a definition three lines the potential output is when when the output you get which in this with this production function is the employment you get when you're at the unemployment at the natural rate of unemployment and now I can construct the difference the minus that this is something we call the output Gap and you may hear typically when people talk about issues of monetary policy often is described in terms of this variable More Than This Gap say people talk about the output Gap if the output Gap is positive that means output is above the natural rate of out the potential output when the output Gap is negative output is below potential output so I can re write this you know this minus that is just that and now I can I can replace uus un n here for H minus Yus YN / L and I get the Philips curve now written in terms of the output Gap and inflation so this says when output is above potential output when the output Gap is positive then inflation exceed expected inflation conversely when output is below potential output then inflation is below expected inflation okay but the logic is exactly the same as the logic we had here why is that this happens well because when output is above the potential output that means also unemployment is lower than the natural rate of unemployment okay so that's a that's the logic any question about this no okay good so anyway so now we have a a Philips curve and our aslm model so so let's put them together and suppose for now and when last example when I carry around is that expected inflation is equal to lag inflation so this a case in which expected inflation is not well anchor and then we're want to talk about what happens when it's anchor and not anchor so suppose that that inflation is actually whatever is this year's inflation that's what you expect for next year okay so here I have an example in which here I'm plotting our islm now which I'm using remember the real interest right here here H and in this diagram down here I'm plotting the Philips curve okay so first thing let's look about this Philip SC why is that where sloping here is output so this this is a parameter Pi n so and and and this is the left hand side variable so it's obviously increasing in output why is that well because if output grows that means unemployment goes down that means wages go up prices go up and you get inflation that's a mechanism okay so in this particular example we have this is the real interest rate that the FED has set at this moment that's equilibrium output what I'm trying to tell you here is that nothing has change in the way you calculate equilibrium output you just use for that you only need the stop diagram in the short run I tell you what the real interest rate is set by the is which is a decision by the Fed then I know where my is is I can pin down output I don't need this diagram to really pin down equilibrium output okay nothing is different there but and this is an example in this particular case we have that inflation is rising here and the question is why so for this what I'm trying to say is that for this is which is a function of fiscal policy of how confident consumers are and stuff like that if the FED chooses this real interest rate we end up with this output but it turns out that this level of output is increasing inflation and the increase in inflation I can read here I see the change in inflation is positive here why is this happening um if you're changing the alpha that means you have a different level ofemployment which changes the um expected inflation R yeah well actually here I don't need to take take this diagram would have also work with expected inflation as a constant here I'm I'm more looking at what happens to inflation I'm saying if output is above the natural rate of output then inflation is above expected inflation but I can take expected inflation as a constant in fact here it is a constant because constant in the sense that is given at time T because it's a previous year's inflation but what is important is that you have too much aggregate demand this economy is running very hot if output is positive then that is going to lead to inflationary pressures in this particular model where expected inflation is equal to l inflation this is pretty bad because not only you get inflation above the target of the FED but inflation is rising over time so this is a case in which this Central Bank is setting the real interest rate too low okay now you may want Japan is doing a little bit of this but they have a reason is that they have had inflation so low that it makes sense for them to build a little a little inflation in the US it made less sense remember the US got into trouble because it was in a situation like this for a long period of time I mean the you the reason we have today 6% inflation well depends which indicator you use is because the US experience sort of a year with a situation like this a year and a half okay and that's what sometimes people said the Fed was behind the curve they they for for a variety of reasons one initially potential output the Cline because of all the covid related issues they expected that to recover quickly so they says well let it go because I'm not going to start moving my policy right around for something that will recover quickly as soon as Co is gone well it took longer to recover and then it came the sort of the Russian war shock and so on and so natural rate of unemployment moved to the left to start and second because of an enormous policy support primarily H and the fact that that houses were able to save a lot during it there was a lot of pent up demand then we had enormous aggregate demand when we came out of it and the real interestate that we had was just way too low for all that agregate demand and that low potential output so we were in a situation like this and inflation began to climb initially expected inflation was very well anchor and then we began to lose the anchor then we recover it and and now we're losing it again we shall see what happens after this current episode but that was exactly a situation of the US and of most economies around the world China is in a different story but in most economies around the world you certainly Europe all of them the UK Continental Europe and the UK Latin America when you look the situation was like that just real interest were way too low for a um um the natural rate the potential the level of the potential output we had at that time and so we got into situation like this okay so that's the short run in the short run if you have an interest rate that is very low I mean again in the short run you you know how to determine output given a real interest rate and then now you can say a little more say okay but that's going to put inflation it's going to cause inflationary pressures up or down depending on whether you are to the right or to the left of the natural rate of output that's a new twist about the short run that you know but now let's start moving over time so what happens over time well first let me Define something well potential output we know what it is but I'm going to define something which is called the natural rate of interest rate sometimes called the neutral interest rate sometimes called the weelian interest rate let me not get into that story but I'm going to Define implicitly the natural rate of interest rate or the neutral rate of interest or some people call it rst star you may have heard of RS star in the newspapers people talk about R star when they are talking about RAR they're talking about that okay is simply the interest rate that that makes the natur the potential output the equilibrium of the Goods Market okay so I'm solving implicitly I say I want to get as a result as an I want to get as a result of this equilibrium here H the natural rate of output what is the interest I need to pick so that's the case okay so I want to get the natural rate of output here the potential output I know that there is an interest rate real interest rate at which that holds no it's a matter looking for the interest rate that does that and in this particular diagram is this you see at this interest rate the ASI equilibrium output is exactly the natural rate of output okay so what I know is that eventually the economy will have to go there no eventually the economy will have to go there so how will this happen in practice the way we happen is okay this is the point we were at in the previous slide no so we were here well that's building in inflationary pressure what do you think will happen inflation start climbing who will react who is in charge not letting inflation get get carried away Central Bank know the Fed so what they'll start doing is hiking interest rate which is exactly what they have been doing no and as they hike interest rate you know they're going to keep they take they start increasing the real interest rate interest until they get to this point okay that's idea so the point is that in the medium run a a the real interest real variables determine real variables not monetary policy monetary policy has to follow whatever it is that the economy throws at them banks have to follow whatever is the real interest rate if they made a mistake and they set an real interest rate which is not consistent with a stable inflation they're going to learn about it and over time they're going to have to fix that and when will the problem go away only when H they they reach the natural rate of unemployment okay and so that's what will happen as the real interest start going up from here to there then you start seeing the change in inflation this particular mole ER um declining and declining and when you get to an natural rate of output at least you get a stable inflation is this adjustment clear okay good okay so that's what happened in the medium run so the medium run is described as moving from that point here the whole process of going back to a situation where we converge to the Natural rate of interest rate and therefore the natural rate of output and the natural rate of unemployment and all these kind of things okay so that's the short run is whatever his output is That's So slm the medium run is whatever the the natural rate tells you should be the natural rate of unemployment the natural rate of output and therefore the natural rate of interest rate or weelian interest rate or the neutral interest rate or our star that's all pinned down there in the in the in the medium run and the transition is obviously going from the short run like pure LS slm to the Natural rate type analysis okay now I assume here and that's related to your answer I assume here that expected inflation was an anchor that is that expected inflation was equal to l inflation that's I I told you before that's not what Central One banks want to be because that means that if you mess up inflation is high and and then in order to bring it down you also have to bring down expected inflation you need to cause a recession and you can see that here so suppose that the Central Bank starts with the level of inflation that it like suppose that this is the model so what I said before the expected inflation is equal to lag inflation suppose that the Central Bank starts at the level of inflation that it likes 2% in the US okay I suppose that for whatever reason whatever shock it finds itself with an interest rate that is too low a real interest rate is too low that means in inflation exceeds expected inflation which was 2% well by next year say this suppos this Gap is 2% well by next year the G inflation is 4% okay so if your inflation is 4% in fact in the US it got to be 9% if you are at 9% level of inflation and this is the model of expected for expected inflation you have then Houston you have a problem because it's not enough with raising interest rate up to this point suppose that the FED says wow I don't like 9% I'm going to go back to that that clearly tells me that my output is way above the natural rate of output I'm going to hike interest rate and somebody tells the fed this is your natural interest rate a very good research Department tells him look this is your natural interest hike it to there suppose the FED hikes the interest rate to that point what happens so the FED realized here this was going really wrong they end up with 9% inflation so but somebody tells him look this is your natural your neutral interest rate your R star bring it there and the FED immediately reacts and takes it there what happened is the Fed happy with the final outcome and supposed the res Department was really good so they got got it right so the r star was the right R star okay and the FED implemented that policy move interest rate suppose that the interest rate the real interest rate they had was minus 1% I'm telling you numbers that are not that different from what we had minus 1% and and and the research Department tells no your your RN is really 1% so they hike interest rate by 2% immediately and now what happens so I guess that question is a little bague but but I'm saying is the Central Bank happy now that it o I got we got the right natural rate neutral rate it's called neutral rate well I'm telling you I wouldn't be asking you if the Fed was happy after that so why do you think why why are they unhappy why is the Fed unhappy after that not unhappy with the policy but but but when I'm saying the adjustment is not completed at that point why and I'm trying to make the bigger point for why central banks are so eager to maintain credibility and not have this kind of model of expected inflation they want the markets to believe them that that they have a Target and that they're going to go to that Target and and that to set their expected inflation equal to that constant equal to a Target that's what they dream with because if they don't get that if they get this instead things are nasty and I'm trying to describe that Nas what what what is happening now so what happens here okay so so so we went here inflation got to be 9% and now the FED boom hike interest rate by 200 basis point it got to the Natural rate we're back at output equal to Natural rate of output what is happening to inflation here so now we're back at the natural what is happening to inflation well this diagram tells you something very specific it says it's not changing so now your inflation at least is not changing okay so that's good at least not Rising here it was Rising it's not changing but what is the problem inflation not changing when you're at 9% is not a good outcome for the FED want 2% not 9% okay so they when you have this modification you need to do more than that you know because you need to bring expected inflation down so you need to overshoot a Fed that finds itself with 9% inflation and has expected inflation and anchor needs to be inflation much lower so needs to raise interest in the short run much higher than the natural rate of interest rate so it gets negative inflation here so you can bring the 9% back to 2% no so I have to generate a minus 7% here and to generate a minus 7% here I need to bring output much below the natural rate of output I need to cause a big recession to do that and that's the reason the bank central banks don't want to be in this scenario because with this of inflation if expected inflation becomes an anchor then there's no way around that the FED will have to cause a big recession to get out of inflationary problem okay contrast that with a case in which the market the expected inflation is not equal to lag inflation but is equal to whatever the FED tells them is the long run average 2% so now suppose that therefore rather than having here Pi minus one I have that Target Pi Bar which is 2% so yeah we got to 9% but for the FED to go back to say the FED would say whoop I mess up you know clearly set a real interest that was way too low and so I end up with 9% inflation but if credibility is maintained and still people expect 2% in the medium run then that means that the FED doesn't need to cause a recession to bring inflation back to the normal level it just needs to bring output to a level equal to potential out so it just need to raise interest to RN to the Natural rate of the r star not to our Star Plus something in order to have this inflation in the short okay and we're there at this moment in the verge of these two worlds we have been alternating between the two worlds still more biased towards the good World in which really the FED doesn't need to cause a the need the FED needs to slow down the economy because it still need to bring out put down to YN but that's a small change in practice all these things are growing over time it just means that the economy grows at a lower pace for a few quarters okay but it's very different to have to bring temporarily output down here because for that you need to sort of bring the growth has to become negative for some period of time in order to bring inflation down good so big lessons from uh this part is that as I said before in the M run so so I haven't changed at I haven't changed any of the two models I told you what was the model of the short run the slm that's still true here I told you then what was the model of the natural rate of unemployment and all that and that there we didn't have any monetary policy or anything like that we we look at what happened in the labor market and we determin the natural rate of an employment and that was it okay so so the medium run here is when we are in that world which has nothing to do with monetary policy it has all to do with real variables okay what is a n what is a equilibrium long-ter real interest rate what is a natural rate of unemployment things of that kind um but monetary policy what does do is certainly determine in the short run equilibrium output and but in the medium run it's is determines what is the nominal interest rate equilibrium nominal interest rate and the level of inflation because the economy will have a real interest rate which is the rst star and RN the economy has RN but the fed and the FED will not get to pick what RN is the only thing that the FED will get to pick in the medium run is what is a nominal interest rate that is consistent with that RN because supposed the RN is say 2% if the if the economy ends up having 3% inflation on average that means that the nominal interest r rate for the long run is going to have to be 5% is instead that economy has 2% inflation average then that means that the the long run nominal interest rate will be 4% so monetary policy affects the nominal interest rate nominal variables in the M run but not the real variables the real variables are determined by the real sector and that's often refer as the neutrality of money in the medium run and the long run money tends to be neutral and that's that's what it means that real variables are determined by something entirely different but in the short run monetary policy is the main game game in town and in the medium run it's just about inflation it's not about real activity um Let me let me stop here