MACRO FINAL

What is M2?

(M1 +) • On-demand savings account • Short-maturity safe saving vehicles held by retail investors (CD's, MMF, ect)

What is M4?

(M3 +) • Very liquid and safe bonds

What is M1?

(MB is not included) - reserves are not a part of M1 - this matters a lot because there is a tendency to increase the amount of reserves (but that depends on how you define money) • Currency in circulation • On-demand deposits

The funcitional definition of money and the three uses

- Medium of exchange -Unit of account -Store of value

Assumptions of classical dichotomy and final equation

- v is fixed -classical dichotomy ◦ y(p) or (pi) = g(m) -g(y)

What is money today

-cash -IOUs from banks -money is the payment system

The Phillips curve equation

Inflation = expected inflation + demand pull + cost push ◦ Demand conditions ‣ Often called demand pull ‣ Do people like your stuff? Enough to spend more money on it? Bad demand conditions could made demand a negative number ◦ Supply conditions ‣ Often called cost push ‣ Cost structures. Are the price of your components changing • Ex: an oil shock if you are a driving service expected inflation is what the FED is most concerned with because it is a self fulfilling prophecy and really hard to change.

The actual definition of a recession?

NBER decides • A recession is significant decline in economic activity in economic activity spread across economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale retail sales

Structure of the short-run model

Nominal interest rate - MP curve Real interest rate - IS curve Short-run output - Phillips curve

The IS curve

The IS curve does not posit anything. Simply shows the negetive correlation between real interest rate and demand

Quantity theory of inflation

herefore, if your money supply grows as much as the real GDP, there should not be inflation. ‣ What is this missing? (More money does not always mean more inflation)

What happened to Bear Sterns

• BearSterns was saved from bankruptcy by JP Morgan ◦ This was shocking because BearSterns was a huge bank that people thought were strong ◦ What happened was extremely simple ‣ They had to repay losses and had no capital • Fed wanted to save BearSterns so asked JP Morgan to and JP Morgan was hesitant because they new BearSterns could be sneaky ◦ So, the Fed promised them a stop gap ‣ Said that they would make part of their losses whole if that did happen • Fed decided this was a lesser evil than the panic that would occur if the bank crashed ◦ Huge loss for BearSterns, especially the BearSterns employees that had their retirement funds invested in their bank ‣ This was awful because they correlated their investment rate and their savings rate • In hind sight ◦ JP Morgan did not like that deal ◦ They were not buying a house, they were buying a house on fire ◦ Even with the stop gap they were exposed to litigation costs • Policy implications ◦ Will be exceedingly difficult to get any bank to do anything for the treasury or the FED because JP Morgan didnt and it did not go well ◦ Other banks won't take the risk

Fiat Currency

• Currency that exists because someone said let there be currency and the central bank said that was good.

Discretionary vs automatic spending

• Discretionary spending ◦ Congress passes a bill that says spend X on a certain thing ◦ requires approval from the executive ◦ Decision being made • Autonomic spending ◦ Starts with the observation that transfer spending such as stimulus bills increase during a recession ◦ The rules don't change, but the number of people that qualify for government help increases ◦ This work to stabilize the economy and do not require government intervention ‣ Who has the largest automatic stabilizer: France, US, or China • France. They have shallower recession in the US • Welfare system pays out more • Argument that discretionary spending lags and automatic spending doesn't ◦ Argument is that the US needs more automatic stabilizers and less discretionary spending

What it means to be unemployment

• First element of being unemployed ◦ You don't have a job • Second element Have to be actively looking for a job • Available to take a job

Spending during COVID

• Gave stimulus to the individuals so that state regulators in irrelevant states would not have control • This was considered to have been a remarkable job. As opposed to giving to states and splitting equally.

What happens to IS aggregate demand shock

Curve shifts to the right

Okun's law

Cyclical unemployment Current rate of unemployment - natural rate of unemployment = -1/2 (short-run output)

Central Bank Digital Currency (CBDC) and downsides

Every individual has their money in the central bank ‣ This is the next big idea ‣ Note: This is NOT a cryptocurrency ‣ Should central banks offer households direct access to a digital currency • It makes sense logically. Upsides? ◦ This gives you way more control of crime currency ◦ Cash gives aninimity ‣ Downsides? • Not totally safe from foreign manipulation • If the government takes a strong dislike of you, they have the power to manipulate your money. We cannot be sure that we will not have a particular undemocratic government in our lifetime ◦ That is way countries under dictatorships like CBDC

Causality of IS curve

R is exogenous and Y is endogenous

Fiscal policy

When the government purposefully increases G or C indirectly • therefore, there will be high tax today o thigh tax tomorrow ◦ you have to repay the increased spending at some point • How big will the impact on the IS curve be if you decide on a massive increase on government purchases paid for by taxes. ◦ These two things cancel out. Government purchases go up and private consumption goes down ◦ The effect will be very modest at best ‣ You want to spend the money today and tax it later when the recession is over • Then, you do get a shift in the IS curve. • For every dollar of increased government spending, the effect on the IS curve is roughly 75%

American Recovery and Reinvestment Act

• In the middle of the Great Recession, they needed to convince congress to vote for a certain bill ◦ Trying to convince congress that without the stimulus unemployment would eventually resolve, but both the pessimistic and optimistic perspectives say that it will resolve faster with stimulus ‣ After the stimulus bill, unemployment increased. Why? • Fox News argument: you made it worse by intervening in the free market • Other argument: you have no idea how bad this would be without the stimulus bill ◦ We don't know which story is true. But both make sense. There is not enough data to tell them apart ◦ But, you do want to know who is right to prepare for the next recession

Recessions exogenous variables

• Inflation • demand shocks • Interest rate changes • Fiscal policy

behavior of inflation around recessions

• Inflation peaks at the start of the recession and falls drastically during the recession ◦ A boom tends to increase inflation ◦ A recession seems to decrease inflation • This is called the Phillips curve ◦ A positive relationship between the change in flatiron and the short-run output ‣ More common variant: relationship between inflation and unemployment

The quantity theory of money before assumptions

• M x V = P (price level) x Y (real GDP) • Is this an economic model ◦ No, this is just a counting identity ◦ Expressing the same idea twice

Are politicians credible

• No. Their goal is to get re-elected • They see inflation as a fair trade-off to get re-elected • The trade off for the politician is worth it if you are willing to believe inflation is low

Collateral Debt Obligations

• Now they are a lot more risky than people thought • Capital has a lot less worth than we thought • Risk turns out to be a lot more substantial • banks have to come through on their promises to hedge funds • They have to take the SPVs back on their balance sheet including losses • But now, their capital is non-existent and their capital cannot take the hits ◦ Financial institutions start to realize they don't know how exposed other financial institutions are ‣ You can tell nothing by looking at balance sheets because you don't really know where their losses come from • So, financial institutions becomes very suspicious of one another customer

What if politicians managed monetary policy

• One option: let politicians fly by sight ◦ Their job: drop interest rate when needed, but raise them if economy needs pick up ◦ A priori: politicians are more legitimate to make these trade-offs because they are elected ◦ But ‣ Will politicians raise interests rates in a boom as fast as they would lower them in a boom • Probably not because people see the boom as successful • And, they may create a boom before re-elections

Can the Federal Reserve set the interest rate

• One would think that only that federal funds rate can be moved (which is nominal) ◦ Remember the Fischer Equation and the Quantity Equation ‣ Cheaper federal funds leads to more loans leads to more money in the economy leads to more inflation leads to banks raise nominal rates to protect real returns leads to real interest rates don't move leads to no action along IS ◦ So, it would seem that the FED is powerless ‣ Assumption: No! Sticky equation • Inflation does not pick up in the short-run when you increase the money supply ◦ Quantity theory is not operation in the short run ◦ Inflation takes time to pick up ◦ Cheaper federal funds lead to more loans lead to more money in the economy (does not) lead to more inflation so banks (do not) lower nominal interest rates so real interest rates (do not) move down so there is movement down along the IS curve • This is what the MP curve says. Therefore, the fed can set the real rate to where it wants it to be ◦ If the federal reserve feels like increases real rates it can do so which would move the economy into a recession

natural rate of unemployment

• Rate of unemployment that prevails in the long-run ◦ Structural + Frictional

Three types of unemployment

• Structural unemployment ◦ Level of unemployment that is due to the structures of the economy ◦ Different structures cause different countries to have different unemployment rates • Frictional unemployment ◦ Why is unemployment never zero even in a high functioning economy ‣ Takes time and energy for employers to meet employees ‣ You need to look for an engineer • Even if there are unemployed engineers, you need to find them and they need to find you • Cyclical unemployment ◦ The difference between current/observed unemployment and the natural rate (as explained below) ◦ Think a recession - leads to cyclical unemployment

Example of monetary policy: the end of the housing bubble

• Suppose housing prices have been rising and then fall sharply ◦ The aggregate demand parameter declines. Why? ‣ Aggregate demand parameter is ‣ Y = a -b(R-r) • a ‣ This happens because when a goes down there is a decrease in consumption • Those who are hit by the bubble and those who fear what is happening to others in the economy ◦ this is a shift in the IS curve to the left • What could the central bank do? ◦ Lower the nominal rate ◦ If judged correctly and without like, the economy can avoid a decline in output and therefore a recession ◦ BUT, these are big IFs

The cycle of a recession

• The cycle of the demand shock • People start saving money • Production goes down • People are fires • Wages go down • Causes mor fear • People save even more money ‣ therefore, in the long-run, supply creates demand, but in the short run, it is possible for an economy to underproduce

What do you want out of a model of recessions?

• The effect of shocks to demand ◦ The Solow Model doesn't • Allows us to study the effects of monetary policy ◦ The model must allow for the possibility to affect monetary policy such as fiscal policy and tax changes • Avoid unecessary aspects • Model must allow for meaningful trade offs ◦ can't just mismanage monetary policy because you end up with inflation

Why did the FED do this

• The taylor rule demonstrated that rates had been too low in previous years • Fed is not supposed to sustain an unsustainable housing boom, there are supposed to prevent inflation

Heuristic definition of a recession

• What definition do you get from looking at the graph ◦ Recessions seems to start when every the short-run GDP (output gap) becomes negative ◦ Seems to end when GDP starts increasing again ◦ We want to use the definitions of recessions as policy guides

The Volcker Disinflation

• What if one could "reset" inflationary expectations? ◦ If someone could announce inflation will be only 2%, then it will only be 2% ‣ But, he has no credibility ‣ As did the Fed at the end of the 1970s • What now? ◦ Only left with the choice of increasing interest rates to create a recession ◦ This recession will last only for as long as interest rates go up ◦ In this position, you want a steep increase in interest rate for extreme measures: you want people to believe you. ‣ This is what Volcker did • The faster you start it, the faster people believe you, the faster it will be over again ◦ This was timed really well with Ronald Reagens election ◦ recession stops when expectations are back in line • How long did the increase in credibility last? ◦ It has kept it by not mismanaging inflation since then

What happens during a big economic shock

• people are going to reduce their spending out of fear • now there is a demand shock • What do firms do? ◦ They are not going to produce for people who aren't buying ◦ So, we need to go back to the production function ◦ They will not purposefully decrease A or K because it is pointless ◦ So what they decrease is labor ‣ unemployment goes up ‣ Wage in the aggregate goes down ‣ So everyone is consuming less

What is M3?

‣ (M2 +) • Short maturity safe saving vehicles held by institutional investors (repo's, offshore dollars, institutional CD and MMF)

What will become of banks under CBDC

‣ Banks make money in two ways: • 1. Lending you money through giving out IOUs ◦ If the CBDC comes through, the definition of money changes to an IOU only through the central bank • 2. Make money through transactions ◦ This is being undone by fintec ‣ All of this is to say banks are in trouble • Banks are getting competition from all sides • Hard to see what banks could be doing 20 years from now that someone else could not be doing for cheaper • Even Venmo will become useless. The government has the power to make this happen if they decide that this is what they want to happen

Why the government hates bitcoin

‣ Because, the last thing that you want as a government is some uncontrolled and unmonitored payment system ‣ If you believe bitcoin will become parallel money you believe people will take over a payment system that is unsteady will succeed • And you have to believe that the government will let this happen

Bitcoin - What is it

‣ Bitcoin is blockchain (distributed ledger technology) - removes the need for trust

Can Politicians generate low inflation?

‣ Can politicians generate low inflation? • Phillips curve says output is zero when inflation is expected • There is a boom ◦ First thing that happens is that you move up the Phillips curve ◦ Politicians likely won't bring inflation down to what it should be. They would let it run its course or even fuel it ‣ so they would raise their expectations • Which shifts the IS curve up • This process continues until you have a nearly vertical Phillips curve ◦ At this point, any boom leads to a massive increase inflation

Car Insurance vs Flood insurance

‣ Car insurance • Imagine everyone has a $100 car and your car has a 1% chance of the car being a total loss • The premium is $1.50 • Would you buy the insurance? ◦ Yes. If you are risk averse you would buy it even if it is a little more than the expected loss ‣ most people are risk averse • Say there are 1M cars out there and everyone is insured through this insurance • How much premium will be collected ◦ 1.5M dollars • How much will the insurance company pay to people loosing their cars ◦ 1M dollars ‣ Changing everything: flood insurance • Everyone has a $100 house and these houses have a 1% chance of getting flooded • There is the same premium • So, the collected premium is 1.5M dollars • But, losses are different because if there is a flood, all the houses will need insurance ◦ If the flood doesn't happen you have no losses ◦ If the flood does happen you are out 100M ‣ here, you don't have close to enough money to pay your losses ◦ This flood insurer is a rip-off because they can't make good on their promise ‣ The fundamental difference is that car accidents are de-correlated • The cars average out to 1% breaking down • Floods are a correlated risk ‣ Reinsurers insure the insurers for if the food were to happen

The Classical Dichotomy

‣ Essentially saying inflation does nothing for the real side ‣ This is also known as monetary neutrality • money is neutral, it is just a unit of account • Money as a veil ‣ This is a theory for the long-run • And in the long run this is true. Why? ◦ If we could grow the real economy by just playing around with the price level we would do it - would lead to infinite growth ‣ Venezuela tried this and it failed ◦ So, it should obviously be true that the classical economy works in the long-run ◦ Long-term growth does not require the concept of money ‣ This is not true in the short-run

What is not inflation

‣ Gas prices • it is not a story about any specific good or service getting more expensive. It is about price level going up. ‣ Asset price increases • If all prices on the stock market go up, it is still not inflation • This is because inflation pertains to final goods and services ‣ Grade inflation • Everybody tends to get higher and higher grades • You are squeezing up to a fixed point (an A) • Relative ratio of prices doesn't change during inflation

How can you overcome the demand shock recession

‣ Goal is to increase the lost demand • Increase government spending • Increase interest rate to make spending less expensive

Government policies and short-run fluctuation

‣ Government purchases can be a source of short-run fluctuation • This has happened for real. In 1991 there was a minor recession because of a decrease in government spending on military material ◦ This can also work the other way around by increasing government spending ◦ But, not all government policies effect change ‣ Needs to effect government purchases

The global savings cut

‣ Gut - "excess" ‣ The United States had an access of savings with desire to invest • Where did that money come from? ◦ Everything moved to the US for investment purposes ‣ Higher investment demand contributed to higher availability of mortgages

Does it work for politicians to manage recessions?

‣ No. Why? • It is hard to tell when a shock happens in real time • Hard to tell the premise effects of a shock ◦ Don't know how big the recession is • Monetary policy is not immediately effective ◦ Overall ‣ The central bank is going to get it wrong too late

How to define price level

‣ How the cost changes in a representative basket of goods • That basket of goods would include things like 1/7 of a washing machine because the average household buys a new washing machine every 7 years ◦ This is obviously flawed ‣ Everything that is bought in the economy compared to all households equally • Representative households represent all households equally so that consumption pattern does not really represent any given household ‣ We look at a basket of good and how much it costs • Then we look at the same basket of goods and how much it costs a month later ◦ How do you measure those price changes? ‣ Go to shops and use scanner data ‣ Have to make sure the goods are uniform • Formula is just (P(t+1) - P(t))/P(t)

Bitcoin - 51% hack

‣ If you have 51% of computing power, you can update bitcoin in whatever way you see fit ‣ You would need to give yourself a believable amount of bitcoin ‣ But, it is nearly impossible to accomplish this

Employment fluctuations

‣ In normal times the economy grows and the population grows so the labor force also grows. ‣ In recession times, the number of employees goes down ‣ This graph stops at the beginning of the pandemic • At the beginning of the pandemic, the graph drops so much that it needed to be completely rescaled • We don't even know how to begin to handle this unemployment

The housing boom

‣ In real terms, housing market doubled in the US between 2000 and 2007 ‣ This indicates a 10% growth rate • Some states like florida had housing prices triple ‣ Why did this happen? • Not a demand side story of people all deciding to move to Miami • So, more money available

Purpose of Monetary Policy

‣ Increasing the amount of spending in the economy ‣ They have to encourage banks to loan money ‣ So what do they do? • They make reserves cheaper ◦ That way banks will worry less about loans draining their reserve s ‣ But still won't lend to people who will not pay back because that still drains their capital

Is Bitcoin a good source of money

‣ Is it a good store of value? • Probably not. I would not put all my retirement money in bitcoin ‣ It is a good unit of account? • No. The bitcoin only has value because you express it in dollars. ‣ Is it a good means of payment. • No. It is not used very frequently and people do not use it to buy things that we are proud of. Also, we don't know if they next person will accept it.

Bitcoin - Why is the system appealing

‣ It is completely decentralized ‣ Updating is done out of pure self interest Great if you dont trust the CB

Why the rich win inflation?

‣ Large surprise inflations can lead to large redistributions of wealth ‣ Who wins? • People with nominal debt ◦ Goods and services cost of debt goes down • Who are the nominal debters vs the real debters ◦ Mortgages are nominal debt ◦ Credit card debt is probably real ◦ So who gets hit the hardest? ‣ People on the poor end of the wealth distrubution ‣ What about assets? • You want real assets (inflation indexed) ◦ For example, stocks ◦ your house ‣ What if your savings are cash • This is really bad for you • Again, this will affect poor people more than rich • if you are a renter, your cost for living also goes up with inflation probably at a better rate than your minimum wage job ‣ In the simplest terms, inflation sends the wealth of the poor to the reach • Making it worse ◦ Taxes are based on nominal income ◦ If an investment does work, you pay for it on nominal taxes ‣ If there is inflation, taxes go up even more ‣ Meaning, some investment projects will not be profitable even if they are successful with inflation • Inflation distorts relative prices ◦ Prices compared to what they should be in the long run go out of wack ‣ Why is this a problem? • Because prices are the mechanism of the economy • If prices are out of wack, you don't know what to produce as a producer

What happened next

‣ Many subprime borrowers were now facing mortgages that were increasing from their initial teaser rates • By august 1007 nearly 16% of subprime mortgages with adjustable rates were in default • You want to sell the house but you can't sell it for as much as you want ‣ Then things get worse • The bank takes your house when you are in default and sells it • If all the banks take the houses and sell them at the market at the same time, housing prices will go down • Now more people who were counting on increased housing prices are screwed • The more houses you sell off because of default, the more housing prices decrease and the more houses you need to end up selling ◦ Now you are in a downward spiral of the housing market ◦ Also, people will not want to buy houses in this market ‣ Therefore, supply is exploding and demand is plummeting

How C, I, and g chananged

‣ Massive losses of paper wealth • People started saving more in the US ‣ increase in cost of credit for non-financial firms • Firms invest less ‣ Government (at all levels) looses revenue and costs increase • gov spends less ‣ Guess what happened to C + I + G • It goes down ◦ Oil Prices ‣ To matters worse, oil prices were extremely volatile in this period

Where does new bitcoin come from

‣ Mining ‣ This amount decreases over time. Eventually the amount of bitcoin will remain consistent

What is the creation of money

‣ More money is more IOUs ‣ In the aggregate, banks have to increase the amount that the owe their deposit holders. ‣ How do you do that? • Wrong answer ◦ Savings (It is just money you are not transferring) • Right answer ◦ A new mortgage ‣ Alice takes out 100 dollar mortgage ‣ the bank has an asset of 100 ‣ She gets 100 • Where do those 100 dollars come from? ◦ It is created ◦ Banks can create IOUs at will ◦ A bank writes more IOU's without deposits going down elsewhere ◦ This is mostly done through debt creation ◦ Banks create more deposits in return for a promise to later payments (mortgage, consumer loan, credit card debt

Can the nominal rate be negative?

‣ No. If the central bank offered you owns at a negative rate, you would take out 1M loans and make money ‣ Any loan with negative interest rate is basically giving you money for free which clearly can't happen ‣ Same is true for the investment side • No bank would offer you a negative return on your savings because you would never do that ‣ The past shows that nominal rates can be zero for a very long time

Cardiac arrest of the financial system

‣ Not a clean bankruptcy that taught a lesson ‣ Suddenly, everyone realized that no one is safe • major funding issues for most banks (and other financial institutions) ‣ Certainties are all off the table • You don't know what risks banks are exposed to ◦ In crises times all you care about is the return of your money ‣ Now, people just buy treasuries because they won't get increased funds, but they know they will get some money back ◦ Everyone is worried about everyone ‣ became very expensive to borrow money as a bank ‣ Basically a bank run from other banks ‣ There is no FDIC, so the bank run really works ◦ More with cardiac arrest ‣ No one lends to anyone ‣ Massive flight to safety ‣ Everyone buys government bonds which are not profitable, but safe ‣ Many other markets are paralyzed

Things that you would think create money but don't

‣ Printing ‣ Increasing reserves to allow more lending (money multiplier does not exist) ‣ The fed used to buy a bunch of financial assets and pay for them with a bunch of new money • They don't do this anymore

Reasons for the great inflation of the 1970s

‣ Reason One: • OPEC- coordinated oil price increases ◦ This leads to a cost push ‣ Reason Two: • US monetary policy was too loose ◦ The conventional wisdom was that reducing inflation required permanent increase to unemployment ◦ In reality, disinflation requires only a temporary recession ‣ Reason three: • the Federal reserve thought they say a recession that was not there ◦ If people start expecting inflation, it will fulfill itself ◦ You can't let people expect ‣ Reason Four: • the federal reserve e did not have perfect information ◦ Thought the productivity slowdown was a recession ◦ It was actually a change in potential output ◦ The Fed lowered interest rates in response to what they perceived was a demand shock ‣ Which increases output above potential ‣ created an artificial boom

Proper definition of short-run

‣ So far, the long run • A guide to how the economy behaves on average ‣ By output, I actually mean potential output • The amount that the economy would produce if all inputs were utilized at their lon-run sustainable levels • Potential output - long run output • Average out the wiggles ◦ Output as we are observing it right now could deviate from expected output ‣ Such as a financial crises ◦ Should we care about short-run ‣ In the long run what matters are growth decisions, but not really about this ‣ We care about a recession tomorrow morning much more ‣ it is really hard to get a job in a recession • So, do not graduate in a recession

Quantative Easing

‣ The central bank buys bonds from bank A and bank B for resp. $100 and $150 • Note: these are bonds that the banks hold as assets 9i.e., investments), not debt they issue themselves ‣ The how • The central bank buys a good number of bonds from commercial banks • These are bonds that bank A and bank B were holding as assets • Bank A and bank B hold bonds. ◦ Bank A mighty sell a bond to the central bank ‣ This is known as an open market operation - it is done entirely voluntarily ‣ The central bank does this by credited bank a with the money they gave them for the bond ‣ This is really all QE is ‣ Why would they do this? • They do it to encourage lending • What if the interest rate on reserves is 0%? How can you stimulate lending ◦ You can't through conventional MP ◦ So, the best thing to do is make reserve money cheaper ◦ Now, you do QE. ◦ What will happen to bond prices? ‣ Bond prices will go up • Supply and demand 101 ◦ What will happen to interest rates? ‣ Interest rates go down ‣ This is the goal

Capital Requirement

‣ The legal obligation that a financial institution have certain ration of its assets funded by capital on its balance sheet • Loss-bearing capital • Banks have a strong incentive to have as little capital as possible ‣ Depending on how many assets you have and how risky they are, the regulator will tell you to meet specific capital requirements • More risks means more capital and more capital means less profits ‣ Therefore, banks will seek leverage • Banks have a very strong incentive to minimize the apparent size and apparent riskiness of their asset side • They do this in order to lessen their capital requirements ‣ do other financial institutions 9insurers, pension funds, ect) need capital/ • Yes.

Macroeconomic outcome of the recession

‣ The recession, starting in December 2007, was first visible in unemployment ‣ By 2009 • Output was 7 percent below potential • Unemployment peaked at 10% ‣ Febuary 2010 • 8.5 millions jobs lost ‣ Compared to an average recession, this is way worse • Average recession ◦ Investment takes the hit ◦ Spending doesn't go up, but it doesn't go down that much • This recession ◦ Complete crash of investment ◦ Consumption also goes down ◦ GDP goes down a lot through investment and consumption ‣ Government purchases go up ‣ Federal government decided to increase its purchases • They were trying to undue the recession

Other problems with bitcoin

‣ There is a hard learning curve. Your grandma does not know how to use bitcoin. ‣ We need a payment system that works for everyone. If you don't know how money works u need adult supervision for your life. ‣ Blockchain is really cool, but it does not solve a problem that we actually have.

Bitcoin - How does it work?

‣ What do you have when you have one bitcoin? • Ledger out there that says who owns every dollar or fraction of a dollar of bitcoin • This ledger is public ‣ You also have a private key • If you want to transfer one bitcoin to me you use the public and private key. • The use of both public and private is that it is very hard to encrypt but very easy to verify transaction • Private key used to encrypt.. public key used to decrypt ‣ Now the ledger is updated. Who does the updating? • Bitcoin mining means verifying other peoples transactions. You do this because the system will give you more bitcoins. • If i give myself 1,000,000 bitcoin, everyone else will catch this and the ledger only updates by consensus.

What happens when the central bank lowers the nominal rate?

‣ When the central bank lowers its own nominal rate, it makes money more available • What happens? ◦ This increases inflation ◦ Therefore, the real return rate of the bank decreases ◦ So, the bank has to increase its nominal rate to keep the real rate constant ◦ Does this cause movement along the IS curve ‣ No. This is a demonstration of monetary neutrality ‣ The struggle you are facing with moving the IS curve

The fiscal cause of inflation

‣ Why would the government allow for it to happen? • Hey don't central banks and the economy control their money better? ‣ If you are a government facing a spending bill, where do the dollars come from that you are going to spend? • Spending = Taxes (from the population) + changes in debt (borrowing) + changes in the money supply (printing more money yourself) • Example: ◦ You are Hugo Chavez ◦ Your tax income collapses for issues you did not anticipate ◦ This makes it challenging to borrow more money because people think you will not pay it back ◦ Now, you can either use your spending or increase your money supply ‣ The problem is you cannot afford to spend less ‣ So, politically your only option is to increase M

Can the real rate be negative

‣ Yes ‣ In the inflation rate is higher than the nominal rate ‣ This is happening rate now ‣ If you want the real rate to be higher than the nominal rate, you need deflation

Measuring Inflation

‣ You always use an annualized rate • What is that? ◦ Same as GDP thought process. If last month had been a whole year that prices would rise by 12% • You do this so that you can easily compare rates

NINJA loans

‣ You can get a loan without proof of income, job, or assets ‣ This is clearly very dangerous ‣ Income and assets were self-reported ‣ you pay the 1%, and then flip the house

What happens if inflation increases in the following cases? (Just read)

‣ You have a pension that is defined in nominal terms • You are unhappy because the purchasing power of your pension just went down ‣ A bank issues loans at a fixed nominal rate, but funds itself as a variable rate • Very unhappy because your assets time is fixed in nominal terms but your liability side becomes more expensive • So the difference between your assets and your liabilities becomes significant ‣ You have a variable rate (inflation index) mortgage • The money you have to pay on your mortgage may go up before your wage does • If this happens you have to pay more of your money than you anticipated and you might not be able to pay your mortgage ◦ This might happen because it is safer for banks so banks will charge less for a mortgage

How o you loose money on bitcoin

‣ You share your private key or you get hacked ‣ This is very worrying because it went wrong for bitcoin owners which are a part of the most sophisticated part of the population ‣ Imagine if everyone in society had it, this would cause major problems • It would be quite easily for the elderly who don't understand technology to be hacked

How it started to come crashing down

‣ between 2004 and 2006, the Fed raised its interest rate from 1.25 to 5.25 percent ‣ All those unsustainable mortgages went up ‣ Therefore, it is hard to find a buyer than is willing to pay 20% more than you did las year ‣ Harder and harder to find people who are willing to buy houses

Recessions endogenous variable

‣ endogenous variable? • Short-Run output (the output gap) ◦ The percentage deviation of actual output from its potential

What period defines recession

‣ two consecutive quarters of decline in real GDP • You still hear this sometimes • Not bad definition, but someone misses the point • The problem is GDP is very far below the output gap. • This definition DOES NOT include the graph to the side

Securitization

◦ Bank has a ton of mortgages on its balance sheet from sub-prime mortgages ‣ Therefore the regulators will say that they need a ton of capital ‣ So bank says: what if I sell of mortgages to someone else and get cash • This is called: Securitization ◦ what will regulator say about cash vs mortgages ‣ You need less capital because cash is more safe ◦ But, what about the bank that you sell your mortgage to ‣ Someone needs to put money into that bank so that they get the mortgage ‣ you basically hide your mortgages in an SPV ‣ Then you ask hedge funds to put cash into the SPV so that the mortgages hide there • SPVs do NOT have capital requirements • So, banks remain liable for the risk ‣ Then, if the mortgages go south, the hedge funds make no money • The bank says don't worry because the mortgages are covered by houses and housing prices go up • Not all of them will crash • Hedge funds then say to banks ◦ If you are sure the risks don't happen, why don't you guarantee our money back ◦ Banks agree ◦ As long as housing prices go up, this is maintainable ◦ But, this is a very fragile banking system

Best definition of inflation

◦ Best definition of inflation ‣ Reduction of the purchasing power of your money

Examples of IS shifts

◦ Changes in consumption relative to potential output ◦ Technological improvements that stimulate investment demand given the current interest rate ◦ Changes in government purchases relative to potential output ◦ Interactions between the domestic and foreign economies that affect exports and imports

Monetary financing

◦ Definition of Monetary Financing ‣ When central banks buy the government debt directly from the government ◦ How difficult is it to buy government debt ‣ Quite easy for the central bank ‣ Any central bank you can think of has probably done thing ◦ Imagine you are the government three months into the pandemic ‣ You just gave your stimulus bill ‣ This is all debt financed ‣ Where do you find the trillion dollars if you are the US government? • Markets. You sell a trillion dollars worth of bonds with the promise to pay them back ◦ The problem: there isn't even a trillion dollars in this market. ◦ If you force the market to provide it to you the market will have insane interest rates which doesn't work • So, they go to the central bank for this money. They are the only ones who can quickly create this liquidity ◦ That said. The bank does this as a last resort. ◦ Why can't the government do this at any time to control interest rates? ‣ New line of thought called MMT (modern monetary theory) says the bank should go to the central bank when interest rates are too high ‣ Other says that if you systematically use the central bank to buy debt whenever you don't like the interest rate it will cause inflation ◦ How does the central bank pay for it? ‣ Creates more reserves. Cost less ‣ What happens to bank reserves them? Not the monetary financing ◦ But, the central bank can't just pay for everything ‣ This would cause inflation

What is inflation?

◦ Inflation definition? ‣ In the simplest terms, it is when prices go up ‣ In more exact terms • The percentage change in an economy's overall price level

What happened to AIG

◦ It gets worse ‣ AIG - who had long-term life insurance assets sold insurances on mortgages ‣ You pay them a premium and if the mortgages don't pay, they will make you whole ‣ Assuming the mortgages are well diversified, this is not a real risk for AIG ‣ When the crises hit, everyone asked for the mortgage money on insurance • This is the flood insurance story ‣ If AIG goes bankrupt, half the baking system will follow ◦ Does the FED save AIG? ‣ Justice would say no, they deserve to go bankrupt ‣ But, the problem is, half the banking system relies on AIG ‣ So, they saved AIG for 150 billion dollars ‣ US FED became the owner of AIG

output gap equation

◦ Output is equal to the long-run trend plus short-run fluctuations ‣ Actual output = long-run trend + short-run fluctuations ◦ The short-run fluctuations of the percentage change of deviations from potential GDP ‣ The diffference in actual and potential output, expressed as a percentage of potential output ‣ Referred to as "detrended output", it "short run output", or "the output gap" ‣ ‣ gap out output compared to it's potential as a percentage

What people did

◦ People then think if housing prices are going up, they should buy a house just to sell it in a year and make a profit ‣ Banks became more and more creative in thinking they should flood their mortgages to more people • So they started looking for sub-prime loaners • For the people who don't qualify for prime ◦ It makes now sense lend to people that don't meet the exact requirement that was made in the 60s ◦ The problem? ‣ Banks went completely overboard ‣ they were essentially lending money to everyone including poor credit records ‣ Or people with really high debt to income ratios ◦ You plan to be out of loans by the time that the interest rate goes up ‣ So, people took out crazy loans ‣ Banks are basically giving out mortgages like candy

Say's law

◦ Supply creates its own demand More supply means more added value means more ability to consume No demand constraint on production

Causation of inflation

◦ Therefore, inflation is determined by the difference between the growth rate of the money supply 9g(m)) and the growth rate of real GDP (g(y))

Is Fiscal policy good or bad?

◦ This money is either being spent on growth or things that you will want to be spending your money on ◦ If you are going to renovate JFK airport, it makes sense to do it during a recession because you get additional effects on the IS curve ◦ This money is additional so the 75 cents is good

How to measure short-run output?

◦ This would not work completely because the margin of error might be bigger than what you are measuring ◦ It can be done if your solow model is extremely detailed and accurate ◦ This is what is often done • Method Two: Noticing the trend of GDP ◦ What you will notice are wiggles that are booms and recessions ◦ With your best fit line, you can't really see the booms and recessions ◦ How to improve this graph? ‣ Substract the green line from the blue line to just look at the wiggles • In other words, take the trend out to just look at the variations ◦ When you are above the line now you are producing above capacity ◦ When you are below you are producing below capacity

Conclusions of fiscal policy

◦ We should have infrastructure projects that are ready before the recession ◦ Wait for a recession to happen and then flip the switch ◦ You pre-vote and pre-fund are

the collapse of Lehman brothers and moral hazard

◦ What happened after the collapse of BearSterns ‣ Lehman Brothers crashed • another mind-blowing crash • They had heavy mortgage loss and could not raise more capital ◦ Capital is loss bearing, so no one wanted to buy capital knowing the bank would collapse • Now, the FED refuses guarentees, drawing a line in the sand ◦ Why did they do this? ‣ Trying to prevent moral hazard ‣ This lasted 36 hours • Barkley's wanted to buy Lehman Brothers and the British gov wouldnt let them • Lehman brothers filed for bankruptcy on Monday, September 15th, 2008

Shoe leather cost of inflation

◦ Your grandma gives you 1,000 dollars ◦ You don't know what to do with it right now ◦ If inflation is really high, you have lost a ton of money of purchasing power if you wait to spend the money on something ◦ You will therefore spend your time worrying about purchasing power ◦ This is a waste of time and efficiency ◦ This is a metaphor for the fact that inflation creates a cost for you that would not exist if it were not real

The Fischer Equation

◦ i = R + (pi) ‣ The nominal rate is equal to the real rate + inflation • The nominal rate is the rate that you control as the central bank • The real rate is the rate that you care about • The link between these two is inflation ◦ Explains monetary policy, investment behavior, and why inflation is such an important concept

What is money destruction

◦ money creation in reverse ‣ Decreasing the number of IOU's • Every single time you pay off a debt (including your credit card debt), you are technically destroying money • If you go to starbucks and pay for coffee, starbucks receives the IOU • At the end of the month, you pay this "debt" ‣ What if we all paid off our debts? • Forgetting about interest, all the money was created through debt • So, if you paid off all your debt, there would be no money ◦ But that would never happen

Real vs. Nominal Interest Rates

◦ while we know this in terms of GDP, the same is true for interest rates ‣ Real interest rates will be in goods ‣ Nominal interest rates will be in dollars • Banks always charge at a nominal rate • If I borrow $100 at 8%, the next year you have to pay $108 ‣ What makes interest rate high or low • 8% is a really high number • But, in the 1970s, inflation rate was really high so 8% seemed good • But why? ◦ If inflation is happening at a really high rate, their income will increase but their interest rate doesn't change ◦ This works because the amount that you agree to pay is in today dollars whereas the money you pay back is in your next year dollars ◦ So if you borrow $100 at 8% and next year inflation rate is 12%, you still just pay 108 ◦ The purchasing power of the 108 dollars is lower ‣ Therefore, the real interest rate is -4% ‣ This is the real inflation rate ◦ The nominal interest rate ‣ Is the official interest rate on a savings account, a loan, a bond • In very few cases do financial institutions use real interest rate ‣ It is paid in "current dollars" ‣ Not informative on the cost of a loan for true return of a financial investment ◦ the real interest rate ‣ Is expressed in a "constant dollars' - purchasing powers • Alternative view (expressed in goods) ‣ Representative of true cost or return in terms of the purchasing power of goods ◦ Rate of return on investment of a term is mainly in real terms ‣ All costs go up, but so does income