what he was say is he added two more parameters to look into when studying the aggregate output of short term. previously he taught that if interest rates go up, investment will go down which will lead to lower output. lets take the investment parameter alone (i-PI+X) this is the new parameters in the interest of investment, meaning if expected inflation which is PI rises it mean that (i-PI+X) will go down meaning more investment which lead to higher output which leads to the curve to move to the left. with X (Credit Spread) it is the opposite if X is lower it will happen the same thing as Pi higher. he was correlating this with the great recession what we usually see in the great recession is that expected inflation tend to be very low and even negative and credit spread is very high. so what you will likely see is real interest rate bigger that nominal interest rate and credit spread at the 10 and 20%. also he mentioned that what usually the FEDs do in such conditions, they start lower their interest rates and usually it leads to liquidity trap and they start intervein in the more unconventional way.
So a rise in the risk premium implies a higher expected rate of inflation? Why would investments go down if expected inflation is high, wouldn't they want to protect their buying power by investing?
My apologies, this is my understanding so far: Suppose risk premium rises, this implies higher expected inflation, this implies higher nominal interest rates, and this causes investment to go down. Is this correct?
@@Clorxo Well, the risk premium can imply many things. It may be company specific, that the market thinks a specific company has a higher probability of default than other companies. Therefore, the market wants a higher risk premium (higher interest on their bond) in order to make the higher risk worth it. It could also mean that the market expects higher inflation in the future, but that's not a company specific risk premium. The nominal interest rate won't move because of the increase in risk premium, since the nominal interest rate is set by the FED, and not by the market participants. The real interest rate is what will increase, which is the difference between the nominal interest rate of the bonds and the price the market is willing to pay for the bonds. The real interest rate is the nominal interest rate minus the expected inflation. It is not that firms will stop investments because inflation and nominal interest rates go up, but if REAL interest rates go up, it essentially means that investments will be less attractive compared to earlier. Think of it like this: if nominal rates and expected inflation increase at the same pace, nothing really happens. The real rate will stay the same. If nominal rates increase, but expected inflation increases faster, the real rate will decrease, meaning it would be more attractive for companies to invest in expansion, because their future earnings (buying power) would increase at a faster rate than the interest rate they paid for borrowing. In that case your assumption is right, companies would like to invest in order to preserve their buying power. But, if nominal rates increase at the same time the expected inflation decreases, the real rate would increase, making their investments less attractive, resulting in less investments.
@@Clorxo actually these all things don't happen at a single time.. First the risk premium is higher because nobody wants to lend money... As the time passes on, more and more people try to experiment new things, and so they start to borrow money, and here the boom begins.. As more time goes on, more and more people join this force and by seeing the demand, the central bank infuses money, and due to the excessive supply of money, the money is available at cheaper rates, which in turn increases participation.. As more companies are formed, new products are introduced, and the aggregate demand of the older ones goes up..And here the inflation starts to rise..Due to th heavy supply of money, mis allocation of capital takes place, and when the inflation is very much gone up, then the cycle breaks, and the unnecessary investments start to roll down.. Now you cannot take more money, and keep investing in newer projects, because you have to generate revenue as well, which is pretty much reduced due to the lack of aggregate demand.. That's why it is not possible to keep the buying power at a static level..
Id say there's not a causal relation between risk premium and expected inflation Its just that in a recession(economic background) that both increase in risk premium and expected inflation may occur at the same time(stagflation i think its called?) So under this case the Fed would want to decrease expected inflation by persuading corporations to invest, thus boost investment, which also allows a hike in the nominal interest rate for more flexibility for the Fed in the future Some humble insights, hope that helps!
great lecture series. Thanks MIT
what he was say is he added two more parameters to look into when studying the aggregate output of short term. previously he taught that if interest rates go up, investment will go down which will lead to lower output. lets take the investment parameter alone (i-PI+X) this is the new parameters in the interest of investment, meaning if expected inflation which is PI rises it mean that (i-PI+X) will go down meaning more investment which lead to higher output which leads to the curve to move to the left. with X (Credit Spread) it is the opposite if X is lower it will happen the same thing as Pi higher. he was correlating this with the great recession what we usually see in the great recession is that expected inflation tend to be very low and even negative and credit spread is very high. so what you will likely see is real interest rate bigger that nominal interest rate and credit spread at the 10 and 20%. also he mentioned that what usually the FEDs do in such conditions, they start lower their interest rates and usually it leads to liquidity trap and they start intervein in the more unconventional way.
So a rise in the risk premium implies a higher expected rate of inflation? Why would investments go down if expected inflation is high, wouldn't they want to protect their buying power by investing?
My apologies, this is my understanding so far:
Suppose risk premium rises, this implies higher expected inflation, this implies higher nominal interest rates, and this causes investment to go down.
Is this correct?
@@Clorxo Well, the risk premium can imply many things. It may be company specific, that the market thinks a specific company has a higher probability of default than other companies. Therefore, the market wants a higher risk premium (higher interest on their bond) in order to make the higher risk worth it. It could also mean that the market expects higher inflation in the future, but that's not a company specific risk premium.
The nominal interest rate won't move because of the increase in risk premium, since the nominal interest rate is set by the FED, and not by the market participants. The real interest rate is what will increase, which is the difference between the nominal interest rate of the bonds and the price the market is willing to pay for the bonds. The real interest rate is the nominal interest rate minus the expected inflation.
It is not that firms will stop investments because inflation and nominal interest rates go up, but if REAL interest rates go up, it essentially means that investments will be less attractive compared to earlier. Think of it like this: if nominal rates and expected inflation increase at the same pace, nothing really happens. The real rate will stay the same. If nominal rates increase, but expected inflation increases faster, the real rate will decrease, meaning it would be more attractive for companies to invest in expansion, because their future earnings (buying power) would increase at a faster rate than the interest rate they paid for borrowing. In that case your assumption is right, companies would like to invest in order to preserve their buying power. But, if nominal rates increase at the same time the expected inflation decreases, the real rate would increase, making their investments less attractive, resulting in less investments.
@@Clorxo actually these all things don't happen at a single time..
First the risk premium is higher because nobody wants to lend money... As the time passes on, more and more people try to experiment new things, and so they start to borrow money, and here the boom begins.. As more time goes on, more and more people join this force and by seeing the demand, the central bank infuses money, and due to the excessive supply of money, the money is available at cheaper rates, which in turn increases participation..
As more companies are formed, new products are introduced, and the aggregate demand of the older ones goes up..And here the inflation starts to rise..Due to th heavy supply of money, mis allocation of capital takes place, and when the inflation is very much gone up, then the cycle breaks, and the unnecessary investments start to roll down..
Now you cannot take more money, and keep investing in newer projects, because you have to generate revenue as well, which is pretty much reduced due to the lack of aggregate demand..
That's why it is not possible to keep the buying power at a static level..
Id say there's not a causal relation between risk premium and expected inflation
Its just that in a recession(economic background) that both increase in risk premium and expected inflation may occur at the same time(stagflation i think its called?)
So under this case the Fed would want to decrease expected inflation by persuading corporations to invest, thus boost investment, which also allows a hike in the nominal interest rate for more flexibility for the Fed in the future
Some humble insights, hope that helps!