Okay, thanks a lot. It's a great honor to be here to honor you. I would like to resonate very much what President Mario Draghi said about your abilities and your interest, your curiosity in macro finance, in particular financial stability and our discussions we had over the years. I value them very much.

In particular, I remember when we once walked on the banks of the river Rhine and we talked about various things, in particular one particular issue, and it also showed you open-mindedness and your curiosity and intellectual exchange. I really value this and I hope we can stay in touch afterwards. What I want to talk today, I want to talk about financial frictions in macro models. I think that's one of the themes

Constantia was pushing very much so within the ECB and the ECB actually was doing a lot of progress in these dimensions. But I would like to go a little beyond that, also go into tokens and blockchains and inside money creation because once you think of financial frictions, money has a particular role and

then actually new forms of money might interplay with that. And so the talk will be in two parts. One is on the macro models and the second part will be on the models of money in the digital age and I will also touch upon some currency competition

which some things I'm recently interested in. But the first part is on macro models and essentially, I would like to say one aspect which came up before is a shift away from impulse response functions much more to a risk dynamics or resilience view of the macro economy. So additionally what we did in macro economics,

essentially we have a one-time shock and the one-time shock hits the economy like say here and then, you know, it propagates over time so it will last even though it's a one-time shock, it will last long and it might be amplified because it feeds back so it might be amplified much more today as well. So there's a persistent element to it and there's an amplification. The famous models,

Bernanke-Gertrach-Elichris, Kiyotaki-Muhr and so forth who have pushed this line. But importantly that they return to the steady state is actually deterministic. So once you have a shock, you for sure, everybody in the economy knows that you walk back. There's no uncertainty how long the recession will last and how risky it will be subsequently and that's essentially what was

the predominant view before the crisis. And with financial frictions, risk matters a lot because essentially finance is mostly about risk and the question is how to capture more risky, more rich environment which captures the

resiliency of the system and whether we drop off to a lower growth path or whether, you know, we return back to the existing growth path. So what the macro literature has done since the crisis is very much focused on nonlinearities saying, oh, there's not a linear effect. So it can be very different once you move further away from the steady state

so things amplify much more dramatically. And this, if you put it in a model even though the shock itself has no fat tails, so it's let's say a normally distributed shock, then the outcome in the economy has fat tails because nonlinearities translate a normal shock into a shock with fat tails and you get skewness of downside shocks

act very differently from upside shocks and with financial frictions that's very natural because a downside shock comes with capital constraints and other liquidity constraints which amplifies in downside but not might not amplify so much in the upside. So you get skewness in the macro dynamics. And what I would like to stress is this endogenous volatility dynamics.

So the volatility might change dramatically and this time varying. So it's not always the same. Suddenly volatility will go on a much more volatile environment and things move around. So what I've plotted here is just if you have a state variable, you have a drift which is given by this. So the state variable is essentially at the steady state at this point because the drift is zero.

So it doesn't, here the drift is negative so it drifts the system, drifts back and here the state, the drift is positive, it drifts to this and you end up in this stochastic steady state. But it's never the case that you're in this steady state because the system is constantly shocked and the volatility itself is also much higher.

So in this range the volatility is just given by the fundamental volatility but in that range below the steady state you have the total volatility because it's the fundamental volatility plus some amplification, some indulgence volatility which makes the total volatility much higher. So new macro will reflect all this stochastic volatility environments and make this a much richer environment.

And what does it mean to have this stochastic volatility? The precautionary motive plays a very important role because if the world becomes more uncertain people shift into different assets that behave differently, they're safe more and everything feeds back and makes the whole world and again more stochastic because that's essentially what this does.

And two paradoxes we essentially would like to emphasize and stress here is the volatility paradox. The volatility paradox says if the current volatility is very low, if you measured volatility is very low then the risk is building up in the background and be aware that's actually when the times are most risky. So that's essentially low measures of volatility is actually a danger rather than a sign of a great moderation.

And the second one is this paradox of prudence and I will come back to this. Essentially what's micro-prudent is not necessarily macro-prudent, it's most likely macro-imprudent. That's essentially very close to Keynes's paradox of thrift, just applied to the risk space rather than the consumption savings space.

So that's essentially what I wanted to stress. And the second component which essentially comes more from the finance literature which entered a macro, if you focus on traditional macro, if you saw how the asset prices, how they're affected, how long-term bond prices are affected,

they're most affected by changes in cash flows. If you change the interest rate, there will be less interest rates down the road. But the recent literature is actually shown that actually the stochastic discount factor matters much more. And the stochastic discount factor reflects risk premia. So essentially risk premia matter much more than news about the confidence and risk premia matter much more than the cash flow news itself.

And that's empirically well-documented in the failure of the expectation hypothesis. The expectation hypothesis essentially saying that future risk, future interest rate matter for understanding long-term bond prices but empirically what matters is much more the change in risk premia.

The same is true for the uncovered interest rate parity and other puzzles, empirical puzzles, which all point to a time varying risk premia as a key driver in the macro economy. Of course, it makes the whole modeling way more challenging because we have to go away from a stock and a flow analysis much more to a risk and a risk premium analysis.

And that's a much more difficult animal to handle, especially if it's moving around, if it's time varying. So that's essentially the shift in macro models away from stock flow to more risk perspective and a resilience perspective. Then I would like to go, once you go to this risk perspective, you say, oh, the markets are imperfect,

the financial markets are imperfect, and then the national role for money emerges. Okay, because you would like to hold some money because there's a risky world out there and hopefully money is less risky and people rush into money. Okay, so there's the traditional models, Alice Samuelson, the world G model, which is the traditional way to justify money.

But there's also money as a store of value, as a safe asset. We're in the Bewley model, you know, money essentially is the way to save in a safe form. And you have some idiosyncratic endowment shocks, you have some labor income, suddenly the unemployment uncertainty is much going up, then you would like to save more and then demand for money is going up.

I've worked with Uli Sanikov on a different type of model. There's also a desingratic risk, but the desingratic risk comes with investment. So physical capital investments have become much more risky in recessions. And then you would like to shift your portfolio more into less risky money rather than being invested in capital. So everybody shifts away from physical capital investments towards much less risky money investments.

And then there's of course money as a medium of exchange and money as a lower transaction cost. And that's essentially models of outside money where there's no big role for the financial sector. And of course, then what you want to do is you want to create a financial sector,

which should be core of any macro model, which creates this money inside money, not only the outside money, but also inside money. And banks play a particular role, not only a monitoring role, but also diversifying away some of this idiosyncratic risk you have in various models. And they can absorb and diversify away the idiosyncratic risk.

And if the banks are undercapitalized, they cannot do this job anymore. And they push the idiosyncratic risk back to the households. And that leads to even more money demand. Well, banks, they create some inside money. And the inside money, and I will come back to this, might be even better now than outside money as a medium of exchange. And we will come back in future types of money.

It might be that there might be new forms of money, whether banks or IT firms. Play a more important role. So let me just say to this second idea, essentially, that if you look back in history, we have different forms of money. This is a yap stone, which was the unit of account.

It's in fixed supply. It's hard to forge. And you can see one of these outside monies. It's a good unit of account, but it's not a good medium of exchange. You can try it and lift it and see whether you can pass it on to somebody else. So typically what you would like to have here is essentially pass on this medium of exchange to somebody else.

And if you can't pass it on, you derive claims from this thing. So if somebody comes along, I give you a token or a piece of paper, which gives you a claim on this type of stone. And then this piece of paper is traveling around when you make payments. And that's essentially creating inside money. And I will come back, new forms of money in form of tokens,

electronic tokens will do the same thing. Gold is the same thing. What's interesting is typically new forms of money, like Bitcoin and cryptocurrency are criticized for being a bad store of value and for being bad mediums of exchange because it can't handle the transaction volume, what Visa card and other electronic forms of money, inside money do.

But the same could have been said to gold. You know, in the olden days, whenever there was a new discovery of a new gold source, the value of gold changed dramatically, or whenever a new ship came from the new world to the old world, and suddenly gold supply tripled.

So you could have said the volatility was very high. So you could have criticized gold as a good source of outside money as well. And there's this famous paper by Tom Sargent and first of all, they're saying the big problem is small change. So the problem is essentially if you have gold coins, it's too valuable to pay little things. Okay. And that was a big problem. So it was not, gold itself was not an ideal way to do the role of medium exchange either.

So in a sense, there is, you know, for different forms of outside money, like gap stones or gold are not the ideal form either. And this is a way we should see in the context of new cryptocurrencies and how this, the things will play out.

So essentially, we will always end up most likely with a two-tier financial system with fractional reserve banking. And as was mentioned before, in Switzerland, which will be voted upon on June 10th, is along this line to get rid of this fractional reserve banking.

So you will have an anchor currency, this gold or the Yapstone, which will serve as a unit of account. And you will have some currency, which is essentially not a claim to anybody. But then you have deposits, which essentially is inside the money on these anchor currencies. And that serves mostly as a medium of exchange. And then you have credit and you have this triangle here,

where the anchor is typically a very small supply, but then the credit is expanding and the triangle is expanding essentially at the bottom, up and down. And, you know, the banking of this initial anchor could be commodity like gold, it could be less liquid credit claims, or it could be just data.

So it might be just some data control by certain IT firms. So let me go back to this two-tier financial system and emphasize. This is from my work with Unisanykov, essentially how such a fractional reserve banking system is prone to things we have seen

and Victor has experienced during the crisis. So you have essentially banks which have some risky claims, let's say some credit and loans to one sector in particular, and this sector is also holding some money and the bank is issuing inside money. There will be some outside money, let's say in form of reserves, which is held by the banking sector.

And let's see what happens if you have a negative shock to one sector in the economy for which the banking sector is very exposed to. So it could be some housing sector, whatever sector it is. And let's dissect the whole shock, the implications of the shock into four steps. So the first step essentially is that,

you know, there will be some losses in the assets, but because the banks have exposure to this sector, the banks will suffer too. And of course, they can diversify across these sectors. So there will be some average or some assets will lose more, others will lose less and the banks diversify across this. But there will be an overall loss

if it's a sector-wide shock or a macroeconomy-wide shock, the banks will suffer and their net worth is going down. And if these risky claims go down by 5% because of leverage, the net worth will go down by much more than 5% by 40%. And this way, after that loss, the banks will be way more levered than they are before.

And what is the microbrudent response to that? The microbrudent response to this is to shrink a balance sheet, okay? So that's what triggers the whole thing. Now, if you can just say, let's stop here and the banks keep on doing and diversify all these idiosyncratic risks from this sector away, things will be fine.

But now they shrink the balance sheets and at the lever. So essentially, they extend less credit to this and this extending less credit means this sector has to shrink the balance sheets too and they have to fire sell some of the assets. And this fire selling of these assets will actually lead to this liquidity spirals

and depressed the asset price even further, which lowers the assets value of this sector as well, lowers the risky claims, which hurts the banks again. So if there would be a one monopolistic bank, it wouldn't do that. But if they're competing banks, they don't internalize this fire sell externalities and that's why it translates into more losses

for the other banks. And that's where this paradox of prudence comes in. So if you think of every bank on its own is acting microbrudent, you say, oh, after the shock, I was way more levered, I have to bring back my leverage ratio again. And that's actually a prudent thing to do. But by doing this, you affect all the asset prices

and that makes the whole thing on the macro scale much more dangerous and much more risky because you lose then further on the assets of the sector, you lose risky claims value and this actually brings the losses down further. And that's essentially what is microbrudent, might not be macrobrudent.

It's the same thing as what Keynes said in the savings space. If everybody starts to save at a higher rate, if I save more, then I spend less and U of income is less and hence the total income is going down. At the end, we ultimately save in dollar terms on Euro terms, we save less. So the interesting thing is also

that when the banks deliver, not only on the asset side, there's this fire sell that's going on, but they also create less inside money. When they create less inside money, total money supply shrinks. So the inside money, so outside money supply is still fixed, but the inside money is shrinking. So total money supply is shrinking

and that leads to disinflationary pressures and lower inflation and that's lowers, this increases the real value of these liabilities for the banks, which shrinks the net worth even further. So you might say, what's about money demand? What happens, money supply shrinking, but money demand is actually expanding.

Why? Because the banks that take out idiosyncratic risk in the economy and diversify it away, and if they are not active anymore, the idiosyncratic risk has to be held back by the households. And as the households have to hold more idiosyncratic risk, they shift away from physical investments into more money holding. So the portfolio choice,

which let's say was 70, 30 before, will now be 60, 40. So they want to ask more money. So you have a shrinkage in money supply and expansion in money demand. And both forces essentially lead to lower inflation. And to less activity in the real economy and so forth. And this essentially you would like to stop. That's where the central bank comes in

and essentially as the inside money shrinks, you expand the outside money and contrast that. And this might also be done through stabilizing differential banking system. Now let me go back to this. Essentially you can think of this triangle, you can think as inside money expands and shrinks and holding outside money fixed,

you can think of the triangle essentially going together in the recession and expansion expands further. And that's essentially the way you can think this outside money and inside money kicking in. Now in a world with a digital economy, we have to rethink money the way it is, but essentially we don't have to rethink so much. We just go back to the foundations

and there will be some new elements to it. So what's the role of cash in reserves? What forms of money will emerge? What should central banks endorse and fight? Should they fight digital money or central bank digital currencies? Should there endorse cryptocurrency or the blockchain technology more generally? And how does it affect the competition among currencies?

And that's essentially what I want to focus in. Then I talk at the end about tokenization. So that's basically the paper I've done with Joseph Abadi. So the first thing you might ask, how does the old system was, we always had a centralized ledger and it was controlled by some intermediaries that keep track of the banking accounts and all this.

And the way you incentivize a bank from not lying and from not distorting the facts is through a franchise value. So you give them dynamic incentives over time. So if they're lied, they lose the franchise value and then the value goes away. In a blockchain environment, you have many people who keep track of the same ledger.

So it's distributed. It's distributed and you keep essentially, you lose decentralized franchise value because there's free entry. So everybody can become a miner or a writer on a blockchain. And so you don't have this franchise value. So this dynamic incentivization is gone.

You essentially need some static incentivization. So essentially you can classify this in things. So if you have the traditional setting, you have one monopolist, let's say, and he has a franchise value, or a few players, he has a franchise value, you can incentivize this monopolist to do the right thing by giving him some franchise value,

some carrots over time. He doesn't want to ruin his future in profits. So he will actually do the right thing. On the other hand, if you have a blockchain, you don't have the dynamic incentive because free entry. So you have many potential writers and you need a different incentive scheme. And the way you can characterize blockchain so the private existing system

is very much centralized intermediaries who keep track of things on a ledger or on a central record-keeping device. And blockchains with the public blockchain are down there. Permissioned blockchains are in between. There's a permissioned blockchain are essentially settings like Ripple where actually a few players

have the right to write on this ledger and not many of them. I mean, there's no free entry. So in between. Okay, so the last thing I would like to emphasize is the fork. So once you have a blockchain, a blockchain consists of a chain of blocks. That's why it's called blockchain.

So you have different blocks. And then at some point, some people might say, oh, this, that's what we want to write as a true history of transaction of payments. Or others might disagree and split in some different framework. Or it might also be that in this blockchain we have implemented a certain monetary policy rule.

So the monetary policy rule might say 5% inflation. And others say, no, we don't like this. We want to fork off, or fork away from this blockchain and go for 2% inflation. So you can have, through this blockchain, you can have competition across different monetary policy rules where some fraction of miners or writers decide,

okay, we go for a different rule. And then depends whether the users of this cryptocurrency will come along to this new framework or not. So essentially there are two forms of competition. So one form of competition is this free entry that makes this blockchain, this public blockchain different.

And as I mentioned before, the restricted entry leads to this permission blockchains. But the other difference in competition is this ability to fork, okay? And what makes this ability to fork so different from existing competition? The ability to fork, once you fork, you carry all information on the blockchain with you, okay?

So one, if let's suppose there's a currency out there and I want to create a new currency, I don't know who was much in what wallet and all this. It's very hard to carry over to a new currency. But in blockchain technology, I can just fork the whole blockchain and all the information which was on the existing branch of the blockchain

will carry over to the new branch, okay? This makes competition way more fierce among these currencies. Well, let me put it differently. If you look at the old-fashioned Hayekian currency competition, so there's cash, which you can think of imaginary ledger, or each of you has some money in their wallets

and if I write everything down, I would have this imaginary ledger. And nobody really knows the distribution of this cash. And if I want to propose a new currency, it will be very hard to coordinate over and bring to this new currency. On the other hand, if I have a cryptocurrency, I can propose a new fork, a new branch,

branching away and all the information which was an existing branch will be carried over to the new branch. It's way easier to start up a new currency and say, okay, I will propose a currency with a lower inflation rate or with a different monetary rule. And of course, I have to coordinate many people

which I have to do at the moment now, but it's way more easy. Okay, so this reminds me of some analogy of 1922 in Greece, and I see that Yanis is here. There was actually a forking going on in 1922 when at some point,

what's nice about the Greek currency at that time is that it was always written 500 here and 500 here. And there was a law where you can cut the money into two parts and then you can use both parts. And one part was supposedly converted into a bond

and the other one was back in circulation. And essentially this way, it's like a fork competition because you don't need to know who has how much money, but all the information is actually capped and I fork it nicely off. So let me jump over that.

Let me just skip to the final point was that I talked about this inside money, but you can think of a system where essentially the unit of account and the initial transaction among the banks is done on a cryptocurrency way. But what really happens on the private issues

when people pay on the iPhone back and forth, these are just tokens from some IT companies. And that's what you see in China and other Asian countries evolving and coming up. So essentially it will be less of the crypto side. So the crypto side will be much more the outside money side and will be the interbank market might do on a permissioned blockchain,

some crypto transactions, but the private transactions will happen much more on token basis because the banks or some people or some entities which are part of this interbank market, Tencent, Alibaba and so forth, they will issue tokens and then people pay with these tokens and this can be done at a much higher frequency than compared to what the blockchain technology allows one.

So let me conclude. So we have macro models. I think we moved away from the simple response function world to an endogenous volatility dynamics. The paradox of prudence, I think is very important here. And then we have various money models and because of financial frictions

and this leads, combined with idiosyncratic risk, leads to endogenous demand for money and that's essentially can expand depending how the volatility moves around over the cycle. Money in the digital age, we will hear, I think, next and more in the next panel. The additional way is to have a centralized monopolist ledger.

New ways to have these decentralized ledgers. But I think the interesting thing in terms of currency competition is this fork competition where the competition can be much more powerful because it requires much less coordination compared to existing currency competition. So it's way more powerful than an Hayekian competition.

And then we will have this tokenization by social media firms and payment firms like Tencent, Alipay, Amazon and Apple. It will be very similar to the free banking era in the 19th century in the US. The inside money will be the tokens, the outside money will be a cryptocurrency potentially and perhaps we need some digital money after all

because machines will have to pay each other rather than humans. So I stop with this futuristic thought. Thanks again. Thank you.

So I'm certainly very delighted to be here honoring Vitor and to meet one of the titans that essentially kept the Eurozone together. I see many of them here but you were certainly very central in all this. As Mario mentioned,

you certainly had to deal with many, many shocks. And I learned today that you did that while holding an enormous number of office hours. To my co-panelists here. So I admire you for that, Vitor. Marcos sent me three papers last Friday, all of them fascinating,

as always with his work. And I invite you to, I recommend that you actually read them. I will focus on one of the topics, the one that relates to what he calls, they call the I-theory of money. I think it's a great framework to study interaction between price stability and financial stability.

Just to remind you what it does, it's a framework within complete markets. Households essentially have projects but they cannot sell claims on these projects. Intermediaries play the role of absorbing part of the idiosyncratic risk generated by household's projects and at the same time they supply inside money,

which they used to provide. Here is money in the Samuelson sense of a store of value, no? But it's a way of diversifying your portfolio, making your portfolio a little safer given that you're so invested in these projects with idiosyncratic risk. Now when the balance sheet of intermediaries become impaired then both functions

essentially are hurt. And that I think is the point that I like the most of all this work, work that Julian and Marcus have done, which that produces an imbalance in the risk market. Essentially agents need to demand more money

because they now need to absorb too much risk and they don't want to hold that risk and that's what leads to this downward spiral that he described. Now in that role, monetary policy then, when you look at monetary policy from that perspective, really what it's trying to do is to try to help again the agents to absorb the risk

that the productive structure needs to generate in order to function. But what it highlights as well is that well if money is distracted in doing this, in helping with the risk markets, then you are likely to generate moral hazard and you need to have another tool to deal with that.

So very naturally complementary, you have monetary policy and macroprudential policy sort of operating together when risk markets are the focus of analysis. So I think this again, I love every single paper they have written together, not only for the messages of the individual papers,

but I think again it aligns very well at least with something that I think is very core for macroeconomics and I think this, their work is very instrumental in shifting a bit macro into what I, something I like to characterize as recentric macroeconomics. And let me summarize it with this very simple diagram.

The way we normally think about macro models, regular macro models, the ones we use for everyday recessions and the ones we write in papers typically, is mostly about sort of the upper boxes there, no? A productive capacity when it expands, capital generates output and we need to find the demand for that output, no?

And monetary policy is a lot about finding the demand and fiscal policy about finding the demand for that output. But when output expands, when an economy grows, it also generates risks. There are new risks that arise and we also need to find the demand for that risk, no? And lately, or when at least we won't get significant financial events,

actually the imbalance is much larger in the bottom panels than in the top panels. So the key game is how do we generate demand for the risk that the productive structure very naturally generates and that obviously what matters is not the risk it generates but also the risk that is perceived by economic agents. So at times like this, the red box that comes from the supply side

looks enormous to economic agents and the red box that is on the demand side looks very small. And when you think about monetary policy, conventional monetary policy is just increasing the appetite for that risk, no? If you lower interest rate for any given expected return capital gains that you may have on risky assets,

then by lowering the interest rate, you increase the Sharpe ratio of risky assets and that induces sort of an increase in demand for risk. Now, in a good significant financial event like the one you had to deal here with, that's not gonna be enough, no? That you can expand a little bit that red box to the right but it's never gonna be enough to absorb sort of all the risks

that you have on the left. And if you're not able to do that, then asset prices collapse. That relates to what Roger was talking about, asset prices collapse, that fits into aggregate demand and then that contaminates immediately the goods markets, no? And so you can think about QE policies especially when they have a credit component and so on, it's really about adding appetite for risk somehow

or it's about shrinking a little bit the supply of assets by absorbing that into the balance sheet of somebody that is not as sensitive to risk as households and investors are. So I see their work very much as moving us in the direction of thinking

about macro more in these terms. I've done some work and it's easier when you receive the papers very late to talk about your own work along these lines. In fact, I like so much this idea of recentry that that's in the title of the paper that Al Simsek and I wrote recently and it's really a much more traditional macro model

but with this perspective. So we call it a recentry model of aggregate demand recessions and there too, macro potential policy will play a very important complementary role. And the basic idea is very simple. I have no idea how much time you have so I will tell you the story three times. Five minutes. In words and so on and so on. Five minutes.

Okay, well, so let me tell you once the story and probably I will reveal it twice. So what happens here is occasionally risk rises dramatically. Risk perception rises, risk premium rises. It could be because of problems in balance sheets and intermediaries or something else. And that, if it is sufficiently high

then the central bank will try to relax monetary policy, lower interest rate but at some point it's not enough. We hit the zero lower bound and that triggers a traditional recession. Now, one of the points of this work is that that gives us feedback. In fact, we were talking about causality

with Royer but really what happens is they feed into each other because the risk premium, you know, leads to a declining interest rate. When that's not enough to balance the risk markets then asset prices collapse but when asset prices collapse demand collapse or when demand collapse the dividends collapse and profits collapse and therefore asset prices collapse and there's a downward spiral that develops.

And how deep that downward spiral is, well, the only thing that can balance that is some hope that you're going to get out of this situation and then when asset prices decline, well, that gives you a big expected capital gain. But for that you need to hope that you get out of the stuff very soon because if not, there is no capital gain to be had.

And so the degree of pessimism you have is very important in stabilizing an economy. And in that context, speculation during the good time is particularly damaging, okay? Because speculation by its very nature makes the economy extrapolative. In good times, the optimist may do very well. In bad times, the pessimist do very poorly.

So to the extent that you have a speculation, you're going to have the wrong selection of individuals dominating the asset pricing at the time in which you fall into a deep crisis. And the anticipation of this even can produce even larger and larger effects, okay? So the reason for macroprudential regulation here

is different from the one that Marcos highlighted but it's related. It's not a matter of moral hazard and so on but it's a matter, it could be complementary, but it's a matter of an aggregate demand externality. It's the fact that you will need optimists when things go wrong. You need people that can value highly assets.

Banks, because they can leverage and so on, are those type of agents, okay? It's not about believing to the world whether or not necessarily, but it's about agents that can value things highly and you need somebody that supports us in markets when things go very wrong. Because of an aggregate demand externality, this is not a model of a pecuniary externality, it's a model in which there's an aggregate demand externality

which you need to offset. If you don't have monetary policy to dilute, that's what triggers the aggregate demand externality. Macroprudential regulation helps you because it protects the wealth of those agents that you need very much in a recession. Am I pointing at the right place or? Oh, okay.

So I have very little time clearly, but let me explain in equations I think what Roger was trying to say and John as well. So the model really is two equations. The first equation is really is the goods market equilibrium and there's lots of shocks going around,

everything is normalized. All that they have there in the left hand side is capacity utilization. And the right hand side is consumption as a function of asset values, Q, and Q theory, investment as a function of Q. What you see from that equation is that you need high asset prices in order to support aggregate demand

so you can have full capacity utilization. But that means that asset prices are really locked into this goal, into this role. You need an asset prices that are sufficiently high at Q star in order to have full employment. And the question then becomes, well, how do I ensure that I have enough wealth,

house prices, stock market, and so on, how do I ensure that I can support that wealth that the economy needs in order to have full employment? Well, for that I need to look at the risk market condition. What is happening in the risk market in the red box that I have at the bottom? That's what the second equation does. On the left hand side you have the supply of risk

that the economy has, the volatility of the economy, the perceived volatility. And on the right hand side is a complicated way of writing the Sharpe ratio. It's a proxy for the demand for risk in the economy. So the issue is, well, suppose that the risk premium rises dramatically, the perception of volatility rises. Well, that immediately shifted, am I pointing,

well, anyways, it shifted left hand side up immediately, and it also shifted right hand side down because for any expected return, given more risk, there is less demand for that risk. And so the role of monetary policy, as I said earlier on, is really to, I'm having a ball here with this stuff,

there is a lag, talking about PLL and so on. So interest rate policy will try to offset that, but if the jump in volatility sufficiently high is not enough, and then asset prices will drop, but when asset prices drop there,

in order to generate an excess return, no, I expected capital gain, but when that happens, that brings down the aggregate demand and you get excess capacity. So here you have two scenarios. One in which there's a low risk premium environment, in which interest rates are positive, and that's enough to ensure the asset prices, the amount of wealth that you need

to support full employment, interest rates are positive. Another one is a high risk premium state, in which the interest rate becomes binding, and then asset prices collapse, that generates a recession and so on. So the only thing I want to say is that now pessimism matters a lot, both for good times and bad times. To be a pessimist in good times

means that you think that it's very likely that you may go into this high volatility, high risk premium environment. And if that's the case, it's easy to see in the formula, which is there at the bottom, at the top, that the equilibrium interest rate starts declining in the good state. Not necessarily because now you're afraid

that when things go wrong, you're not going to have the interest rate to deal with that, asset prices will have to collapse, and therefore you need a lower interest rate to compensate for the expected capital gain that now takes place when you go into high vol regime. I'm almost done. And then in the bad state, well, then pessimism matters a lot

because, as I said before, when asset prices falls, if you keep dividends constant, asset prices fall, that immediately makes an excess return, an increase in excess return. But if dividends comes along, expected profits come down because the demand is coming down, then that doesn't work. And in fact, in our mall,

what happens is the economy implodes. The more asset prices drop, the more profits demand drops, the more profits drop, the more asset prices drop, and there's no end to that. The economy implodes. The only thing that saves you is optimism. And what is optimism? Optimism is saying, okay, look, this stuff is going to end in the near future.

And if it ends in the near future, then a sufficiently large drop in asset prices gives you enough of a capital gain that that stabilizes the economy. I'm done. It's a good conclusion anyway. It's a fantastic conclusion anyway. I'm almost done. Optimism will save us. Well, you need enough optimism.

That's an economy that they say you can see how, as economy becomes more and more pessimistic, the whole feedback sort of starts going worse and worse. And I'm not going to be able to say anything about speculation, but the blue line shows for the same level of wealth, distribution of level of wealth, for the same level of pessimism,

collective pessimism, when you have more speculation, more heterogeneity in beliefs, the drop in asset prices, the feedback is more negative. And that's the reason you need to do macroprudential regulation here. And you do wonderful things with macroprudential policy. But in any event, so let me conclude here. So these are both views

that I call recentrics. They have differences, but they have something in common. And that's what I want to finish with. It's a very recent perspective of macro that highlights wealth effects. And I think everyone in the panel has done that. And the key question is, how does the economy absorb the risk being generated by the productive structure?

And how to integrate monetary and macroprudential policies to make that absorption process smoother so it doesn't contaminate the real side of the economy? This is a variety of moles now, new moles that really think about the world, about macro in these terms. Let me end here. Thank you very much Ricardo.

So for the audience, there will be a quiz on Ricardo's model.