Download Chapter 18

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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
18.1
Understand what the IS curve is and how it is derived.
18.2
Explain the significance of the MP curve and the Phillips curve.
18.3
Use the IS–MP model to illustrate macroeconomic equilibrium.
18.4
Discuss alternative channels of monetary policy.
18A
Use the IS-LM model to illustrate macroeconomic equilibrium.
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The Fed Forecasts the Economy
•In July 2012, the Fed lowered its forecasts for economic growth.
•In determining monetary policy, the Fed’s forecasts of future economic growth
are crucial.
•The Fed knows that changes in interest rates and the money supply affect the
economy with a lag, so policies it implements today will not have their full effect
on the economy for a year or more.
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Key Issue and Question
Issue: By December 2008, the Fed had driven the target for the federal
funds rate to near zero.
Question: In what circumstances is lowering the target for the federal
funds rate unlikely to be effective in fighting a recession?
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18.1 Learning Objective
Understand what the IS curve is and how it is derived.
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The IS Curve
IS–MP model is a macroeconomic model consisting of an IS curve, an MP
curve, and a Phillips curve.
IS curve is a curve that shows the combinations of the real interest rate and
aggregate output that represent equilibrium in the market for goods and
services.
MP curve is a curve that represents Federal Reserve monetary policy.
Phillips curve is a curve showing the short-run relationship between the output
gap (or the unemployment rate) and the inflation rate.
The IS Curve
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Equilibrium in the Goods Market
The IS Curve
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The IS Curve
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Figure 18.1 (1 of 2)
Illustrating Equilibrium
in the Goods Market
Equilibrium in the goods market
occurs at output level Y1,where the
AE line crosses the 45°line.
The IS Curve
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Figure 18.1 (2 of 2)
Illustrating Equilibrium
in the Goods Market
If the level of output is initially Y2
and aggregate expenditure is AE2,
then rising inventories cause the
economy to move down the AE
line until it reaches equilibrium at
output level Y1.
If the output level is initially Y3 and
aggregate expenditure is AE3, then
falling inventories cause the
economy to move up the AE line
until it reaches equilibrium at
output level Y1.
The IS Curve
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Potential GDP and the Multiplier Effect
Potential GDP is the level of real GDP attained when all firms are producing at
capacity.
At potential GDP, the economy achieves full employment, and cyclical
unemployment is reduced to zero.
So, potential GDP is also called full-employment GDP.
Autonomous expenditure is expenditure that does not depend on GDP.
A decline in autonomous expenditure results in an equivalent decline in income,
which leads to an induced decline in consumption.
Multiplier effect is the process by which a change in autonomous expenditure
leads to a larger change in equilibrium GDP.
Multiplier is the change in equilibrium GDP divided by a change in autonomous
expenditure.
The IS Curve
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The IS Curve
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Figure 18.2
The Multiplier Effect
The economy is initially in
equilibrium at YP.
As a result of falling I, the
aggregate expenditure line
shifts from AE1 to AE2.
The economy moves down
the AE line to a new
equilibrium level of
output,Y2.The decline in
output is greater than the
decline in investment
spending that caused it.
The IS Curve
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Solved Problem 18.1
Calculating Equilibrium Real GDP
trillion
The IS Curve
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Solved Problem
18.1
Solved
Problem
Calculating Equilibrium Real GDP
The IS Curve
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Fiscal policy is a change in federal government purchases and taxes intended
to achieve macroeconomic policy objectives.
The IS Curve
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Constructing the IS Curve
The focus of Fed policy is changing the federal funds rate which will cause
changes in other market interest rates. So, we need to incorporate the effect of
changes in interest rates into our model of the goods market.
The real interest rate equals the nominal interest rate minus the expected
inflation rate.
An increase in the real interest rate causes I and C to decline.
A higher domestic real interest rate also makes returns on domestic financial
assets more attractive relative to those on foreign assets. So, the exchange
rate rises, and thus NX reduces (imports increase and exports decrease).
So, a higher interest rate causes a reduction in aggregate expenditure and a
lower equilibrium level of output.
A decrease in the real interest rate will have the opposite effect—increasing I,
C, and NX.
The IS Curve
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Figure 18.3
Deriving the IS Curve
Panel (a) uses the 45°-line diagram to show the effect of changes in the real interest rate
on equilibrium in the goods market. Panel (b) plots the points from panel (a) to form the IS
curve.
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The Output Gap
According to the Taylor rule (Chapter 15), the Fed has a target for the real
federal funds rate and adjusts that target on the basis of changes in two
variables: the inflation gap and the output gap.
The inflation gap is the difference between the current inflation rate and a target
rate.
The Output gap is the percentage difference between real GDP and potential
GDP.
The IS Curve
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Figure 18.4
Output Gap
The output gap is negative during recessions as real GDP is below potential
GDP.
The IS Curve
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Figure 18.5
The IS Curve Using the
Output Gap
The graph shows the IS curve with the
output gap on the horizontal axis.
Values to the left of zero on the horizontal
axis represent negative values for the
output gap (recession).
Values to the right of zero on the horizontal
axis represent positive values for the output
gap (expansion).
The vertical line, Y = YP, is also the point
where the output gap is zero.
The IS Curve
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Shifts of the IS Curve
An increase or a decrease in the real interest rate results in a movement along
the IS curve.
Changing other factors that affect aggregate expenditure will cause a shift of
the IS curve.
Aggregate demand shock is a change in one of the components of aggregate
expenditure that causes the IS curve to shift.
The IS Curve
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Figure 18.6
Shifts in the IS Curve
For any given level of the real interest rate, positive AD shocks shift the IS
curve to the right and negative AD shocks shift the IS curve to the left.
The IS Curve
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18.2 Learning Objective
Explain the significance of the MP curve and the Phillips curve.
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The MP Curve and the Phillips Curve
Equilibrium real
According to the Taylor rule:
•when the inflation rate rises above the Fed’s target inflation rate of about 2%,
the FOMC will raise its target for the federal funds rate.
•when the output gap is negative, the FOMC will lower the target for the federal
funds rate.
The MP Curve and the Phillips Curve
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The MP Curve
Figure 18.7
The MP Curve
The MP Curve and the Phillips Curve
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The Phillips Curve
The Fed relies on an inverse relationship between the inflation rate and the
state of the economy: When output and employment are increasing, the
inflation rate tends to increase, and vice versa.
A graph showing the short-run relationship between the unemployment rate
and the inflation rate has been called a Phillips curve.
The position of the Phillips curve can shift over time in response to supply
shocks and changes in expectations of the inflation rate.
The effect of changes in the unemployment rate on the inflation rate is captured
by the gap between the current unemployment rate and the natural rate of
unemployment—the unemployment rate when the economy is at full
employment.
The gap between the current rate of unemployment and the natural rate
represents cyclical unemployment.
The MP Curve and the Phillips Curve
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The Phillips Curve
Taking all of these factors into account gives us the following equation for the
Phillips curve:
The MP Curve and the Phillips Curve
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The Phillips Curve
Figure 18.8
The Phillips Curve
The Phillips curve illustrates
the short-run relationship
between the unemployment
rate and the inflation rate.
The MP Curve and the Phillips Curve
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The Phillips Curve
Figure 18.9
Shifts in the Phillips
Curve
An increase in expected
inflation or a negative
aggregate supply shock
shifts the Phillips curve up.
A decrease in expected
inflation or a positive
aggregate supply shock
shifts the Phillips curve
down.
The MP Curve and the Phillips Curve
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Okun’s Law and an Output Gap Phillips Curve
The Phillips curve can be modified to show the relationship between the inflation
rate and the output gap, instead of the unemployment rate.
Okun’s law is a statistical relationship between the output gap and the cyclical
rate of unemployment, as discovered by Arthur Okun.
The MP Curve and the Phillips Curve
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Okun’s Law and an Output Gap Phillips Curve
Figure 18.10
Using Okun’s Law to Predict the Cyclical Unemployment Rate
The graph shows that Okun’s law does a good job of accounting for the cyclical
unemployment rate.•
The MP Curve and the Phillips Curve
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Okun’s Law and an Output Gap Phillips Curve
Figure 18.11
The Output Gap Version
of the Phillips Curve
An increase in expected inflation
or a negative supply shock shifts
the Phillips curve up.
A decrease in expected inflation
or a positive supply shock shifts
the Phillips curve down.
The MP Curve and the Phillips Curve
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Making the Connection
Did the Aftermath of the 2007–2009 Recession Break Okun’s Law?
During 2009 and 2010, White House economists were criticized for their
inaccurate predictions of the unemployment rate.
After Congress passed the stimulus program, the unemployment rate was still
much higher than the predicted peak 8%, and it went as high as 10.0% in 2009.
One reason for the faulty forecasts was that Okun’s law sharply underestimated
the unemployment rate.
Rising labor productivity may be an explanation. When labor productivity
increases, firms can produce the same amount of output with fewer workers.
Firms maintained their production levels with fewer workers—thereby leading to
a larger increase in unemployment than many economists had forecast.
Okun’s law has had difficulty in accounting for the unemployment rate following
the last two severe recessions.
The MP Curve and the Phillips Curve
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Making the Connection
Did the Aftermath of the 2007–2009 Recession Break Okun’s Law?
Beginning in 2009, Okun’s law indicates that cyclical unemployment should have been
about 1% lower than it actually was. In late 2011, the pattern reversed.
The MP Curve and the Phillips Curve
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18.3 Learning Objective
Use the IS–MP model to illustrate macroeconomic equilibrium.
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Equilibrium in the IS–MP Model
Figure 18.12
Equilibrium in the
IS–MP Model
Panel (a) shows that the IS
curve and the MP curve
intersect where the output
gap is zero and the real
interest rate is at the Fed’s
target level.
Panel (b) shows the Phillips
curve when the actual and
expected inflation rates are
equal.
Equilibrium in the IS–MP Model
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Making the Connection
Where Did the IS–MP Model Come From?
British economist John Maynard Keynes developed the basic ideas behind the
IS curve in his 1936 book The General Theory of Employment, Interest, and
Money.
The IS curve first appeared in an article written by John Hicks in 1937. Hicks
did not use an MP curve but an LM curve, with LM standing for “liquidity” and
“money.”
Hicks’s approach is called the IS–LM model. The LM curve shows
combinations of the interest rate and output that would result in the market for
money being in equilibrium.
The model assumes that the Fed chooses a target for the money supply, but
we know that since the early 1980s, the Fed has targeted the federal funds rate
instead.
In 2000, David Romer suggested dropping the LM curve in favor of the MP
curve approach that has become more standard for analyzing monetary policy.
Equilibrium in the IS–MP Model
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Using Monetary Policy
to Fight a Recession
Figure 18.13
Expansionary Monetary Policy
Equilibrium in the IS–MP Model
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Complications Fighting the Recession of 2007–2009
During the 2007–2009 recession, a smooth transition back to potential GDP did
not occur.
One reason is that even though we have been assuming that the Fed controls
the real interest rate, the Fed is in fact able to control the federal funds rate, not
other market interest rates.
Normally, the Fed can rely on the long-term real interest declining when the
federal funds rate declines. This was not the case for the recession of 2007–
2009.
During the financial crisis, the default risk premium soared as investors feared
that firms would have difficulty repaying their loans or making the payments on
their bonds.
Equilibrium in the IS–MP Model
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Figure 18.14
An Increasing Risk Premium During the 2007–2009 Recession
During the financial crisis of 2007–2009, the default risk premium soared, raising interest
rates on Baa-rated bonds relative to those on Aaa-rated bonds and 10-year U.S. Treasury
notes.
Equilibrium in the IS–MP Model
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Figure 18.15
Expansionary Monetary
Policy in the Face of a
Rising Risk Premium
Equilibrium in the IS–MP Model
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Making the Connection
Trying to Hit a Moving Target: Forecasting with “Real-Time Data”
The Fed relies on forecasts from models similar to the IS–MP model to guide its
policymaking, and data gathered by various government agencies.
GDP is measured quarterly by the Bureau of Economic Analysis (BEA) of the
Department of Commerce.
The advance, preliminary, and final estimates of a quarter’s GDP are not
released until about one, two, and three months after quarter-end and are still
subject to revisions.
The start of 2001 may prove why these revisions matter: While the advance
estimate of the first quarter’s GDP showed an increase in real GDP of 1.98%,
current BEA data indicate that real GDP actually declined by 1.31%.
So, in addition to the other problems the Fed faces in conducting monetary
policy, the data it uses to make its forecasts may be subject to many revisions.
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Making the Connection
Trying to Hit a Moving Target: Forecasting with “Real-Time Data”
Equilibrium in the IS–MP Model
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Solved Problem 18.3
Using Monetary Policy to Fight Inflation
Fed Chairman Paul Volcker took office in August 1979 with a mandate to bring
down the inflation rate.
Use the IS–MP model to analyze how the Fed can change expectations of
inflation to permanently reduce the inflation rate.
Be sure that your graphs include the IS curve, the MP curve, and the Phillips
curve.
Also be sure that your graphs show the initial effect of the Fed’s policy on the
output gap and the inflation rate.
Finally, be sure to illustrate how the economy returns to long-run equilibrium at
a lower inflation rate.
Solving the Problem
Step 1 Review the chapter material.
Equilibrium in the IS–MP Model
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Solved Problem
18.3
Solved
Problem
Using Monetary Policy to Fight
Inflation
Step 2 Describe the policy the Fed
would use to reduce the inflation rate
and illustrate your answer with a
graph.
To lower expected inflation,
the Fed can cause a decline
in real GDP by raising the
real interest rate.
The Phillips curve shows that
if real GDP falls below
potential GDP, the inflation
rate will decline.
Equilibrium in the IS–MP Model
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Solved Problem
18.3
Solved
Problem
Using Monetary Policy to Fight
Inflation
Step 3 Show how after the Phillips
curve shifts down the Fed can return
the economy to potential output at a
lower inflation rate.
Equilibrium in the IS–MP Model
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18.4 Learning Objective
Discuss alternative channels of monetary policy.
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Are Interest Rates All That Matter for Monetary Policy?
Economists refer to the ways in which monetary policy can affect output and
prices as the channels of monetary policy.
In the IS–MP model, monetary policy works through the channel of interest rates:
•The Fed uses open market operations to change the real interest rate, which…
•affects the components of aggregate expenditure, which…
•changes the output gap and the inflation rate.
We call this channel the interest rate channel.
A key assumption is that borrowers are indifferent as to how or from whom they
raise funds and regard alternative sources of funds as close substitutes.
As we will see next, bank loans play no special role in this channel.
Are Interest Rates All That Matter for Monetary Policy?
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The Bank Lending Channel
Bank lending channel is a description of the ways in which monetary policy
influences the spending decisions of borrowers who depend on bank loans.
In this channel, a monetary expansion increases banks’ ability to lend, and
increases in loans to bank-dependent borrowers increase their spending.
In the interest rate channel, an increase in output occurs because a lower
federal funds rate causes other interest rates to fall.
Both channels are similar in one respect: An increase in bank reserves leads to
lower loan interest rates, lower bank loan rates, and lower interest rates in
financial markets.
Are Interest Rates All That Matter for Monetary Policy?
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In the bank lending channel, an expansionary monetary policy causes
aggregate expenditure to increase for two reasons:
(1) the increase in households’ and firms’ spending from the drop in
interest rates,
(2) the increased availability of bank loans.
In other words, if banks expand deposits by lowering interest rates on loans,
the amounts that bank-dependent borrowers can borrow and spend increases
at any real interest rate.
So, in the bank lending channel, an expansionary monetary policy is not
dependent for its effectiveness on a reduction in interest rates.
Similarly, a contractionary monetary policy is not dependent for its effectiveness
on an increase in interest rates.
Are Interest Rates All That Matter for Monetary Policy?
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The Balance Sheet Channel: Monetary Policy and Net Worth
Monetary policy may also affect the economy through its effects on firms’
balance sheet positions.
Economists have attempted to model this channel by describing the effects of
monetary policy on the value of firms’ assets and liabilities and on the liquidity
of balance sheet positions (i.e., the quantity of liquid assets that individuals hold
relative to their liabilities).
The liquidity of balance sheet positions is a determinant of spending on
business investment, housing, and consumer durable goods.
Balance sheet channel is a description of the ways in which interest rate
changes resulting from monetary policy affect borrowers’ net worth and
spending decisions.
Implication: Even if monetary policy has no effect on banks’ ability to lend, the
decline in borrowers’ net worth following a monetary contraction reduces
aggregate demand and output.
Are Interest Rates All That Matter for Monetary Policy?
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A comparison of the three channels of monetary policy:
Are Interest Rates All That Matter for Monetary Policy?
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“In what circumstances is lowering the target for the federal funds rate
unlikely to be effective in fighting a recession?”
The Fed realized by the fall of 2008 that its usual policy of fighting recessions
primarily by lowering its target for the federal funds rate was unlikely to be
effective.
The IS–MP model developed in this chapter provides one explanation of why
this was true.
Although the Fed lowered the target for the federal funds rate nearly to zero,
an increase in the risk premium caused the interest rates paid by many
businesses to rise.
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18A
Use the IS-LM model to illustrate macroeconomic equilibrium.
IS–LM model is a macroeconomic model of aggregate demand that
assumes that the central bank targets the money supply.
LM curve is a curve that shows the combinations of the interest rate and
the output gap that result in equilibrium in the market for money.
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Deriving the LM Curve
Figure 18A.1
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Deriving the LM Curve
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Shifting the LM Curve
Figure 18A.2
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Shifting the LM Curve
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Monetary Policy in the IS–LM Model
Figure 18A.3
Expansionary
Monetary Policy
At the initial equilibrium
at point A, real GDP is
below potential real
GDP.
Increasing the supply of
real balances shifts the
LM curve to the right,
from LM1 to LM2.
Equilibrium will move to
point B with real GDP at
its potential level, while
the real interest rate will
fall from r1 to r2.•
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