Download Monetary Theory II

R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
18
Monetary Theory II:
The IS–MP Model
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
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
18
Monetary Theory II:
The IS–MP Model
THE FED FORECASTS THE ECONOMY
•In July 2010, the Federal Reserve lowered its forecasts for economic growth.
The Fed cited continued weakness in the housing market, a slow recovery in the
labor market, and less than favorable financial conditions for growth.
•The Bank of England and the French government also reduced their forecasts
for the growth of real GDP in 2010 and 2011.
•Having some idea of the likely state of the economy in the future helps to guide
policy today. In preparing its forecasts, the Fed, foreign central banks, and private
forecasters usually rely on macroeconomic models.
•AN INSIDE LOOK AT POLICY on page 574 discusses four policy options the
Federal Reserve was considering in late 2010 to provide additional stimulus to
the U.S. economy.
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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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IS–MP model A macroeconomic model consisting of an IS curve, which
represents equilibrium in the goods market; an MP curve, which represents
monetary policy; and a Phillips curve, which represents the short-run
relationship between the output gap (which is the percentage difference
between actual and potential real GDP) and the inflation rate.
IS curve A curve in the IS–MP model that shows the combinations of the real
interest rate and aggregate output that represent equilibrium in the market for
goods and services.
MP curve A curve in the IS–MP model that represents Federal Reserve
monetary policy.
Phillips curve 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
Table 18.1
The Relationship Between Aggregate Expenditure and GDP
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
Panel (a) shows that 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
In panel (b), if the level of output is
initially Y2, aggregate expenditure
is only AE2.
Rising inventories cause firms to
cut production, and the economy
will move down the AE line until it
reaches equilibrium at output level
Y1.
If the output level is initially Y3,
aggregate expenditure is AE3.
Falling inventories cause firms to
increase production, and the
economy will 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 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 sometimes called fullemployment GDP.
In the context of this basic macroeconomic model, autonomous expenditure is
expenditure that does not depend on the level of GDP.
A decline in autonomous expenditure results in an equivalent decline in income,
which leads to an induced decline in consumption.
Multiplier effect The process by which a change in autonomous expenditure
leads to a larger change in equilibrium GDP.
Multiplier 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 potential
GDP,YP, and then the
investment component, I, of
aggregate expenditure falls.
As a result, 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
The IS Curve
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Solved Problem
18.1
Calculating Equilibrium Real GDP
The IS Curve
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The IS Curve
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Constructing the IS Curve
The focus of Fed policy is establishing a target for the federal funds rate, with
the expectation that changes in the federal funds rate will cause changes in
other market interest rates. Therefore, 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, raising the exchange
rate. The rise in the exchange rate increases imports and reduces exports,
thereby reducing NX.
A decrease in the real interest rate will have the opposite effect—increasing I,
C, and NX.
So, a higher interest rate causes a reduction in aggregate expenditure and a
lower equilibrium level of output.
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. With the real interest rate initially at r1, the aggregate
expenditure line is AE(r1), and the equilibrium level of output is Y1 (point A).
If the interest rate falls from r1 to r2, the aggregate expenditure line shifts upward from
AE(r1) to AE(r2), and the equilibrium level of output increases from Y1 to Y2 (point B).
If the interest rate rises from r1 to r3, the aggregate expenditure line shifts downward from
AE(r1) to AE(r2), and the equilibrium level of output falls from Y1 to Y3 (point C).
In panel (b),we plot the points from panel (a) to form the IS curve. The points A, B, and C
in panel (b) correspond to the points A, B, and C in panel (a).•
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The Output Gap
With 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.
Output gap The percentage difference between real GDP and potential GDP.
Figure 18.4
Output Gap
The output gap is
negative during
recessions
because real GDP
is below potential
GDP.•
The IS Curve
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Figure 18.5
The IS Curve Using the
Output Gap
This graph shows the IS curve with the
output gap, rather than the level of real
GDP, on the horizontal axis.
Values to the left of zero on the horizontal
axis represent negative values for the
output gap—or periods of recession—
and values to the right of zero on the
horizontal axis represent positive values for
the output gap—periods of 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 A change in one of the components of aggregate
expenditure that causes the IS curve to shift.
Figure 18.6
Shifts in the IS Curve
For any given level of the real
interest rate, positive demand
shocks shift the IS curve to the right
and negative demand 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 Taylor rule tells us that 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. And when the output gap is negative—that is, when real GDP is less than
potential GDP, 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 when output and employment are
decreasing, the inflation rate tends to decrease.
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 best way to capture the effect of changes in the unemployment rate on the
inflation rate is by looking at the gap between the current unemployment rate
and the unemployment rate when the economy is at full employment, which is
called the natural rate of unemployment. 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.
Point A represents the
combination of a 4%
unemployment rate and a
4% inflation rate in one year.
Point B represents the
combination of a 7%
unemployment rate and a
1% inflation rate in another
year.•
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 will
shift the Phillips curve up.
A decrease in expected
inflation or a positive
aggregate supply shock will
shift 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 MP Curve and the Phillips Curve
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Okun’s Law and an Output Gap Phillips Curve
Figure18.10
Using Okun’s Law to Predict the Cyclical Unemployment Rate
Okun’s law states that the output gap is equal to negative 2 times the gap between the
current unemployment rate and the natural rate of unemployment. 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
Figure18.11
The Output Gap Version
of the Phillips Curve
The MP Curve and the Phillips Curve
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This Phillips curve differs from
the one shown in Figure 18.8 by
having the output gap, rather
than the unemployment rate, on
the horizontal axis. As a result,
the Phillips curve is upward
sloping rather than downward
sloping.
When the output gap equals zero
and there are no supply shocks,
the actual inflation rate will equal
the expected inflation rate.
An increase in expected inflation
or a negative supply shock shifts
the Phillips curve up,
and a decrease in expected
inflation or a positive supply
shock shifts the Phillips curve
down.•
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Making the Connection
Did 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 2007–2009 Recession Break Okun’s Law?
The graph shows that beginning in 2009, Okun’s law indicates that cyclical
unemployment—the difference between the actual rate of unemployment and
the natural rate of unemployment—should have been about 1% lower than it
actually was.
In late 2009 and early 2010, the gap between actual cyclical unemployment
and the level indicated by Okun’s law widened to about 1.5%.
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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Figure18.12
Equilibrium in the
IS–MP Model
In panel (a), 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.
In panel (b), the Phillips
curve shows that because
the output gap is zero, 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.” The LM curve shows combinations of the interest rate and output that
would result in the market for money being in equilibrium.
Hicks’s approach is called the IS–LM model. The model assumes that the
Federal Reserve chooses a target for the money supply. We know, however,
that since the early 1980s, the Fed has targeted the federal funds rate, not the
money supply.
In 2000, David Romer of the University of California, Berkeley, 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
Figure18.13
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 in the IS–MP model
that the Fed controls the real interest rate, in fact, the Fed is able to target the
federal funds rate but typically does not attempt to directly affect other market
interest rates.
Normally, the Fed can rely on the long-term real interest declining when the
federal funds rate declines and rising when the federal funds rate rises. The
recession of 2007–2009 did not represent normal times, however.
During the financial crisis, particularly after the failure of Lehman Brothers in
September 2008, the default risk premium soared as investors feared that firms
would have difficulty repaying their loans or making the coupon and principal
payments on their bonds.
Equilibrium in the IS–MP Model
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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.•
Figure18.14
Equilibrium in the IS–MP Model
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Figure18.15
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 macroeconomic models to guide its
policymaking. The Fed uses models similar to the IS–MP model and relies on
data gathered by a variety of federal government agencies.
GDP is measured quarterly by the Bureau of Economic Analysis (BEA), part 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. Benchmark revisions occur in even later years.
The start of 2001 may prove why these revisions matter. Indicators showed that
the U.S. economy might be headed for recession after the dot-com stock
market bubble had burst. Though the advance estimate of the first quarter’s
GDP showed a fairly healthy increase in real GDP of 1.98% at an annual rate,
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
We saw in Chapter 15 that 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
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 tells us
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
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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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: Through open market operations, the Fed changes the real interest rate,
which affects the components of aggregate expenditure, thereby changing the
output gap and the inflation rate.
We call this channel the interest rate channel. An underlying assumption in this
approach 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 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, and (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.
Therefore, 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—that is, the quantity of liquid assets that households
and firms hold relative to their liabilities. According to these economists, the
liquidity of balance sheet positions is a determinant of spending on business
investment, housing, and consumer durable goods.
Balance sheet channel A description of the ways in which interest rate
changes resulting from monetary policy affect borrowers’ net worth and
spending decisions.
The balance sheet channel emphasizes that 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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Table 18.2
Channels of Monetary Policy
Most economists believe that accepting the bank lending or balance sheet
channel does not require rejecting the interest rate channel’s implication
that monetary policy works through interest rates. Instead, the bank lending
and balance sheet channels offer additional methods by which the financial
system and monetary policy can affect the economy.
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?”
As we have seen throughout this book, the recession of 2007–2009 was
accompanied by a financial crisis that made the recession unusually severe.
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 demanded
by investors caused the interest rates, such as the Baa bond rate, paid by
many businesses, to rise despite the Fed’s efforts.
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AN INSIDE LOOK AT POLICY
Slow Growth Despite Low Interest Rates Has Fed Searching for New Options
WALL STREET JOURNAL, Fed Ponders Bolder Moves
Key Points in the Article
At a meeting of world policymakers, Ben Bernanke described four policy options
the Federal Reserve was considering to provide additional stimulus to the U.S.
economy: (1) resuming purchases of long-term securities, (2) lowering the
interest rate banks receive for reserves they keep with the Fed, (3) promising to
keep short-term interest rates low for a longer period than markets expected, and
(4) raising the Fed’s inflation target.
In an attempt to reach a policy consensus, Bernanke weighed arguments made
by Federal Reserve Bank presidents and other members of the central bank’s
Board of Governors.
Harvard economist Martin Feldstein expressed his opinion that none of the Fed’s
options was likely to significantly boost the economy or reduce the risk of
deflation.
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AN INSIDE LOOK AT POLICY
The graph shows an initial longrun equilibrium at Y =YP.
A decline in aggregate
expenditure shifts the IS curve
to the left, producing an output
gap. This represents the impact
of the housing and financial
crises that caused the recession
in 2007.
The shift from MP1 to MP2
shows the effect of
expansionary monetary policy in
reducing the real interest rate,
from r1 to r2.
The graph illustrates the
problem facing the Fed: It can
try to reduce the real interest
below r2, but even an interest
rate of zero is not enough to
eliminate the output gap.
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APPENDIX
The IS–LM Model
18A
Use the IS-LM model to illustrate macroeconomic equilibrium
IS–LM model A macroeconomic model of aggregate demand that
assumes that the central bank targets the money supply.
LM curve 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
Deriving the LM Curve
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Shifting the LM Curve
Figure 18A.2
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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