Download IS-MP

Summary
• The long-run model determines potential output and
the long-run rate of inflation.
• The short-run model determines current output and
current inflation.
• In any given year, output consists of two components:
– The long-run potential output
– Short-run output
Yt
• Short run output
– Is the percentage difference between actual and
potential output.
– Is positive when the economy is booming.
– Is negative when the economy is slumping.
• Recession:
– Our Definition:
• A period when actual output falls below potential
• Short-run output becomes negative
• (Ỹ < 0)
– Usual Definition
• (Roughly) 2 Quarters of negative GDP.
• Declared by the NBER Business Cycle Dating Committee.
• (ΔY < 0)
• Short-run fluctuation
– The difference in actual and potential output,
expressed as a percentage of potential output
– Referred to as “detrended output” or shortrun output:
Ỹ<0
Ȳ
ΔY<0 but
Ỹ>0
ΔY>0 but
Ỹ<0
Ỹ<0
ΔY
<0
ΔY
>0
Recession Ends
• A recession:
– Begins when actual output falls below potential,
and short-run output becomes negative.
– Ends when short-run output starts to rise and
become less negative.
• During a recession:
– Output is usually below potential for
approximately two years, which results in a loss
of about $2,400 per person.
– Between 1.5 million and 3 million jobs are lost.
Measuring Potential Output
• There is no directly observable measure
of potential output in an economy.
• Ways to measure potential output:
– Assume a perfectly smooth trend passes
through quarterly movements of real GDP.
– Take averages of the surrounding actual
GDP numbers.
9.3 The Short-Run Model
• Short-run model features:
– Open economy exists where global booms
and recessions impact the local economy.
– The economy will exhibit long-run growth
and fluctuations.
– Central Bank manages monetary policy to
smooth fluctuations.
• The short-run model is based on three
premises:
1. The economy is constantly being hit by
shocks:
• Shocks: factors that cause fluctuations in output or
inflation.
2. Monetary and fiscal policies affect
output:
• Policymakers may be able to neutralize shocks to
the economy.
3. There is a dynamic trade-off between
output and inflation:
• The Phillips curve is the dynamic trade-off between
output and inflation.
Philips curve
The Empirical Fit of the Phillips
Curve
• Empirically, the slope is approximately
one-half.
– Meaning: if output exceeds potential by 2
percent, the inflation rate increases one
percentage point.
How the Short-Run Model Works
• Assume policymakers can select shortrun output through monetary policy
• Example:
– 1979: inflation was increasing because of
oil prices
– Monetary Policy: raise interest rates
– What happens?
– Recession!
Important thing about the Philip
Curve
• This is about accelerating and
decelerating inflation. This is a change
in the change of the price level
• Is the Philips Curve fixed?
– Supply Shocks.
– Expectations.
Okun’s law
Okun’s Law
Cyclical
unemployment
Current rate of
unemployment
Natural rate of
unemployment
Short-run
output
Okun’s Law 1960 Recession
Okun’s Law 1969 Recession
Okun’s Law 1980/1981
Recession
Okun’s Law 1990 Recession
Okun’s Law Great Recession
11.1 Introduction
• In this chapter, we learn
– The first building block of our short-run
model: the IS curve
• describes the effect of changes in the real
interest rate on output in the short run.
– How shocks to consumption, investment,
government purchases, or net exports—
“aggregate demand shocks”—can shift the
IS curve.
– A theory of consumption called the lifecycle/permanent-income hypothesis.
– That investment is the key channel through
which changes in real interest rates affect
GDP in the short run.
• The Federal Reserve exerts a
substantial influence on the level of
economic activity in the short run.
– Sets the rate at which people borrow and
lend in financial markets
• The basic story is this:
• The IS curve
– The IS curve captures the relationship
between interest rates and output in the short
run.
– There is a negative relationship between the
interest rate and short-run output.
– An increase in the interest rate will decrease
investment, which will decrease output.
11.2 Setting Up the Economy
• The national income accounting identity
– Implies that the total resources available to
the economy equal total uses
– One equation with six unknowns
Investment
Consumption
Production
Imports
Government
purchases
Exports
• We need five additional equations to solve
the model:
Consumption and Friends
• Level of potential output is
given exogenously.
– Consumption C,
government purchases G,
exports EX, and imports IM
depend on the economy’s
potential output.
– Each of these components
of GDP is a constant
fraction of potential output.
• the fraction is a parameter
• Potential output is smoother than actual
GDP.
– A shock to actual GDP will leave potential
output unchanged
• The equation depends on potential output.
– Shocks to income are “smoothed” to keep
consumption steady.
The Investment Equation
A term weighting the
difference between
the real interest rate
and the MPK
The share of
potential output that
goes to investment
Real
interest
rate
Marginal
Product of
Capital
(MPK)
• The MPK
– Is an exogenous parameter
– Is time invariant
• If the MPK is low relative to the real
interest rate
– Firms should save money and not invest in
capital
• If the MPK is high relative to the real
interest rate
– Firms should borrow and invest in capital
• In the short run, the MPK and the real
interest rate can be different.
– Installing capital to equate the two takes time.
11.3 Deriving the IS Curve
1. Divide the national income accounting
identity by potential output.
2. Substitute the five equations into this
equation.
3. Recall the definition of short-run output.
Simplifies the equation for the IS curve:
• The gap between the real interest rate and
the MPK is what matters for output
fluctuations.
– Firms can always earn the MPK on new
investments.
• The parameter
– Is
– Is called the aggregate demand shock
– Will equal zero when potential output is equal
to actual output
Case Study: Why is it called the “IS Curve”?
• IS stands for “investment = savings”
• See this again in Chapters 17 and 18.
11.4 Using the IS Curve
The Basic IS Curve
• When the demand shock parameter
equals zero, the IS curve has a shortrun output of 0 where the real interest
rate is equal to the long-run value of the
MPK.
The Effect of a Change in
the Interest Rate
• When the real interest rate changes, the
economy will move along the IS curve.
– An increase in the interest rate
• causes the economy to move up the IS
curve
• Causes short-run output to decline
• When the real interest rate changes, the
economy will move along the IS curve:
– The higher interest rate
• raises borrowing costs
• reduces demand for investment
• reduces output below potential
• If the sensitivity to the interest rate were
higher
– The IS curve would be flatter
– Any change in the interest rate would be
associated with larger changes in output
– Draw horizontal and vertical IS curves.
An Aggregate Demand Shock
• Suppose that information technology
improvements create an investment
boom.
– The aggregate demand shock parameter will
increase.
– Output is higher at every interest rate and the
IS curve shifts right.
– For any given real interest rate Rt, output is
Demand shock
higher when
parameter
Case Study: Move Along or Shift?
A Guide to the IS Curve
• A change in R shows up as a
movement along the IS curve.
– The IS curve is a graph of R versus
short-run output.
• Any other change in the parameters
of the short-run model causes the IS
curve to shift.
A Shock to Potential Output
• Shocks to potential output
– Change actual output by the same amount in
our setup
– Do not change short-run output
• Some shocks to potential output may change
other parameters. Earthquake, for example:
– Reduces actual and potential output by the
same amount
– Leads to an increase in short-run output
because it also increases the MPK
Other Experiments
• Imagine that Japan enters into a
recession.
– The aggregate demand parameter for
exports declines.
• the IS curve shifts to the left
– thus the Japanese recession has an
international effect.
– We could shock any of the other aggregate
demand parameters.
11.5 Microfoundations of the
IS Curve
• Microfoundations
– The underlying microeconomic behavior
that establishes the demands for C, I, G,
EX, and IM.
Consumption
• People prefer a smooth path for
consumption compared to a path that
involves large movements.
• The permanent-income hypothesis
– People will base their consumption on an
average of their income over time rather than
on their current income.
• The life-cycle model of consumption
– Suggests that consumption is based on
average lifetime income rather than on
income at any given age.
• The life-cycle model of consumption:
– Young people borrow to consume more
than their income.
– As income rises over a person’s life
• consumption rises more slowly
• individuals save more
– During retirement, individuals live off
their accumulated savings.
• The life-cycle/permanent-income (LC/PI)
hypothesis
– Implies that people smooth their consumption
relative to their income
– This is why we set consumption proportional
to potential output rather than actual output.
• Alaska:
– Residents receive a refund based on
state oil revenues.
– A separate refund from federal tax
revenues
– A study shows that:
• consumption does not change when
residents receive the oil revenue refund.
• the same individuals increase consumption
when federal tax refunds are received.
Multiplier Effects
• We can modify the consumption
equation to include a term that is
proportional to short-run output.
• Solving for the IS curve
– Will yield a similar result
– Now includes a multiplier on the aggregate
demand shock and interest rate terms:
• the multiplier is larger than one
• With a multiplier:
– Aggregate demand shocks will increase
short-run output by more than one-for-one.
– A shock will “multiply” through the economy
and will result in a larger effect.
• If short-run output falls with a multiplier
– Consumption falls
– Which leads to short-run output falling
– Consumption falls again
– “Virtuous circle” or “vicious circle”
Investment
• At the firm level, investment is
determined by the gap between the real
interest rate and MPK.
• In a simple model
– The return on capital is the MPK minus
depreciation.
• The richer framework includes:
– Corporate income taxes
– Investment tax credits
– Depreciation allowances
• A second determinant of investment
– The firm’s cash flow
• the amount of internal resources the
company has on hand after paying its
expenses
What is wonky about this
model?
• What does it mean to say R > r?
• Can we explain this with cash flow?
Financing out of firm’s savings?
– Why finance a project at r when you can
save with paper assets at R?
Government Purchases
• Government purchases can be
– A source of short-run fluctuation
– An instrument to reduce fluctuations
• Discretionary fiscal policy
– Includes purchases of additional goods in
addition to the use of tax rates
– For example, the government can use the
investment tax credit to encourage
investment
• Transfer spending often increases when
an economy enters into a recession.
• Automatic stabilizers
– Programs where additional spending
occurs automatically to help stabilize the
economy
– Welfare programs and Medicaid are two
such stabilizer programs.
• receive additional funding when the
economy weakens
• Fiscal policy’s impact depends on two
things:
1. The problem of timing
• discretionary changes are often put into
place with significant delay.
2. The no-free-lunch principle
• implies that higher spending today must
be paid for today or some point in the
future.
• such taxes may offset the impact of the
discretionary spending adjustment.
Case Study: The Macroeconomic
Effects of the American Recovery
and Reinvestment Act of 2009
• Economists had a wide range of opinions
about the effectiveness and costs of the
stimulus.
• Congressional Budget Office (CBO) gave
estimates of unemployment with and
without a stimulus.
– Estimated 9 percent peak without a stimulus
– Actual unemployment rate with stimulus was
above this.
Net Exports
• If Americans demand more imports
– The IS curve shifts left and reduces shortrun output
• If foreigners demand more American
exports
– The IS curve shifts right
11.6 Conclusion
• Higher interest rates
– Raise the cost of borrowing to firms and
households
– Reduce the demand for investment
spending
– Decrease short-run output
Summary
• The IS curve
– Describes how output in the short run
depends on the real interest rate and on
shocks to the aggregate economy
– Shows a negative relationship between
output and the real interest rate
• When the real interest rate rises, the cost of
borrowing increases, leading to delayed
purchases of capital.
• These delays reduce the level of investment,
which in turn lowers output below potential.
• Shocks to aggregate demand can shift
the IS curve. These shocks include:
– Changes in consumption relative to
potential output
– Technological improvements that stimulate
investment demand given the current
interest rate
– Changes in government purchases relative
to potential output
– Interactions between the domestic and
foreign economies that affect exports and
imports
• The life-cycle/permanent-income
hypothesis
– Individual consumption depends on average
income over time rather than current income
– Serves as the underlying justification for why
we assume consumption depends on
potential output
• The permanent-income theory
– Does not seem to hold exactly
– Consumption responds to temporary
movements in income as well.
• When we include this effect in our IS
curve, a multiplier term appears.
– That is, a shock that reduces the aggregate
demand parameter may have an even larger
effect on short-run output.
• A consideration of the microfoundations
of the equations that underlie the IS
curve reveals important subtleties.
• The most important are associated with
the no-free-lunch principle imposed by
the government’s budget constraint.
• Depending on how government
purchases are financed, they can also
affect consumption and investment.
– partially mitigating the effects of fiscal policy
on short-run output
Additional Figures for
Worked Exercises
12.1 Introduction
• In this chapter, we learn:
– How the central bank effectively sets the real interest
rate in the short run, and how this rate shows up as the
MP curve in our short-run model.
– That the Phillips curve describes how firms set their
prices over time, pinning down the inflation rate.
– How the IS curve, the MP curve, and the Phillips curve
make up our short-run model.
– How to analyze the evolution of the macroeconomy in
response to changes in policy or economic shocks.
• The federal funds rate
– The interest rate paid from one bank to
another for overnight loans
• The monetary policy (MP) curve
– Describes how the central bank sets the
nominal interest rate
• The short-run model summary:
– Through the MP curve
• the nominal interest rate determines the
real interest rate
– Through the IS curve
• the real interest rate influences GDP in the
short run
– The Phillips curve
• describes how booms and recessions
affect the evolution of inflation
12.2 The MP Curve: Monetary
Policy and the Interest Rates
• Large banks and financial institutions
borrow from each other.
• Central banks set the nominal interest
rate by stating what they are willing to
lend or borrow at the specified rate.
• Banks cannot charge a higher rate.
– everyone would use the central bank.
• Banks cannot charge a lower rate.
– They would borrow at the lower rate and lend
it back to the central bank at a higher rate.
– This is called the arbitrage opportunity.
• Thus, banks must exactly match the rate
the central bank is willing to lend at.
From Nominal to Real Interest Rates
• The relationship between the interest
rates is given by the Fisher equation.
Nominal
interest
rate
Real
interest
rate
Rate of
inflation
• The sticky inflation assumption
– The rate of inflation displays inertia, or
stickiness, so that it adjusts slowly over time.
– In the very short run the rate of inflation does
not respond directly to monetary policy.
– Central banks have the ability to set the real
interest rate in the short run.
Why is there sticky inflation?
• Imperfect information
• Costs of setting prices
• Contracts also set prices and wages in nominal rather than real
terms.
• There are bargaining costs to negotiating prices and wages.
• Social norms and money illusions
– Cause concerns about whether the nominal wage should
decline as a matter of fairness
• Money illusion
– The idea that people sometimes focus on nominal rather
than real magnitudes
The IS-MP Diagram
• The MP curve
– Illustrates the central bank’s ability to set
the real interest rate
• Central banks set the real interest rate
at a particular value.
– The MP curve is a horizontal line.
• The nominal interest rate
– Is the opportunity cost of holding money
– Is the amount you give up by holding money
instead of keeping it in a savings account
– Is pinned down by equilibrium in the money
market
• If the nominal interest rate is higher than
its equilibrium level
– Households hold their wealth in savings rather
than currency.
– The nominal interest rate falls.
• The demand for money
– Is a decreasing function of the nominal
interest rate
– Is downward sloping
– Higher interest rates reduce the demand for
money.
• The supply of money
– Is a vertical line for the level of money the
central bank provides
Changing the Interest Rate
• To raise the interest rate
– The central bank reduces the money
supply
– Creates an excess of demand over supply
– A higher interest rate on savings accounts
reduces excess demand.
– The markets adjust to a new equilibrium.
Why it instead of Mt?
• The interest rate is crucial even when
central banks focus on the money supply.
• The money demand curve is subject to
many shocks, which shift the curve.
– Changes in price level
– Changes in output
• If the money supply is constant
– The nominal interest rate fluctuates
– Resulting in changes in output
• The money supply schedule is effectively
horizontal at a targeted interest rate.
• An expansionary (loosening) monetary policy
– Increases the money supply
– Lowers the nominal interest rate
• A contractionary (tightening) monetary policy
– Reduces the money supply
– Increases the nominal interest rate
• The economy is at potential when
– The real interest rate equals the MPK.
– There are no aggregate demand shocks.
– Short-run output = 0.
• If the central bank raises the interest rate
above the MPK
– Inflation is slow to adjust.
– The real interest rate rises.
– Investment falls.
Example: The End of a Housing
Bubble
• Suppose housing prices had been rising,
but then they fall sharply.
– The aggregate demand parameter declines.
– The IS curve shifts left.
• If the central bank lowers the nominal
interest rate in response:
– The real interest rate falls as well because
inflation is sticky.
– If judged correctly and without lag, the
economy would not have a decline in output.