Understanding IS Curve and Macroeconomic Equilibrium

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: 18.1 Understand what the IS curve is and how it is derived. Explain the significance of the MP curve and the Phillips curve. 18.2 Use the IS–MP model to illustrate macroeconomic equilibrium. 18.3 Discuss alternative channels of monetary policy. 18.4 Use the IS-LM model to illustrate macroeconomic equilibrium. 18A

3. 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.

4. 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?

5. 18.1 Learning Objective Understand what the IS curve is and how it is derived.

6. The IS Curve 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.

7. The IS Curve Equilibrium in the Goods Market

8. The IS Curve

9. The IS Curve 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.

10. The IS Curve 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.

11. The IS Curve 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. Multiplieris the change in equilibrium GDP divided by a change in autonomous expenditure.

12. The IS Curve

13. The IS Curve 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.

14. Solved Problem 18.1 Calculating Equilibrium Real GDP trillion The IS Curve

15. Solved Problem Solved Problem 18.1 Calculating Equilibrium Real GDP The IS Curve

16. The IS Curve Fiscal policy is a change in federal government purchases and taxes intended to achieve macroeconomic policy objectives.

17. The IS Curve 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.

18. 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.

19. The IS Curve 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.

20. The IS Curve Figure 18.4 Output Gap The output gap is negative during recessions as real GDP is below potential GDP.

21. The IS Curve 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.

22. The IS Curve 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.

23. The IS Curve 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.

24. 18.2 Learning Objective Explain the significance of the MP curve and the Phillips curve.

25. The MP Curve and the Phillips Curve 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.

26. The MP Curve and the Phillips Curve The MP Curve Figure 18.7 The MP Curve

27. The MP Curve and the Phillips Curve 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.

28. The MP Curve and the Phillips Curve The Phillips Curve Taking all of these factors into account gives us the following equation for the Phillips curve:

29. The MP Curve and the Phillips Curve The Phillips Curve Figure 18.8 The PhillipsCurve The Phillips curve illustrates the short-run relationship between the unemployment rate and the inflation rate.

30. The MP Curve and the Phillips Curve 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.

31. The MP Curve and the Phillips Curve 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.

32. The MP Curve and the Phillips Curve 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.•

33. The MP Curve and the Phillips Curve 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.

34. 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

35. 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

36. 18.3 Learning Objective Use the IS–MP model to illustrate macroeconomic equilibrium.

37. Equilibrium in the IS–MP Model 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.

38. 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

39. Equilibrium in the IS–MP Model Using Monetary Policy to Fight a Recession Figure 18.13 Expansionary Monetary Policy

40. Equilibrium in the IS–MP Model 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.

41. Equilibrium in the IS–MP Model 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.

42. Equilibrium in the IS–MP Model Figure 18.15 Expansionary Monetary Policy in the Face of a Rising Risk Premium

43. 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.

44. Making the Connection Trying to Hit a Moving Target: Forecasting with “Real-Time Data” Equilibrium in the IS–MP Model

45. 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 1Review the chapter material. Equilibrium in the IS–MP Model

46. Solved Problem Solved Problem 18.3 Using Monetary Policy to Fight Inflation Step 2Describe 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

47. Solved Problem Solved Problem 18.3 Using Monetary Policy to Fight Inflation Step 3Show 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

48. 18.4 Learning Objective Discuss alternative channels of monetary policy.

49. Are Interest Rates All That Matter for Monetary Policy? 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.

50. Are Interest Rates All That Matter for Monetary Policy? 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.