econ project
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Explaining aggregate demand: the IS-MP model
Explain how the IS curve represents the relationship between the real interest rate and aggregate expenditure.
Use the IS–LM model to illustrate macroeconomic equilibrium.
Use the monetary policy, MP, curve to show how the interest rate set by the central bank helps to determine the output gap.
Use the IS–MP model to understand why real GDP fluctuates.
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| Learning Objectives | |
| After studying this chapter, you should be able to: | |
| 10.1 | |
| 10.2 | |
| 10.3 | |
| 10.A |
10
Fear of falling (into a recession)
By late 2012, U.S economy was three years into a recovery from the severe recession of 2007-2009.
Recovery relatively weak—real GDP still ~5% below potential, unemployment ~8%.
There were fears a new recession would start:
Possibility of sharply increased taxes, decreased spending in 2013.
Economic problems in Europe may spread to U.S.
In long-run models, these things shouldn’t cause problems. But they may in the short run.
Short run is important. Keynes: “In the long run, we are all dead.”
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The U.S. economy has experienced 11 recessions since the end of WWII.
What explains the business cycle?
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Key Issue and Question
Issue:
Question:
The IS-MP model
We develop the IS-MP model to explain changes in real GDP, the inflation rate, and interest rates.
This model helps us understand why economic fluctuations occur and how policymakers use fiscal and monetary policy to reduce the severity of recessions.
The IS-MP model analyzes determinants of real GDP, the inflation rate, and the real interest rate in the short run.
Model assumes price level is fixed (implies horizontal short-run aggregate supply.
The IS-MP model simplifies reality and helps us examine how monetary policy and fiscal policy can be used in an attempt to affect the economy.
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Explain how the IS curve represents the relationship between the real interest rate and aggregate expenditure.
10.1
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10
Initial IS-MP definitions
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 combination of the real interest rate and aggregate output that represents 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 that represents the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.
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Equilibrium in the goods market
Aggregate expenditures on real GDP is determined as the sum of :
Consumption demand (C).
Investment in business plant and equipment, inventories, and housing (I).
Government purchases (G).
Net exports (NX), which are exports minus imports.
Real GDP is the market value of all final goods and services in a period of time.
Goods market uses real GDP.
Equilibrium occurs where the value of goods demanded (AE) equals the value of goods produced (Y)
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Equilibrium and disequilibrium in the goods market
If production exceeds demand, unsold goods accumulate and inventories rise.
If GM produces 250,000 cars, but only sells 225,000, 25,000 are added to GM’s inventories.
Actual investment (counting inventories) exceeds planned investment.
If unplanned investment is widespread, real GDP and employment will decline.
If production is less than demand, inventories are drawn down, actual investment exceeds planned investment, and GDP/employment falls.
If production equals demand, the goods market is in equilibrium.
The relationship between aggregate expenditure and GDP
Table 10.1
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Equilibrium in the goods market
Simplifying assumption: I, G, and NX are exogenous—they do not depend on real GDP.
Only consumption (C) depends on real GDP.
How? Households spend some fraction of each extra dollar of disposable income: the MPC, or marginal propensity to consume.
Marginal propensity to consume (MPC) The amount by which consumption spending changes when disposable income changes.
Here, disposable income is total income (Y) plus transfer payments (TR) minus taxes (T):
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Consumption function and aggregate expenditures
We assume that consumers have some level of consumption that is autonomous (does not depend on income): recall that . Then the consumption function relates consumption and disposable income:
Of the components of disposable income, we assume only real GDP changes (i.e. taxes and transfer payments are autonomous). And disposable income changes one-for-one with real GDP, so:
Then we can form an expression for aggregate expenditures:
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Equilibrium in the goods market
As Y rises, C increases at the rate MPC.
Equilibrium occurs where AE = Y, which is where the AE line crosses the line.
Illustrating equilibrium in the goods market
Figure 10.1a
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Adjustment to equilibrium in the goods market
Suppose output were too high, at Y2.
There is an unplanned increase in inventories.
Firms cut back on production, reducing output.
A similar mechanism takes place if output is too low, say at Y3.
Adjusting to equilibrium in the goods market
Figure 10.1b
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A change in investment spending
Begin with the economy in equilibrium at A, where GDP is equal to potential GDP (YP).
We examine a decline in investment spending: the aggregate expenditure line falls from AE1 to AE2.
New equilibrium at point B results in a larger reduction in GDP than the initial change in investment.
Spending is below production, inventories accumulate, and output and employment fall from Y1 to Y2.
The multiplier effect
Figure 10.2
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The multiplier effect
The change in output is larger than the change in investment spending.
The change has a multiplied effect on equilibrium real GDP.
This is true for any change in autonomous expenditure.
Multiplier effect A series of induced increases (or decreases) in consumption spending that results from an increase (or decrease) in autonomous expenditure; this effect amplifies the effect of economic shocks on real GDP.
How much of a change to we get? That depends on the value of the multiplier:
Multiplier The change in equilibrium GDP divided by the change in autonomous expenditure.
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An expression for the multiplier
Since in equilibrium , we know:
Suppose (autonomous) investment changes by ; then real GDP will go up by some amount , which will then induce some increase in consumption, depending on the marginal propensity to consume:
The same logic applies for a change in any autonomous component of aggregate expenditure:
For example, if MPC=0.75, a $1 billion increase in any autonomous expenditure will increase real GDP by $4 billion.
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The government purchases and tax multiplier
A change in government purchases induces a change in equilibrium GDP in the same way as investment:
A change in taxes works slightly differently. An increase in taxes of size makes an initial change in consumption of ; so:
Then if the , a $1 billion increase in taxes decreases equilibrium GDP by $3 billion.
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Calculating equilibrium real GDP
Use the information on the right to calculate equilibrium real GDP (values in trillions of 2005 dollars).
Suppose taxes change to $2.5 billion, and transfers to $2.0 billion. Recalculate equilibrium real GDP.
Suppose potential GDP is $17.0 trillion. By how much would government purchases have to increase to make equilibrium GDP equal potential GDP? How about taxes? Illustrate your answer with a graph.
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Solved Problem
Calculating equilibrium real GDP
Step 1 Review the chapter material.
Step 2 Answer (a) by solving for equilibrium in the line model. In equilibrium: So equilibrium GDP is $17.6 trillion.
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Solved Problem
Calculating equilibrium real GDP
Step 3 Answer (b) by substituting the values for taxes and transfers into the consumption function, and solving again for equilibrium. In equilibrium: So equilibrium GDP is $16.1 trillion.
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Solved Problem
Calculating equilibrium real GDP
Step 4 Answer (c) by using the values for the government purchases and tax multipliers to calculate the changes necessary to restore GDP to potential. GDP is $0.9 trillion below potential ($17.0 trillion – $16.1 trillion). So government purchases would need to increase by: , or $225 billion. So taxes would need to increase by: 3, i.e. a decrease of $300 billion.
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Solved Problem
Calculating equilibrium real GDP
Step 5 Finish (c) by drawing a graph that shows the changes in government purchases or taxes necessary for short-run equilibrium to occur at real GDP of $17.0.
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Solved Problem
Constructing the IS curve
Monetary policy and financial markets also impact output.
The real interest rate impacts consumption, investment, and net exports.
The real interest rate is relevant to spending decisions.
Declining real interest rate:
Firms more willing to invest, increasing I.
Consumers more willing to borrow and spend, increasing C.
The exchange rate falls, increasing NX.
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Deriving the IS curve
As interest rates fall, C, I, and NX all rise, leading to a shift in the AE line from AE(r1) to AE(r2).
The IS curve is downward sloping as lower interest rates are related to higher equilibrium output.
Deriving the IS curve
Figure 10.3
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Shifts of the IS curve
A change in the interest rate causes a movement along the IS curve.
Changing other factors that affect aggregate expenditure will cause a shift of the IS curve.
Factors that shift the IS curve are demand shocks.
Demand shocks increasing aggregate expenditure shift the IS curve right.
Demand shocks decreasing aggregate expenditure shift the IS curve left.
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A positive demand shock
Recoveries in China and Europe increase U.S. exports and represent a positive demand shock, raising NX, shifting the IS curve to the right.
At the same real interest rate , r1, the economy is at a higher equilibrium level of output.
A positive demand shock and the IS curve
Figure 10.4
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The IS curve and the output gap
Economic fluctuations are measured using output gaps.
Output below potential in a recession yields a negative output gap.
Output above potential in an expansion yields a positive output gap.
We replace the level of output in previous diagrams with the output gap.
Estimate the percentage deviation from potential.
Where output is equal to potential the gap is zero.
We use the symbol Ỹ to represent the output gap where Y = YP.
The IS curve using the output gap
Figure 10.5
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Use the monetary policy, MP, curve to show how the interest rate set by the central bank helps to determine the output gap.
10.2
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| Learning Objective |
10
The monetary policy curve
The monetary policy (MP) curve describes the relationship between the central bank’s target interest rate, and output.
The Fed conducts monetary policy by managing the money supply and interest rates to pursue policy objectives such as:
Price stability.
High employment.
High rates of growth.
Fed focuses monetary policy on interest rates.
MP curve represents the Fed’s control of the federal funds rate, a key short-term interest rate.
The federal funds rate is a rate that banks lend money to one another on an unsecured basis for short periods.
Potential problem for the Fed: long-term real rates are relevant to firm and household decisions.
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Short-term nominal and long-term real interest rates
Term structure of interest rates The relationship among the interest rates on bonds that are otherwise similar but have different maturities.
Differences between short-term and long-term nominal interest rates are due to:
Expectations of future short-term rates given by the term structure.
The term premium.
Term premium The additional interest that investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds.
Combining these two factors gives us the term structure effect (TSE).
The long-term nominal interest rate iLT is determined as:
If the Fed increases the short-term nominal interest rate and TSE is fixed, long-term rates will also increase.
Lower expected future short-term rates would lower long-term rates today.
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Short-term nominal and long-term real interest rates
Risk structure of interest rates The relationship among interest rates on bonds that have different characteristics but the same maturity.
Default risk The risk that a borrower will fail to make payments of interest or principal.
Bonds from issuers that might default pay a default-risk premium (DP).
Long-term nominal interest rates are related to short-term nominal interest rates by adding in TSE and DP:
This gives the long-term nominal interest rate. To obtain the long-term real interest rate, we subtract off expected inflation:
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Can the Fed control the long-term interest rate?
This gives us our final expression for the long-term real interest rate:
The Fed controls the short-term nominal interest rate i.
Assuming that term structure effects, the default-risk premium, and the expected inflation rate all remain unchanged, the Fed can control the long-term real interest rate also.
However when the Fed reduces short-term rates to stimulate spending, the long-term real interest rate may not fall:
Lenders may believe the future short-term nominal rate will be higher.
Making lenders believe otherwise requires credibility.
Lenders may require a higher default-risk premium.
May actually lower if Fed’s actions are likely to be successful.
Lenders may lower expectations of the future inflation rate.
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The effect of the Fed’s actions on expected inflation
The effect of Fed actions on expected inflation are complex.
Suppose the Fed lowers short-term rates to stimulate the economy.
Lenders, households, and firms believe increased economic activity will lead to higher inflation.
Higher expected inflation further decreases the long-term real rate.
However the Fisher effect indicates increases in expected inflation typically result in increases in long-term nominal interest rates, leaving real rates unchanged in the long run.
Since the Fisher effect does not work exactly in the short run, increases in expected inflation may result in decreases in the real interest rate.
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Real interest rates and the global savings glut
Our explanation of the MP curve suggests the Fed can increase the long-term real interest rate by increasing the federal funds rate.
In practice, it’s not quite that easy for the Fed.
The figure shows the nominal target federal funds rate along with the real interest rate on a 10-year TIPS.
The increasing federal funds rate should have increased long-term real interest rates, all else held constant.
In 2005, Ben Bernanke argued a “global savings glut” was keeping long-term real interest rates low.
So all else was not constant.
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Macro Data
Interest rate movements during the 2007-2009 recession
In the 2007-2009 recession, we saw that the Fed can influence long-term rates but does not have full control over them.
The Fed reduced the federal funds rate to nearly zero and indicated it would stay there for an extended period.
Long-term borrowing rates did not fall to zero.
Term premium and default risk premiums still applied.
Default risk premium rose from 0.9% on 8/1/07 to 3.0% on 3/18/09.
Rise in DP offset some of the Fed efforts to keep interest rates low.
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Short term nominal interest rates move together
The Fed and other central banks have interest rate targets and adjusts the money supply to keep interest rates at those targets.
In the U.S., the Federal Reserve targets the federal funds rate; but other short-term interest rates move closely with the FFR.
Short-term nominal interest rates typically move together
Figure 10.6
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Deriving the MP curve
When deriving the MP curve, we assume TSE, DP, and expected inflation are constant, so the Fed controls the long-term real interest rate via the short-term nominal rate.
As the output gap changes, money demand also changes. In order to keep the interest rate it its target level, the Fed increases the money supply.
The result is a horizontal MP curve.
Deriving the MP curve
Figure 10.7
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Shifts of the MP curve
The MP curve is determined by the Fed’s short-term nominal interest rate target, the term structure effect, the default-risk premium, and the expected inflation rate.
If any of the factors determining MP change, the MP curve shifts up.
Example: Reducing the Fed’s target interest rate would shift the MP curve down.
Increasing the Fed’s target interest rate would shift the MP curve up.
Changes in the interest rate target and the MP curve
Figure 10.8
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Factors that shift the MP curve
Factors that shift the MP curve
Table 10.2
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Factors that shift the MP curve—continued
Factors that shift the MP curve
Table 10.2
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Use the IS–MP model to understand why real GDP fluctuates.
10.3
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| Learning Objective |
10
Equilibrium in the IS-MP model
For a given IS curve, the Fed’s choice of the real interest rate determines the equilibrium output gap.
Other factors may affect the MP curve, changing the equilibrium level of real GDP and changing the output gap.
Similarly, demand shocks can affect the IS curve, causing fluctuations to real GDP (assuming the Fed does not change the real interest rate).
Equilibrium in the IS-MP model
Figure 10.9
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Demand shocks in the IS-MP model
Demand shocks affect the IS curve.
A negative demand shock moves the IS curve to the left.
Example: When Iraq invaded Kuwait in August 1990, sparking fears of higher gasoline prices. Consumer confidence decreased, leading to a 3.1% decrease in (autonomous) consumer spending.
The result: a negative output gap (assuming no initial action from the Fed).
A positive demand shock would have the opposite effect.
A negative demand shock and equilibrium real GDP
Figure 10.10
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Will the European financial crisis cause a recession?
Will a recession in the United States result from the European financial crisis?
The recession of 2007-2009 caused large increases in government spending in Europe, and reductions in tax revenues also.
By the end of 2010, many investors doubted Greece’s ability to repay its debts.
IMF and ECB loans to Greece and other countries were made contingent upon the enactment of austerity policies: lower government spending and higher taxes.
By 2012, concerns existed that Greece may abandon the euro, and Spain may have similar problems.
The anticipated financial disruptions would likely push Europe back into a recession.
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Making the Connection
Will the European financial crisis cause a recession?
Meanwhile, the U.S. economy had not fully recovered from the 2007-2009 recession.
Decreasing exports to Europe would shift the IS curve to the left, potentially worsening the U.S. output gap; though the U.S. is not very dependent on exports to Europe.
Further concern: recession in Europe might disrupt spending in the U.S., resulting in a larger negative shift of the IS curve.
Also: potential for failures of European financial institutions or European sovereign debt default could hurt U.S. investors.
The Fed recognized this and undertook further monetary easing to keep the U.S. economy from slipping back into recession.
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Making the Connection
Monetary policy and fluctuations in real GDP
Previously we saw a negative demand shock pushing the economy into recession.
If the Fed recognizes this, it could lower the federal funds rate, shifting the MP curve down.
This is a simplified description of monetary policy, but illustrates how monetary policy typically works.
Though sometimes, especially when rates are near 0%, monetary policy may be ineffective.
The Fed ends a recession
Figure 10.11
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Summary of the IS-MP model
Summary of the IS-MP model
Table 10.3
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Summary of the IS-MP model—continued
Summary of the IS-MP model
Table 10.3
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Using the IS-MP model to analyze the 2001 tax cut
In 2001, the U.S. economy experienced a recession: from March to November 2001, according to the NBER. The output gap remained negative until 2005.
In June 2001, President George W. Bush reduced income tax rates, and gave a one-time tax rebate.
This resulted in an increase in disposable income, leading households to increase their consumption spending.
Use the IS-MP model to analyze the effect of the tax on real GDP and the output gap.
Be sure to show any changes in the IS curve and the MP curve, as well as the old and new equilibrium values of the output gap.
Also, state any assumptions you are making about monetary policy.
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Solved Problem
Using the IS-MP model to analyze the 2001 tax cut
Step 1 Review the chapter material.
Step 2 Draw a graph that shows the initial equilibrium. The economy was in a recession when the act was passed, so the equilibrium real GDP was less than potential GDP with a negative output gap (Ỹ < 0)
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Solved Problem
Using the IS-MP model to analyze the 2001 tax cut
Step 3 Determine which curve shifts. Reducing income tax rates means disposable income will increase. Households increase consumption, and through the multiplier effect aggregate expenditure is now higher at any given real interest rate. The IS curve shifts to the right from IS1 to IS2.
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Solved Problem
Using the IS-MP model to analyze the 2001 tax cut
Step 4 State your assumption about monetary policy and explain the effect of the act on real GDP and the output gap. We have assumed the Fed maintained the real interest rate at the previous level. As we drew the shift of the IS curve, it was not sufficient to lift the economy out of recession—the output gap remained negative—but it did lessen the severity of the recession.
Extra Credit: While we showed the short-run effect of the expansionary fiscal policy, President Bush and members of Congress hoped the tax cuts would have a long-run effect also: increased economic growth. They hoped lowering tax rates would increase incentives to work, save, and invest.
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Solved Problem
IS-MP and aggregate demand
The IS-MP model is a model of aggregate demand.
Recall from previous chapter that the aggregate demand curve represents all equilibrium combinations of real GDP and the price level.
Alternatively: represents all equilibrium combinations of the output gap and the price level.
Deriving the aggregate demand curve
Figure 10.12
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IS-MP and aggregate demand
Consider the effect of an increase in the price level on the IS curve:
Demand for money curve (not shown here) shifts to the right, increasing equilibrium interest rate.
Higher interest rate causes decline in aggregate expenditure: a movement up along the IS curve.
Assumes the Fed allows the interest rate to rise.
Deriving the aggregate demand curve
Figure 10.12
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Expansionary monetary policy
An expansionary monetary policy refers to the Fed intentionally lowering the interest rate.
Equilibrium in the IS-MP model occurs at an improved output gap.
This shifts the AD curve to the right for every price level.
An expansionary monetary policy
Figure 10.13
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Answering the key question
“What explains the business cycle?”
The business cycle refers to the irregular pattern of short-run increases in production and employment followed by short-run decreases in production and employment—expansions followed by contractions.
Most economists believe fluctuations in aggregate expenditure cause the business cycle.
These cause real GDP to increase or decrease relative to potential GDP, i.e. they cause the output gap to fluctuate.
The IS-MP model helps us analyze how fluctuations in aggregate expenditure result in fluctuations in the output gap.
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Use the IS-LM model to illustrate macroeconomic equilibrium.
10.A
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| Learning Objective |
10
IS-LM: an alternative short-run macro model
The Fed could choose to target the money supply instead of the interest rate as in the IS-MP model. The IS-LM model is complementary to the IS-MP model.
IS-LM model A macroeconomic model that assumes that the central bank targets the money supply.
LM curve A curve that shows the combinations of the real interest rate and output that result in equilibrium in the market for money.
The IS-LM and IS-MP models use the IS curve to show the negative relationship between the real interest rate and aggregate expenditure.
The models differ in their treatment of financial markets.
The IS-MP model assumes the Fed has a short-term nominal interest rate target.
The IS-LM model assumes the Fed has a target level of the money stock.
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Appendix
Asset market equilibrium
Savers can allocate their wealth between two broad asset categories.
Money assets, like cash.
Non-money assets, like stocks and bonds.
Each household determines how to allocate wealth.
Remember wealth is a stock of assets.
The markets for money and non-money assets are in equilibrium when the total quantities demanded equal the total quantities supplied.
Total demand for money balances, Md and non-money balances, Nd equals total wealth.
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Appendix
Asset market equilibrium
On the supply side, wealth (W) represents the sum of total quantity of money supplied (Ms) and the total quantity of non-money assets supplied (N).
Setting supply equal to demand, combining terms, and setting excess demand for each type of asset equal to zero:
If the quantity of money demanded exceeds supply, Md > Ms, the quantity of non-money assets supplied must be greater than demanded, Ns > Nd.
Excess demand of one asset equals the excess supply of the other.
Asset prices will adjust, so there is no excess supply or demand in either market.
Each side of the equation above must equal zero.
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Appendix
Deriving the LM curve
Using real money balances, M/P, and the real interest rate, we determine the equilibrium real rate as the intersection between money demand and money supply.
Real money demand depends on the nominal interest rate and the level of real GDP.
If the price level is initially constant, there is little difference between real money supply and nominal money supply and, similarly, for money demand.
Assume the central bank keeps the nominal money stock constant.
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Appendix
Deriving the LM curve
Beginning in equilibrium at point A, if we increase the output gap (i.e. real GDP) from Ỹ 1 to Ỹ 2, money demand increases, thus raising the real interest rate from r1 to r2.
As real GDP rises, the interest rate to keep the money market in equilibrium increases.
Deriving the LM curve
Figure 10A.1
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Appendix
Factors that shift the LM curve
The LM curve shows combinations of the output gap and the real interest rate that result in equilibrium in the market for money.
Factors that affect the market for money other than the output gap shift the LM curve.
Example: The Fed increases the nominal money supply.
If prices remain constant, the real money supply rises.
Money supply shifts to the right.
Real interest rates fall.
At the same output gap as before, the real interest rate is now lower.
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Appendix
Shifting the LM curve
An increase in the money supply shifts the LM curve to the right, reducing real interest rates from r1 to r2.
The real interest rate, r2, previously coincided with a much lower output gap.
An increase in the money supply and the LM curve
Figure 10A.2
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Appendix
Equilibrium in the IS-LM model
The market for goods and services and the market for money are both in equilibrium at the point where the IS curve intersects with the LM curve.
At the equilibrium, the real interest rate equals the equilibrium interest rate, and real GDP equals potential GDP—so the output gap is zero.
Equilibrium in the IS-LM model
Figure 10A.3
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Appendix
Using monetary policy to increase output
If the Fed increases the nominal money stock, the LM curve shifts from LM1 to LM2 and the resulting excess supply of money leads to real rates falling.
Lower real rates lead to more consumption and investment, which is represented by movement along the IS curve.
Real GDP increases relative to potential, and interest rates fall in equilibrium at point B.
An increase in the nominal money stock and equilibrium
Figure 10A.4
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.
An increase in the
nominal mon
e
y supply
shifts the
LM
cu
r
v
e to
the
r
ight, so ...
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Appendix
A positive demand shock
A positive shock to demand, perhaps from a stock market boom, shifts the IS curve from IS1 to IS2. The increase in real GDP that occurs leads to increased money demand with a constant stock of real money.
Real interest rates rise from r1 to r2 and a positive output gap results.
The effect of a positive demand shock on equilibrium
Figure 10A.5
2. ...the output gap
to change from
Y
1
to
Y
2
, and ...
˜
˜
3. ... the real
interest rate to
increase from
r
1
to
r
2
.
A
LM
IS
1
r
1
Real interest
rate,
r
Y
1
0
˜
˜
Output gap,
Y
(percent deviation
from potential GDP)
B
r
2
Y
2
˜
IS
2
1.
A
positive demand
shock shifts the
IS
curve to the right, causing ...
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Appendix
Monetary policy during the Great Depression
Nobel Laureate Milton Friedman criticized the Federal Reserve for allowing the money supply to decrease during the Great Depression.
The nominal money supply decreased from $26.2 billion during the third quarter of 1929 to $18.9 billion during the first quarter of 1933—a 27% decrease in just four years.
Real interest rates on corporate bonds rose from 6% to about 17%, and real GDP fell by more than 25%.
Real GDP equaled potential GDP at the beginning of the Great Depression, but real GDP may have been as much as 35% below potential GDP during the first quarter of 1933!
In Friedman’s view, the decrease in the money supply played an important role in the decrease in real GDP during the Great Depression.
Is Friedman’s view consistent with the IS–LM model?
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Solved Problem
Monetary policy during the Great Depression
Step 1 Review the chapter material.
Step 2 Draw a graph that shows the initial equilibrium in 1929. Real GDP was equal to potential GDP at the outset of the Great Depression, so we start with an output gap equal to zero and a real interest rate of 6%.
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Solved Problem
Monetary policy during the Great Depression
Step 3 Determine the effect of the decrease in the nominal money supply. The 27% decline in the nominal money stock occurred between 1929 and 1933. The LM curves are labeled LM1929 and LM1933. Our new equilibrium has a negative output gap and a higher real interest rate r1933 > r1929.
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Solved Problem
Monetary policy during the Great Depression
Step 4 Compare your graph to the actual experience. A decrease in the nominal money supply should lead to higher real rates and lower real GDP, which is similar to what actually occurred. The real rate rose from 6% to about 17%, while the output gap fell from 0% to about -35%. The IS-LM model gives a prediction consistent with Milton Friedman’s view that the decline in the nominal money stock contributed to the severity of the Great Depression.
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Solved Problem
An alternative derivation of the MP curve
We can use the LM curve to represent monetary policy and derive the MP curve.
Both are derived from the money market model.
Holding fixed expected inflation, the term structure effects and default-risk premium, the real interest rate is set by the Fed.
If the Fed adjusts the money stock to keep the market interest rate constant at the target, the IS-LM and IS-MP models are essentially the same.
Considering a positive demand shock, we see a positive output gap due to the shift in the IS curve from IS1 to IS2.
If the Fed keeps the nominal money supply fixed, then the real rate would rise from r1 to r2.
To maintain the target real rate, the Fed could increase the money supply, driving rates back down from r2 to r1 and pushing the output gap higher.
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Appendix
An alternative derivation of the MP curve
If the Fed acts quickly enough after the demand shock, the economy would move from A to C rather than from A to B.
The LM curve is convenient for modeling a central bank that targets the money supply.
The MP curve is convenient for modeling a central bank that targets the interest rate.
The latter is more appropriate for the Fed.
An alternative derivation of the MP curve
Figure 10A.6
MP
4. ...the output gap to
increase even furthe
r
.
r
target
r
1
3. ... the real interest
rate decreases back to
the target real interest
rate, causing ...
Real interest
rate,
r
Output gap,
Y
~
(percent deviation
from potential GDP)
IS
1
LM
1
A
Y
1
0
˜
IS
2
B
Y
2
~
r
2
1.
A
positive demand
shock shifts the
IS
curve to the right, so...
LM
2
C
~
Y
3
2. ... the Fed increases the
money suppl
y
, which shifts
the
LM
curve to the right and ...
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Appendix