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The IS-MP model: adding inflation and the open economy
Understand the role of the Phillips curve in the IS–MP model.
Use the IS–MP model to understand the performance of the U.S. economy during the recession of 2007–2009.
Understand the IS–MP model in an open economy.
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| Learning Objectives | |
| After studying this chapter, you should be able to: | |
| 11.1 | |
| 11.2 | |
| 11.3 |
11
Where’s the inflation?
In mid-2009, several economists worried that the U.S. would soon enter a period of high inflation.
Why? In responding to the recession, the Fed greatly increased the monetary base—an annualized growth rate of up to 100%, for several months.
Growth rate of money supply had never been above 20% before.
Quantity equation indicates that increase in the money supply should result in increases in the inflation rate.
The forecasts of high inflation turned out to be incorrect.
| Year | Annual growth rate of M2 | Inflation |
| 2007 | 6.2% | 2.3% |
| 2008 | 6.8% | 2.3% |
| 2009 | 8.0% | 1.6% |
| 2010 | 2.5% | 1.4% |
| 2011 | 7.3% | 1.4% |
| 2012 | 10.0% | 1.9% |
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This looks like it’s probably core-CPI. Book: it’s “the Federal Reserve’s preferred measure of the inflation rate for 2007 to 2011”. (“2011” appears to be a typo, should be 2012.)
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Inflation and the IS-MP model
Why was the inflation rate so low during these years?
In the previous chapter, the IS-MP model assumed we were dealing with a short enough period of time that we could consider the price level to be constant.
Now, we extend the model by looking at how changes in the output gap affect the inflation rate.
We will also apply the model to an open economy.
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By certain measures, the recession of 2007–2009 was the worst since the Great Depression of the 1930s.
What explains the severity of the 2007-2009 recession?
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Key Issue and Question
Issue:
Question:
Understand the role of the Phillips curve in the IS-MP model.
11.1
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| Learning Objective |
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The IS-MP model and the Phillips curve
When output and employment are increasing, the inflation rate tends to rise.
A.W.H. Phillips first showed the relationship between the growth rate of nominal wages and the unemployment rate in the U.K.
Higher nominal wage growth was typically associated with lower rates of unemployment.
Higher nominal wages are generally passed along to consumers in the form of higher prices.
Interpretation was that higher inflation was associated with lower rates of unemployment.
The Phillips curve was initially viewed as a structural relationship.
A structural relationship depends on the basic behavior of households and firms and remains unchanged over long periods
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The traditional Phillips curve
If the Phillips curve is a structural relationship, the Fed could:
permanently reduce unemployment if they were willing to accept a higher inflation rate, or
permanently reduce inflation by raising the unemployment rate.
Operated under the assumption of constant expected inflation.
Milton Friedman and Edmund Phelps argued that expected inflation adjusts if current inflation differs from past inflation.
The Traditional Phillips curve
Figure 11.1
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Evidence against the traditional Phillips curve
Two events changed the view that the Phillips curve was a stable long-run relationship:
Friedman and Phelps noted that inflation expectations influence actual rates of inflation. Once actual inflation changed, it was only a matter of time before the stable inverse relationship broke down.
In the 1970s, both the inflation rate and unemployment rose.
Annual inflation rose from 1.9% in 1966 to 14.6% in 1980.
Unemployment rose from 4.0% in 1966 to 6.9% in 1980.
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Evolution of views about the Phillips curve
Clearly the traditional view of the Phillips curve as a structural relationship was incorrect.
Economists have now concluded that the Phillips curve position can shift over time in response to
Supply shocks; for example, an increase in the price of oil
Changes in the expected inflation rate.
After accounting for shifts, the Phillips curve remains a useful tool for explaining the short-run tradeoff between the unemployment rate and inflation.
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What shifts the Phillips curve?
Changes in expectations about the inflation rate shifts the Phillips curve.
If workers and firms expect an inflation rate of 2% per year, but experience an extended period of 4% inflation, they are likely to adjust expectations of future inflation from 2% to 4%.
Real wages of workers would decline if they ignore changes in inflation rates.
Increased expected inflation increases nominal interest rates by the Fisher effect.
At any given unemployment rate, the inflation rate would be 2% higher, shifting the Phillips curve up by 2%.
How should we analyze the effect of changes in the unemployment rate on the inflation rate?
Generally accepted answer: examine cyclical unemployment to capture the effect of changes in unemployment rate on inflation rate.
That is, examine the gap between the natural rate of unemployment and the actual unemployment rate.
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The Phillips curve equation
The Phillips curve equation:
where:
t = current inflation rate
te = expected inflation rate
Ut = current unemployment rate
UN = natural rate of unemployment
st = variable representing the effects of a supply shock (s will have a negative value for a negative supply shock and a positive value for a positive supply shock.)
a = constant that represents how much the gap between the current rate of unemployment and the natural rate affects the inflation rate
Increases in expected inflation or negative supply shocks shift the Phillips curve up, while decreases in expected inflation or positive supply shocks shift the Phillips curve down.
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Changes in expected inflation rates
Expected inflation rates change when economies experience persistent rates of actual inflation different from the rates they expected.
Inflation in the U.S. in the 1960s averaged about 2% per year.
Inflation rates accelerated to 5% per year between 1970-1973.
Inflation rates again accelerated to 8.5% per year from 1974-1979.
Households revised their expectations of inflation.
Every unemployment rate becomes associated with a higher inflation rate.
Decline in inflation rates in the 1980s led to the Phillips curve shifting down.
From 1983-1986, inflation averaged 3.3% per year.
Eventually, households and firms lowered their expectations about inflation, and the Phillips curve shifted down.
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Shifts of the Phillips curve
Supply shocks and changes in expected inflation shift the Phillips curve.
Increases in expected inflation shift the Phillips curve up.
Decreases in expected inflation shift the Phillips curve down
Shifts of the Phillips curve
Figure 11.2
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Okun’s law, the output gap, and the Phillips curve
Translating the unemployment rate into the output gap allows us to integrate the Phillips curve into the IS-MP model.
We can then see how changes in inflation rates and Fed policy are related.
Recall Okun’s law:
where is the output gap in period t.
Using Okun’s law, we relate the output gap to the gap between current and natural rates of unemployment.
Substituting the Okun’s law relationship into the Phillips curve equation yields:
(b is just a/2 from the previous Phillips curve equation.)
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The effect of demand shocks on inflation
The positive coefficient b measures the effect of changes in the output gap on inflation; so gives the effect of demand shocks on inflation.
Inflation often increases during expansions.
Q4 1963: Real GDP was close to potential, inflation 1.7%
Q1 1966, Real GDP 5.9% above potential, inflation 3.8%
Inflation often decreases during recessions.
Q1 1981: Real GDP 0.6% below potential, inflation 11.8%
Q4 1982: Real GDP 7.5% below potential, inflation 3.8%
These “typical” examples illustrate that when real GDP increases relative to potential GDP, inflation typically rises; and when real GDP falls relative to potential, inflation typically falls.
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The effect of supply shocks on inflation
Inflation does not always increase during recessions.
Inflation rose in 1973-1975, 1980, and 1990-1991 recessions.
Each recession was associated with a supply shock.
Supply shocks raise the costs of production of firms, leading to price increases for final goods and services.
Example: Oil prices rose from $3.56 per barrel to $11.16 per barrel in the 1973-1975 recession.
Inflation rates rose from 8.3% to 10.5% during the recession.
Stagflation resulted.
Stagflation A combination of inflation and recession, usually resulting from a supply shock.
Productivity increases can represent positive supply shocks.
Example: High growth rate of labor productivity from 1996-2011
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Expectations of inflation
Expectations of inflation are not directly observable.
We often rely on surveys:
Survey of Professional Forecasters gives consensus estimate of professional economic forecasters.
University of Michigan surveys households.
Measures of expected inflation for the United States, 1971-2011
Figure 11.3
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How do expectations about future inflation form?
Some economists believe that households and firms have adaptive expectations about inflation rates.
Adaptive expectations The assumption that people make forecasts of future values of a variable using only past values of the variable.
A simple form of adaptive expectations is that people expect the value of a variable from last year to occur again this year. In equation form,
When inflation rose during the late 1960s and 1970s, the rise in the actual inflation rate (due to demand and supply shocks) increased the expected inflation rate, driving the actual inflation rate even higher.
Assuming this form of adaptive expectations, the Phillips curve becomes:
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Movement along an existing Phillips curve
We assume no supply shocks, and start at point A, where real GDP equals potential and actual inflation equals expected inflation.
A positive demand shock might lead to an increase in the IS curve and real GDP.
Firms produce beyond normal capacity, input prices rise, and firms pass along price increases to consumers. Higher prices are reflected in a higher rate of inflation.
An Increase in the Output Gap Increases the Inflation Rate
Figure 11.4
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Shifts of the Phillips curve: decrease in expected inflation
Initially there is no output gap, and s = 0 indicating the economy is not experiencing a supply shock.
Now suppose the expected inflation rate falls, and the output gap remains equal to zero.
The new inflation rate will be π2; the economy is at point B, so the Phillips curve must have shifted down.
Shifts of the Phillips Curve
Figure 11.5a
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Shifts of the Phillips curve: negative supply shock
A negative supply shock, such as an increase in oil prices shifts the Phillips curve up.
Again, the economy starts at point A, with no output gap and no supply shock (s1 = 0)
Now we introduce a negative supply shock, which causes the Phillips curve to shift up: if there remains no output gap, firms and households will expect higher inflation.
Shifts of the Phillips curve
Figure 11.5b
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How well does the Phillips curve fit the data?
The “predicted” series here uses adaptive expectations, and uses changes in oil prices to measure supply shocks.
Actual and predicted inflation using the Phillips curve with adaptive expectations for the United States, 1949-2012
Figure 11.6
Using this simple model, we see that the Phillips curve provides a good, but not perfect, explanation of movements of the inflation rate.
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Lots of money but not much inflation
When the recession of 2007-2009 ended, a number of economists predicted the inflation rate would increase substantially.
Potentially worse than the double-digit inflation rates of the 1970s.
But while the monetary base soared, the inflation rate did not take off.
The expansion of the monetary base resulted in smaller-than-expected increases in the money supply.
More importantly, recovery from the recession was slow, with a large output gap and high rates of unemployment through 2012.
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Making the Connection
Lots of money but not much inflation
Usually when the Fed purchases financial securities, the funds end up either in banks as bank reserves, or as currency in circulation.
These funds get multiplied; prior to the recession, the multiplier was typically around 1.5.
But during the recession, the multiplier fell below 1: a money divisor, with increases in the monetary base resulting in smaller increases in the money supply.
Even so, if the economy had expanded strongly, the increases in the money supply would likely have resulted in large increases in the inflation rate.
With real GDP far below potential, there was little pressure for wages and other prices to increase.
The question remains: What will happen to inflation once the economy enters a stronger expansion?
Ben Bernanke claims Fed has an “exit strategy” to allow it to unwind large increases in the monetary base and avoid inflation. But doubts remain.
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Making the Connection
Using monetary policy to fight a recession
We can combine the IS-MP model and the Phillips curve to explain how monetary policy responds to demand shocks.
We traditionally “view” this with the IS-MP diagram and the Phillips curve diagrams “stacked”, as on the right.
Why stacked? The x-axis on each graph measures the same variable: the output gap.
So any change in the output gap on one diagram results in the same change in output gap on the other.
The next two slides will show the individual diagrams closer-up.
Monetary policy responds to a negative demand shock
Figure 11.7
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Using monetary policy to fight a recession
In the top panel, a demand shock moves the IS curve to the left.
With no monetary policy change, there would be a negative output gap, so we would anticipate lower inflation (see the Phillips curve graph).
Expansionary monetary policy (reducing the interest rate) brings the output gap back to zero.
Monetary policy responds to a negative demand shock
Figure 11.7a
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Using monetary policy to fight a recession
Meanwhile, on the Phillips curve, the supply shock had caused a negative output gap, which would result in lower inflation.
But the expansionary monetary policy brings the output gap back to zero, causing the inflation rate to return to its original level.
Monetary policy responds to a negative demand shock
Figure 11.7b
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Fed policy to keep inflation from increasing
During the expansion of the 1990s, the stock market boomed, increasing household wealth and the willingness of households to spend. As a result, aggregate expenditure increased, and the inflation rate accelerated from 1.0% during the fourth quarter of 1998 to 2.4% during the fourth quarter of 2000.
What policy could the Fed have pursued to keep the inflation rate from rising?
Use the IS–MP model to answer this question.
Be sure to show any shifts in or movements along the IS curve, the MP curve, and the Phillips curve.
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Solved Problem
Fed policy to keep inflation from increasing
Step 1 Review the chapter material.
Step 2 Draw a graph that shows the initial equilibrium and the effect of the increase in household wealth. Before the boom, output equaled potential and the inflation rate was 1%. Increased wealth leads to increased consumption, so the IS curve should shift to the right. Inflation should increase to 2.4% at the new equilibrium
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Solved Problem
Fed policy to keep inflation from increasing
Step 3 Determine the Fed’s response. How can the Fed keep the inflation rate from increasing? Raise interest rates (a contractionary monetary policy) far enough to avoid the output gap. In practice, the Fed did increase short-term nominal interest rates, but not quickly enough to prevent the inflation rate from increasing.
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Solved Problem
Use the IS–MP model to understand the performance of the U.S. economy during the recession of 2007–2009.
11.2
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| Learning Objective |
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The performance of the U.S. economy during 2007-2009
The U.S. economy experienced three shocks in the 2007-2009 period:
A financial crisis, which increased the risk premium investors required before making loans.
A decrease in real estate values, which affected the IS curve.
A surge in oil prices, which affected both the Phillips curve and the IS curve.
Real GDP fell from 0.2% above potential in Q2 2007 to 7.4% below potential in Q3 2009.
The inflation rate rose from 1.8% in Q4 2006 to 3.2% in Q3 2008, and then fell to -0.4% in Q2 2009.
We will use the IS-MP model to explain how these three shocks combined to cause the changes in real GDP and the inflation rate.
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Analyzing the financial crisis and the housing crash
The default-risk premium is measured as the difference between the Aaa corporate bond rate and the 10-year Treasury note.
Typically rises during recessions
The risk premium was 0.65% on June 7, 2007.
The average default-risk premium between 1953-2008 was 0.77%.
The default-risk premium rose to 1.25% on August 21, 2007.
Rose to 2.13% by March 17, 2008.
Continued to rise to 2.73% on November 26, 2008.
Remained elevated: 1.56% as late as May 2010
As the risk premium rose, many firms were unable to obtain financing and banks required more collateral to obtain loans.
Households were similarly affected, causing consumption and housing sales to decline.
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Analyzing the financial crisis and the housing crash
In addition, housing prices began to decline in 2006.
Decline in wealth and consumption followed.
Builders cut back on new construction.
Growth went from 6.2% in 2006 to -22.9% in 2008 and -3.0% in 2010.
Reduced construction and wealth led to cuts in consumption and investment.
How will we model these shocks in the IS-MP model?
Financial crisis raises interest rates: MP curve moves up.
Collapse of the housing bubble causes decreased investment and consumption spending: IS curve moves left.
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Analyzing the financial crisis and the housing crash
Initially the economy was at point A: effectively no output gap.
The collapse of the housing bubble shifts the IS curve left, and the financial crisis shifts the MP curve up.
Combined, they result in a large negative output gap.
Each shift widened the output gap, so each shift ought to decrease the inflation rate in the Phillips curve diagram.
The financial and real estate market shocks and the U.S. economy, 2007-2009
Figure 11.8
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Incorporating the oil price shock of 2007-2008
The price of oil rose from $56.60 a barrel in March 2007 to $145.66 in July 2008.
We model this negative supply shock with the Phillips curve shifting up.
Nothing more changes in the IS-MP diagram.
Even with the large negative output gap, inflation expectations were higher, because of the oil price shock.
This brings us to point C.
The oil price shock and the U.S. economy, 2007-2009
Figure 11.9
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For completeness, note that the price of oil dropped to $30.81 in December of 2008. This would result in the Phillips curve falling, and a low (even negative during Q2 2009) inflation rate.
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Modeling short-run fluctuations in the IS-MP model
The recession of 2007-2009 presented three distinct fluctuations, and three different ways to analyze them in the IS-MP model:
The IS curve captures the effect of demand shocks.
Example: the bursting of the housing bubble.
The MP curve shows not only monetary policy changes, but the effects of:
changes in the default-risk premium, as in the financial crisis
changes in investor’s expectations of future interest rates
changes in the expected inflation rate.
The Phillips curve captures the effect of changes in the output gap on inflation.
And also the effects of supply shocks, like rising oil prices.
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Understand the IS–MP model in an open economy.
11.3
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| Learning Objective |
11
The IS curve with a floating exchange rate
If the real interest rate in the U.S. increases:
Foreign investors increase their demand for U.S. dollars.
So the nominal exchange rate will rise.
Demand for U.S. exports will fall, U.S. demand for imports will rise, and hence net exports will fall.
Similarly, if the real interest rate in the U.S. falls, net exports will rise.
This effect reinforces the idea that the IS curve slopes downward.
If foreign real interest rates change, that can affect net exports and hence aggregate expenditures.
The U.S. real interest rate hasn’t changed, so this is a shift in the IS curve.
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Monetary policy with a floating exchange rate
The Phillips curve shows the positive relationship that usually exists between the inflation rate and changes in the output gap.
As the output gap increases, the inflation rate increases.
If the Fed increases the real interest rate as the inflation rate increases, the MP curve will shift up.
The higher real interest rate will attract capital inflows; therefore net capital outflows will decrease.
The nominal exchange rate will rise, causing net exports to fall.
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Equilibrium in the IS-MP model
Equilibrium occurs where the IS and MP curves intersect.
An adjustment in the real interest rate would cause net capital outflows to fall.
Remember that net exports equals net capital outflows, as the exports must be “paid for”.
Equilibrium in the IS-MP model
Figure 11.10
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Gold standard made the Great Depression worse?
When the Great Depression started in 1929, the U.S., Japan, and much of Europe used the gold standard, a fixed exchange rate system.
Exchange rates were determined by the relative amounts of gold in each country’s currency.
If a central bank determined too much gold was flowing out of the country, it would often raise interest rates, attracting more investment.
Economists believe the gold standard worsened the Great Depression.
To maintain their fixed exchange rates, countries increased interest rates, even though that worsened the recession.
Central banks were hence prevented from responding to the Great Depression using monetary policy.
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Macro Data
Gold standard made the Great Depression worse?
In the figure, we see evidence of the gold standard hurting recovery after the Great Depression:
Japan and the U.K were the first countries to leave the gold standard.
In both countries, industrial production fell less, and recoveries started sooner.
The U.S. left the gold standard in 1933.
France left the gold standard in 1936.
These poor economic performances are the primary reason countries did not return to the gold standard in later years.
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Macro Data
The IS-MP model with a fixed exchange rate
Under a fixed exchange rate system, the central bank commits to buying and selling the domestic currency at a fixed nominal exchange rate.
Selling domestic currency is “easy”: can just create more currency.
Buying domestic currency can be harder—might run out of foreign currency to use.
Central banks in Indonesia, the Phillipines, South Korea, and Thailand had this problem during the Asian financial crisis of 1997.
This difference has important implications for the IS-MP model.
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The IS curve with a fixed exchange rate
Under a fixed exchange rate system, the mechanism we described for a floating exchange rate system does not take place:
The nominal exchange rate does not change in response to interest rate changes.
Therefore net exports do not change.
The IS curve is very similar to the IS curve for a closed economy.
If the government alters the fixed exchange rate, the IS curve would shift.
Why? Net exports would change, so aggregate expenditures would change.
But the real interest rate has not changed.
Devaluation of the currency would increase net exports, shifting the IS curve to the right; revaluation would shift it left.
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The MP curve with a fixed exchange rate
Under fixed exchange rates, central banks have limits on the domestic real interest rate.
If the real interest rate is very low, investors would supply domestic currency, demanding foreign currency.
Eventually foreign-exchange reserves would be exhausted.
Therefore we say that there is a lowest real interest rate that the central bank can set while maintaining a fixed exchange rate system—call it .
Then the MP curve cannot fall MPMin which is horizontal at .
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Equilibrium in the IS-MP model with fixed exchange rate
Equilibrium again occurs at point A, where the IS and MP curves cross.
shows the lowest real interest rate the central bank can maintain.
This is the lowest level of net capital outflows that the central bank can afford.
Equilibrium in the IS-MP model with a fixed exchange rate
Figure 11.11
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Can the euro survive?
There are advantages to fixed exchange rates:
Firms that export and import can plan more easily.
Firms can borrow in foreign currencies with less risk.
In 2002, the euro was introduced; by 2012, 17 members of the EU used the euro as their currency, including all of the largest economies except the U.K.
Many important economic policies across the euro zone differ.
Consequently, so do inflation rates, as the figure demonstrates.
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Making the Connection
Can the euro survive?
While the nominal exchange (E) rate between euro-zone countries is fixed, the real exchange rate (e) can differ:
Net exports are dependent on real exchange rates; so net exports fell in Greece and Spain, the countries with more rapidly rising prices.
This was one cause for unemployment rates in 2011 of 21.6% in Spain and 17.3% in Greece.
If Spain and Greece still had their own currencies, their nominal exchange rates could have declined, increasing their net exports.
Iceland, not on the euro, allowed its nominal exchange rate to fall; and partly as a result, its unemployment rate in 2011 was only 7.4%.
What can Spain and Greece do to restore competitiveness?
Lower their inflation rates (difficult), or abandon the euro.
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Making the Connection
Answering the key question
“What explains the severity of the 2007–2009 recession?”
Most economists were surprised by the severity of the 2007-2009 recession.
“Great Moderation” had seen only mild recessions.
Fed had apparently learned to “tame” the business cycle.
Even in early 2007, many economists and policymakers were not even certain a recession would occur.
A key reason the recession was so severe was that it was accompanied by a financial crisis.
Just like the Great Depression.
Financial crises reduce the effectiveness of the Fed’s key policy tool: lowering short-term nominal interest rates.
Sharp increase in the default-risk premium kept long-term real interest rates higher than the Fed desired.
This, combined with banks’ reluctance to loan, caused sharp declines in consumption and investment spending.
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