Money banking and the financial system 1e by hubbard and OBrien chapter 18

Publishing as Prentice HallMonetary Theory II: The IS–MP Model C H A P T E R 18 LEARNING OBJECTIVES After studying this chapter, you should be able to: 18.1 18.2 18.3 Understand what the

R GLENN

HUBBARD

ANTHONY PATRICKO’BRIEN

Money, Banking, and the Financial

System

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Monetary Theory II:

The IS–MP Model

C H A P T E R 18

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

18.1 18.2 18.3

Understand what the IS curve is and how it is derived Explain the significance of the MP curve and the Phillips curve Use the IS–MP model to illustrate macroeconomic equilibrium

18A Use the IS-LM model to illustrate macroeconomic equilibrium

18.4 Discuss alternative channels of monetary policy

THE FED FORECASTS THE ECONOMY

•In July 2010, the Federal Reserve lowered its forecasts for economic growth The Fed cited continued weakness in the housing market, a slow recovery in the labor market, and less than favorable financial conditions for growth

•The Bank of England and the French government also reduced their forecasts for the growth of real GDP in 2010 and 2011

•Having some idea of the likely state of the economy in the future helps to guide policy today In preparing its forecasts, the Fed, foreign central banks, and private forecasters usually rely on macroeconomic models

•AN INSIDE LOOK AT POLICY on page 574 discusses four policy options the

C H A P T E R 18

Monetary Theory II:

The IS–MP Model

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Key Issue and Question

Issue: By December 2008, the Fed had driven the target for the federal

funds rate to near zero

Question: In what circumstances is lowering the target for the federal

funds rate unlikely to be effective in fighting a recession?

18.1 Learning Objective

Understand what the IS curve is and how it is derived.

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The IS Curve

IS–MP model A macroeconomic model consisting of an IS curve, which

represents equilibrium in the goods market; an MP curve, which represents

monetary policy; and a Phillips curve, which represents the short-run

relationship between the output gap (which is the percentage difference

between actual and potential real GDP) and the inflation rate

IS curve A curve in the IS–MP model that shows the combinations of the real

interest rate and aggregate output that represent equilibrium in the market for

goods and services

MP curve A curve in the IS–MP model that represents Federal Reserve

monetary policy

gap (or the unemployment rate) and the inflation rate

Equilibrium in the Goods Market

Table 18.1 The Relationship Between Aggregate Expenditure and GDP

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The IS Curve

Panel (a) shows that equilibrium in the goods market occurs at output

level Y1,where the AE line crosses

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The IS Curve

In panel (b), if the level of output is

initially Y2, aggregate expenditure

is only AE2 Rising inventories cause firms to cut production, and the economy

will move down the AE line until it

reaches equilibrium at output level

Y1

If the output level is initially Y3,

aggregate expenditure is AE3 Falling inventories cause firms to increase production, and the

economy will move up the AE line

until it reaches equilibrium at

Potential GDP and the Multiplier Effect

capacity

At potential GDP, the economy achieves full employment, and cyclical

unemployment is reduced to zero So, potential GDP is sometimes called

full-employment GDP.

In the context of this basic macroeconomic model, autonomous expenditure is

expenditure that does not depend on the level of GDP

A decline in autonomous expenditure results in an equivalent decline in income,

which leads to an induced decline in consumption.

leads to a larger change in equilibrium GDP

expenditure

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The IS Curve

Figure 18.2

The Multiplier Effect

The economy is initially in equilibrium at potential

GDP,YP , and then the

investment component, I, of

aggregate expenditure falls.

As a result, the aggregate expenditure line shifts from

AE1 to AE2 The economy moves down

the AE line to a new

equilibrium level of

output,Y2.The decline in output is greater than the decline in investment spending that caused it.

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Solved Problem 18.1

Calculating Equilibrium Real GDP

The IS Curve

Solved Problem 18.1

Calculating Equilibrium Real GDP

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The IS Curve

The focus of Fed policy is establishing a target for the federal funds rate, with

the expectation that changes in the federal funds rate will cause changes in

other market interest rates Therefore, we need to incorporate the effect of

changes in interest rates into our model of the goods market

The real interest rate equals the nominal interest rate minus the expected

inflation rate An increase in the real interest rate causes I and C to decline

A higher domestic real interest rate also makes returns on domestic financial

assets more attractive relative to those on foreign assets, raising the exchange

rate The rise in the exchange rate increases imports and reduces exports,

thereby reducing NX.

A decrease in the real interest rate will have the opposite effect—increasing I,

C, and NX.

So, a higher interest rate causes a reduction in aggregate expenditure and a

lower equilibrium level of output

Constructing the IS Curve

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Panel (a) uses the 45°-line diagram to show the effect of changes in the real interest rate

on equilibrium in the goods market With the real interest rate initially at r1, the aggregate

expenditure line is AE(r1), and the equilibrium level of output is Y1 (point A)

If the interest rate falls from r1 to r2, the aggregate expenditure line shifts upward from

AE(r1) to AE(r2), and the equilibrium level of output increases from Y1 to Y2 (point B)

If the interest rate rises from r1 to r3, the aggregate expenditure line shifts downward from AE(r1) to AE(r2), and the equilibrium level of output falls from Y1 to Y3 (point C)

In panel (b),we plot the points from panel (a) to form the IS curve The points A, B, and C

in panel (b) correspond to the points A, B, and C in panel (a).•

Figure 18.3 Deriving the IS Curve

The Output Gap

Figure 18.4

Output Gap

The output gap is negative during recessions because real GDP

is below potential GDP •

With the Taylor rule (Chapter 15), the Fed has a target for the real federal funds

rate and adjusts that target on the basis of changes in two variables: the

inflation gap and the output gap The inflation gap is the difference between the

current inflation rate and a target rate

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The IS Curve

This graph shows the IS curve with the

output gap, rather than the level of real GDP, on the horizontal axis.

Values to the left of zero on the horizontal axis represent negative values for the output gap—or periods of recession—

and values to the right of zero on the horizontal axis represent positive values for the output gap—periods of expansion

The vertical line, Y = YP , is also the point where the output gap is zero.

Figure 18.5

The IS Curve Using the Output Gap

For any given level of the real interest rate, positive demand

shocks shift the IS curve to the right

and negative demand shocks shift

the IS curve to the left.•

Figure 18.6

Shifts in 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.

expenditure that causes the IS curve to shift.

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18.2 Learning Objective

Explain the significance of the MP curve and the Phillips curve

The Taylor rule tells us that when the inflation rate rises above the Fed’s target

inflation rate of about 2%, the FOMC will raise its target for the federal funds

rate And when the output gap is negative—that is, when real GDP is less than

potential GDP, the FOMC will lower the target for the federal funds rate

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The MP Curve and the Phillips Curve

Figure 18.7

The MP Curve

The MP 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 when output and employment are

decreasing, the inflation rate tends to decrease

A graph showing the short-run relationship between the unemployment rate

and the inflation rate has been called a Phillips curve The position of the

Phillips curve can shift over time in response to supply shocks and changes in

expectations of the inflation rate

The best way to capture the effect of changes in the unemployment rate on the

inflation rate is by looking at the gap between the current unemployment rate

and the unemployment rate when the economy is at full employment, which is

called the natural rate of unemployment The gap between the current rate of

unemployment and the natural rate represents cyclical unemployment.

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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:

The Phillips curve illustrates the short-run relationship between the unemployment rate and the inflation rate.

Point A represents the

Figure 18.8

The Phillips Curve

The Phillips Curve

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The MP Curve and the Phillips Curve

An increase in expected inflation or a negative aggregate supply shock will shift the Phillips curve up

A decrease in expected inflation or a positive aggregate supply shock will shift the Phillips curve down •

Okun’s Law and an Output Gap Phillips Curve

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The MP Curve and the Phillips Curve

Okun’s Law and an Output Gap Phillips Curve

Okun’s law states that the output gap is equal to negative 2 times the gap between the

current unemployment rate and the natural rate of unemployment The graph shows that

Okun’s law does a good job of accounting for the cyclical unemployment rate •

Figure18.10 Using Okun’s Law to Predict the Cyclical Unemployment Rate

Okun’s Law and an Output Gap Phillips Curve

This Phillips curve differs from the one shown in Figure 18.8 by

having the output gap, rather than the unemployment rate, on the horizontal axis As a result, the Phillips curve is upward sloping rather than downward sloping.

When the output gap equals zero and there are no supply shocks, the actual inflation rate will equal the expected inflation rate.

An increase in expected inflation

or a negative supply shock shifts the Phillips curve up,

and a decrease in expected

Figure18.11

The Output Gap Version

of the Phillips Curve

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Making the Connection

Did the 2007–2009 Recession Break Okun’s Law?

During 2009 and 2010, White House economists were criticized for their

inaccurate predictions of the unemployment rate

After Congress passed the stimulus program, the unemployment rate was still

much higher than the predicted peak 8%, and it went as high as 10.0% in 2009.One reason for the faulty forecasts was that Okun’s law sharply underestimated the unemployment rate

Rising labor productivity may be an explanation When labor productivity

increases, firms can produce the same amount of output with fewer workers

Firms maintained their production levels with fewer workers—thereby leading to

a larger increase in unemployment than many economists had forecast

Okun’s law has had difficulty in accounting for the unemployment rate following the last two severe recessions

The MP Curve and the Phillips Curve

Making the Connection

Did the 2007–2009 Recession Break Okun’s Law?

The graph shows that beginning in 2009, Okun’s law indicates that cyclical

unemployment—the difference between the actual rate of unemployment and

the natural rate of unemployment—should have been about 1% lower than it

actually was

In late 2009 and early 2010, the gap between actual cyclical unemployment

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18.3 Learning Objective

Use the IS–MP model to illustrate macroeconomic equilibrium.

In panel (a), the IS curve and

the MP curve intersect where

the output gap is zero and

the real interest rate is at the

Fed’s target level.

In panel (b), the Phillips

curve shows that because

the output gap is zero, the

actual and expected inflation

rates are equal •

Figure18.12

Equilibrium in the

IS–MP Model

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Making the Connection

Where Did the IS–MP Model Come From?

British economist John Maynard Keynes developed the basic ideas behind the

IS curve in his 1936 book The General Theory of Employment, Interest, and

Money.

The IS curve first appeared in an article written by John Hicks in 1937 Hicks

did not use an MP curve but an LM curve, with LM standing for “liquidity” and

“money.” The LM curve shows combinations of the interest rate and output that

would result in the market for money being in equilibrium

Hicks’s approach is called the IS–LM model The model assumes that the

Federal Reserve chooses a target for the money supply We know, however,

that since the early 1980s, the Fed has targeted the federal funds rate, not the

money supply

In 2000, David Romer of the University of California, Berkeley, suggested

dropping the LM curve in favor of the MP curve approach that has become

more standard for analyzing monetary policy

Equilibrium in the IS–MP Model

Using Monetary Policy

to Fight a Recession

Figure18.13

Expansionary Monetary Policy

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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 in the IS–MP model

that the Fed controls the real interest rate, in fact, the Fed is able to target the

federal funds rate but typically does not attempt to directly affect other market

interest rates

Normally, the Fed can rely on the long-term real interest declining when the

federal funds rate declines and rising when the federal funds rate rises The

recession of 2007–2009 did not represent normal times, however

During the financial crisis, particularly after the failure of Lehman Brothers in

September 2008, the default risk premium soared as investors feared that firms would have difficulty repaying their loans or making the coupon and principal

payments on their bonds