Royal School of Administration Macroeconomics · PDF file© 2013 Royal School of Administration IS–MP: A Short-Run Macroeconomic Model C H A P T E R 9 LEARNING OBJECTIVES After studying

© 2013 Royal School of Administration

Royal School of Administration

IS-MP: A Short-Run Macroeconomic Model

Chapter 9

Macroeconomics

By Group 61. Chum Chamreun2. Sok Piseth3. Kith Sothearith4. Sreng Vichhay5. Lay Piden6. Chheang Damy

© 2013 Royal School of Administration

IS–MP: A Short-RunMacroeconomic Model

C H A P T E R 9

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

9.1

9.2

9.3

Explain how the IS curve represents the relationship between the real interest rate and aggregate expenditure

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

9.5 Use the IS-MP model to understand the performance of the U.S. economy during the recession

9.4 Understand the role of the Phillips curve in the IS-MP model

© 2013 Royal School of Administration 3 of 43

9.1 Learning ObjectiveExplain how the IS curve represents the relationship between the real interest rate and aggregate expenditure.


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.

Phillips curve A curve showing the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.


The IS Curve

Equilibrium in the Goods Market

Table 9.1 The Relationship Between Aggregate Expenditure and GDP


The IS Curve

,YD (disposable income)


The IS Curve

Panel (a) shows that equilibrium in the goods market occurs at output level Y1,where the AE line crosses the 45° line.

Figure 9.1 (1 of 2)Illustrating Equilibrium in the Goods Market


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 output level Y1.•

Figure 9.1 (2 of 2)Illustrating Equilibrium in the Goods Market


The IS Curve

Potential GDP and the Multiplier Effect

Potential GDP 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 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.

Multiplier effect The process by which a change in autonomous expenditure leads to a larger change in equilibrium GDP.

Multiplier The change in equilibrium GDP divided by a change in autonomous expenditure.


The IS Curve



The IS Curve

Figure 9.2The Multiplier EffectThe 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.

Figure 9.2


The IS Curve

To understand how monetary policy and financial markets affect output, we need to explore the effect of interest rates on spending. Changes in the real interest rate affect three of the components of aggregate expenditure: C, I, and Net export (NX).

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 lower domestic real interest rate also makes returns on domestic financial assets less attractive relative to those on foreign assets, decreasing the exchange rate. The decrease in the exchange rate decreases imports and increases exports, thereby increasing NX.

So, a higher interest rate causes a reduction in aggregate expenditure and a lower equilibrium level of output.

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

Figure 9.3 Deriving the IS Curve


The IS Curve

For any given level of the real interest rate, positive demand shocks shift the IS curve to the rightand negative demand shocks shift the IS curve to the left.•

Figure 9.4Shifts in the IS Curve

Shifts of the IS CurveAn 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 A change in one of the components of aggregate expenditure that causes the IS curve to shift.


The IS Curve

The Output Gap

Figure 9.5Output GapThe output gap is negative during recessions because real GDP is below potential GDP.•

Output gap The percentage difference between real GDP and potential GDP.


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 9.6The IS Curve Using theOutput Gap


9.2 Learning ObjectiveUse the monetary policy, MP, curve to show how the interest rate set by the central bank helps to determine the output gap.


MP curve is a curve in the IS–MP model that represents Central Bank monetary policy. This curve shows the effect of the real interest rate on the output gap

Central bank conducts monetary policy by managing the money supply and interest rates to pursue macroeconomic policy objectives such as price stability, high employment and high rate of growth.

Monetary policy that central bank used can control a short-term nominal interest rate, the federal funds rate. And it should be clear that the Fed (central bank) influences long term real interest rates, but does not have complete control over these interest rates


The link between the Short-Term Nominal interest Rate and Long-Term Real Interest Rate

The relationship between long-term nominal interest rates and the short-term nominal interest rates:

Where , I , short-term nominal interest rateTSE, term structure effectsDP, default-risk premium

And to calculate the expected real interest rate :

Where, , expected inflation


The link between the Short-Term Nominal interest Rate and Long-Term Real Interest Rate (1)

The relationship between the long-term real interest rate and the long-term nominal interest rate:

So we can come up with our final equation for the real interest rate:

so there are three factors may decline the long-term real interest rate:- short-term nominal interest rate- default-risk premium- expectation of the future inflation rate


Deriving the MP Curve Using the Money Market Model

When we derive the MP curve, we make the following assumptions:1. The TSE and DP term in equation are constant.2. The expected inflation rate is constant.

Fed changed the short-term nominal interest rate, so the long-term real interest rate changed and it affected consumption and investment.


Shifts of the MP Curve

MP curve will shift if any of these four variable change:- short-term nominal interest rate, i- Term structure effect, TSE- Default-risk premium, DP- Expected inflation rate,

Figure 9.7



9.3 Learning ObjectiveUse the IS-MP model to understand why real GDP Fluctuates.


Equilibrium in the IS-MP Model

Figure 9.8


Monetary Policy and Fluctuations in Real GDP

One of Fed’s monetary policy goals is to stabilize the price level by keeping the inflation rate low. Fed adjusts its target for the short-term nominal interest rate in response to changes in the inflation rate.Figure 9.9


Demand Shocks and Fluctuations in Output

Demand Shocks affect the IS curve and also cause real GDP to fluctuate if the Fed keeps the real interest rate constant. Those shocks include a collapse in consumer confidence that leads to reduce consumption expenditures, rising gasoline prices..

Figure 9.10


9.4 Learning Objective

Understand the role of the Phillips curve in the IS-MP model


The IS-MP Model and the Phillips Curve

Phillips Curve is a graph that shows the short-run relationship between the unemployment rate and the inflation rate.


The equation for the Phillips curve:


Okun’s Law and an Output Gap Phillips Curve

Okun’s law is a way of modifying the Phillips curve to change it from a relationship between the inflation rate and the unemployment rate to a relationship between the inflation rate and the output gap, So we can summarize the relationship between the output gap and the gap between the current and natural rates of unemployment as below;


The Effect of Demand Shocks on Inflation

The inflation often increases during expansions and decreases during recession.

Example, in 1981-1982 recession , real GDP was 0.6% below the potential GDP during the first quarter of 1981 ,but 7.5% below the potential GDP by the end of recession in the fourth quarter of 1982.

As a result, the inflation rate fell from 11.8% during January 1981 to 3.8% during December 1982.


The Effect of Supply Shocks on Inflation

Inflation does not always decrease during recession. Actually, inflation increased during the 1973-1975, 1980 and 1990-1991recession.

Supply shocks raise firm’s cost of production. So firms increase the price of goods they sell.

Oil price increases is one of negative supply shocks that make cost of production increase.

Improving productivity by improving information technology is one of positive supply shocks and it reduces cost of production, so inflation rate.


Adaptive Expectations

Changes in the expected inflation rate can have an important effect on the actual inflation rate.

Some economists believe that households and firms have Adaptive expectations, which is the assumption that people make forecasts of future values of a variable using only past values of variable.

We can express adaptive expectation as:

So we can rewrite the Phillips curve as:


Movement Along an Existing Phillips Curve

Assume no supply shocks ( ), current year inflation rate equals the rate from previous year.


Shift of the Phillips Curve

Figure 9.11


Using Monetary Policy to Fight a RecessionFigure 9.12


9.5 Learning ObjectiveUse the IS-MP model to understand the performance of the U.S. economy during the recession of 2007-2009


The performance of the U.S. Economy During 2007-2009

The U.S. economy experienced three shocks during 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 the Phillip curve

As a result, - Real GDP fell 0.2% below potential GDP (2nd quarter of 2007) and to 7.6% below potential GDP (3rd quarter of 2009).- The inflation rate increased from 1.8% (4th quarter 2006) to 4.4% (3rd quarter 2008), before decreasing to 0.3% (2nd quarter 2009)


Figure 9.13


Figure 9.14


Thanks for Your Attention!

Documents

Royal School of Administration Macroeconomics · PDF file© 2013 Royal School of Administration IS–MP: A Short-Run Macroeconomic Model C H A P T E R 9 LEARNING OBJECTIVES After studying