IS-MP: A Short-Run Macroeconomic Model
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1 September 21i 2015
2 1 Aggregate Demand 2 Monetary Policy
3 Aggregate Demand Keynes (1936), The General Theory of Employment, Interest, and Money Aggregate Demand : The total amount of output demanded in the economy. to understand aggregate demand, we need to know IS curve. IS curve describes the relationship between interest rate and aggregate output when goods market is in equilibrium.
4 Planned Expenditure Planned Expenditure : The total amount of spending on domestically produced goods and services. Planned Expenditure = Aggregate Demand Y pe = C + I + G + NX
5 Consumption Expenditure (C) C = C + (mpc Y D ) cr C : autonomous consumption expenditure mpc : marginal propensity to consume Y D : disposable income (Y-T) c : a parameter reflects how consumption respond changes in the real interest rate r : real interest rate Real interest rate affects on savings decisions.
6 Planned Investment Spending (I) I = Ī dr Ī : Fixed Investment d : a parameter reflects how investment respond to changes in the real interest rate. Real interest rate affects on investment decisions through cost of finance. Goverment Purchases and Taxes Goverment Purchases : G = Ḡ Taxes T = T disposable income : Y T
7 Net Exports (NX) NX = NX xr NX : autonomous net export x : a parameter reflects how net export respond to changes in the real interest rate real interest rate affect net export through the exchange rate : changes in real interest rate changes in return capital flow changes in export and import prices changes in net export
8 Goods Market Equilibrium Y = Y pe Y = C + I + G + NX Y = C + (mpc Y D ) cr + Ī dr + Ḡ + NX xr Y = C + Ī + Ḡ + NX + (mpc Y ) (mpc T ) (c + d + x)r subtracting mpc Y from both dies of equation Y (mpc Y ) = Y (1 mpc) = C + Ī + Ḡ + NX (mpc T ) (c + d + x)r dividing both sides of equation (1 mpc) Y = [ C + Ī + Ḡ + NX (mpc T )] 1 1 mpc c+d+x 1 mpc r
9 IS Curve Aggregate Demand 1 Y = [ C + Ī + Ḡ + NX (mpc T )] c + d + x 1 mpc 1 mpc r }{{}}{{} The equation shows how to determine aggregate output when goods market is in equilibrium. It shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium. First component of the equation explains shifts in IS curve (given interest rate) Second component of the equation explains movements on IS curve (changes in real interest rate)
10 Monetary Policy Aggregate Demand Monetary Policy Central Banks use a very short-term interest rate as their primary policy tool. The interest rate is overnight interest rate at which banks lend to each other. We need real interest rate : r = i π e - changes in nominal interest rate changes in real interest rate (only if actual and expected inflation remain unchanged in the short-run) - We know prices are sticky in the short-run. Central bank can determine the real interest rate in the short-run. not long run, because prices are flexible in the long-run. In the long-run, real interest rate is determined by the interaction of saving and investment.
11 MP Curve Aggregate Demand Monetary Policy MP curve indicates the relationship between the real interest rate which central bank sets and the inflation rate. r = r + λπ MP has an upward slope : - Policy makers follow Taylor principle to stabilise inflation. - Interest rate is raised more than any rise in expected inflation. - Real interest rate rise if there is a rise in inflation. Shifts in MP curve shows changes in stance of monetary policy : - tightening of monetary policy : MP - easing of monetary polcy : MP
12 AD Curve Aggregate Demand Monetary Policy MP curve shows how central bank respond to changes in inflation with setting interest rate IS curve shows how changes in interest rate affects equilibrium output. AD curve shows the relationship between the quantity of aggregate output and inflation rate(given inflation expectations and stance of monetary policy)
13 Monetary Policy
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