Royal School of Administration. Macroeconomics

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1 Royal School of Administration Macroeconomics Chapter 9 By Group 6 1. Chum Chamreun 2. Sok Piseth 3. Kith Sothearith 4. Sreng Vichhay 5. Lay Piden 6. Chheang Damy IS-MP: A Short-Run Macroeconomic Model 2013 Royal School of Administration

2 C H A P T E R 9 IS MP: A Short-Run Macroeconomic Model LEARNING OBJECTIVES After studying this chapter, you should be able to: 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 9.4 Understand the role of the Phillips curve in the IS-MP model 9.5 Use the IS-MP model to understand the performance of the U.S. economy during the recession 2013 Royal School of Administration

3 9.1 Learning Objective Explain how the IS curve represents the relationship between the real interest rate and aggregate expenditure Royal School of Administration 3of 43

4 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 2013 Royal School of Administration 4of 43

5 Equilibrium in the Goods Market Table 9.1 The Relationship Between Aggregate Expenditure and GDP The IS Curve 2013 Royal School of Administration 5of 43

6 ,YD (disposable income) The IS Curve 2013 Royal School of Administration 6of 43

7 Figure 9.1 (1 of 2) Illustrating Equilibrium in the Goods Market Panel (a) shows that equilibrium in the goods market occurs at output level Y 1,where the AE line crosses the 45 line. The IS Curve 2013 Royal School of Administration 7of 43

8 Figure 9.1 (2 of 2) Illustrating Equilibrium in the Goods Market In panel (b), if the level of output is initially Y 2, aggregate expenditure is only AE 2. Rising inventories cause firms to cut production, and the economy will move down the AE line until it reaches equilibrium at output level Y 1. If the output level is initially Y 3, aggregate expenditure is AE 3. Falling inventories cause firms to increase production, and the economy will move up the AE line until it reaches equilibrium at output level Y 1. The IS Curve 2013 Royal School of Administration 8of 43

9 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 fullemployment 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 2013 Royal School of Administration 9of 43

10 The IS Curve 2013 Royal School of Administration 10 of 43

11 2013 Royal School of Administration 11 of 43

12 Figure 9.2 Figure 9.2 The Multiplier Effect The economy is initially in equilibrium at potential GDP,Y P, and then the investment component, I, of aggregate expenditure falls. As a result, the aggregate expenditure line shifts from AE 1 to AE 2. The economy moves down the AE line to a new equilibrium level of output,y 2.The decline in output is greater than the decline in investment spending that caused it. The IS Curve 2013 Royal School of Administration 12 of 43

13 Constructing 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. The IS Curve 2013 Royal School of Administration 13 of 43

14 Figure 9.3 Deriving 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 r 1, the aggregate expenditure line is AE(r 1 ), and the equilibrium level of output is Y 1 (point A). If the interest rate falls from r 1 to r 2, the aggregate expenditure line shifts upward from AE(r 1 ) to AE(r 2 ), and the equilibrium level of output increases from Y 1 to Y 2 (point B). If the interest rate rises from r 1 to r 3, the aggregate expenditure line shifts downward from AE(r 1 ) to AE(r 2 ), and the equilibrium level of output falls from Y 1 to Y 3 (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) Royal School of Administration 14 of 43

15 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. Aggregate demand shock A change in one of the components of aggregate expenditure that causes the IS curve to shift. Figure 9.4 Shifts in the IS Curve 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. The IS Curve 2013 Royal School of Administration 15 of 43

16 The Output Gap Output gap The percentage difference between real GDP and potential GDP. Figure 9.5 Output Gap The output gap is negative during recessions because real GDP is below potential GDP. The IS Curve 2013 Royal School of Administration 16 of 43

17 Figure 9.6 The IS Curve Using the Output Gap 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 = Y P, is also the point where the output gap is zero. The IS Curve 2013 Royal School of Administration 17 of 43

18 9.2 Learning Objective Use the monetary policy, MP, curve to show how the interest rate set by the central bank helps to determine the output gap Royal School of Administration 18 of 43

19 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 2013 Royal School of Administration 19 of 43

20 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 rate TSE, term structure effects DP, default-risk premium And to calculate the expected real interest rate : Where,, expected inflation 2013 Royal School of Administration 20 of 43

21 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 longterm 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 2013 Royal School of Administration 21 of 43

22 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 Royal School of Administration 22 of 43

23 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 Royal School of Administration 23 of 43

24 2013 Royal School of Administration 24 of 43

25 9.3 Learning Objective Use the IS-MP model to understand why real GDP Fluctuates Royal School of Administration 25 of 43

26 Equilibrium in the IS-MP Model Figure Royal School of Administration 26 of 43

27 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 Royal School of Administration 27 of 43

28 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 Royal School of Administration 28 of 43

29 9.4 Learning Objective Understand the role of the Phillips curve in the IS-MP model 2013 Royal School of Administration 29 of 43

30 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 Royal School of Administration 30 of 43

31 The equation for the Phillips curve: 2013 Royal School of Administration 31 of 43

32 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; 2013 Royal School of Administration 32 of 43

33 The Effect of Demand Shocks on Inflation The inflation often increases during expansions and decreases during recession. Example, in 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 As a result, the inflation rate fell from 11.8% during January 1981 to 3.8% during December Royal School of Administration 33 of 43

34 The Effect of Supply Shocks on Inflation Inflation does not always decrease during recession. Actually, inflation increased during the , 1980 and recession. 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 Royal School of Administration 34 of 43

35 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: 2013 Royal School of Administration 35 of 43

36 Movement Along an Existing Phillips Curve Assume no supply shocks ( ), current year inflation rate equals the rate from previous year Royal School of Administration 36 of 43

37 Shift of the Phillips Curve Figure Royal School of Administration 37 of 43

38 Using Monetary Policy to Fight a Recession Figure Royal School of Administration 38 of 43

39 9.5 Learning Objective Use the IS-MP model to understand the performance of the U.S. economy during the recession of Royal School of Administration 39 of 43

40 The performance of the U.S. Economy During The U.S. economy experienced three shocks during the 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 (2 nd quarter of 2007) and to 7.6% below potential GDP (3 rd quarter of 2009). - The inflation rate increased from 1.8% (4 th quarter 2006) to 4.4% (3 rd quarter 2008), before decreasing to 0.3% (2 nd quarter 2009) 2013 Royal School of Administration 40 of 43

41 Figure Royal School of Administration 41 of 43

42 Figure Royal School of Administration 42 of 43

43 Thanks for Your Attention! 2013 Royal School of Administration 43 of 43