R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

R. GLENNHUBBARDANTHONY PATRICKO’BRIEN Money,Banking, andthe Financial System

Monetary Theory II:The IS–MP Model 18 C H A P T E R LEARNING OBJECTIVES After studying this chapter, you should be able to: 18.1 Understand what the IS curve is and how it is derived Explain the significance of the MPcurve and the Phillips curve 18.2 Use the IS–MP model to illustrate macroeconomic equilibrium 18.3 Discuss alternative channels of monetary policy 18.4 Use the IS-LM model to illustrate macroeconomic equilibrium 18A

Monetary Theory II:The IS–MP Model 18 C H A P T E R • 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 Federal Reserve was considering in late 2010 to provide additional stimulus to the U.S. economy.

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 IScurve is and how it is derived.

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 Aggregate expenditure, AE, equals: Equilibrium occurs in the goods market when the value of goods and services demanded—aggregate expenditure, AE—equals the value of goods and services produced—real GDP, Y. So, at equilibrium The Relationship Between Aggregate Expenditure and GDP Table 18.1

The IS Curve The consumption function is the relationship between current consumption spending and current income, or GDP. Algebraically: where . We have the following expression for aggregate expenditure, substituting in the expression above for C:

The IS Curve Figure 18.1 (1 of 2) Illustrating Equilibrium in the Goods Market Panel (a) shows that equilibrium in the goods market occurs at output level Y1,where the AE line crosses the 45° line.

The IS Curve Figure 18.1 (2 of 2) Illustrating Equilibrium in the Goods Market 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.•

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. MultiplierThe change in equilibrium GDP divided by a change in autonomous expenditure.

The IS Curve How large is the multiplier? It is quite large in our simple model. To see this, recall that our expression for aggregate expenditure is: and that at equilibrium: So, substituting, we have: or, rearranging terms: If investment changes, while government purchases and net exports remain unchanged, then we have: or rearranging terms: If, as we assumed earlier, MPC is equal to 0.90, the value of the multiplier equals:

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.

18.1 Solved Problem Calculating Equilibrium Real GDP Use the following data to calculate the equilibrium level of real GDP and the value of the investment spending multiplier: , Solving the Problem Step 1Review the chapter material. Step 2Use the data to calculate equilibrium real GDP. So, at equilibrium: Substituting the values above gives us: The IS Curve

18.1 Solved Problem Solved Problem Calculating Equilibrium Real GDP Step 3Calculate the value of the multiplier from the data given. The expression for the investment spending multiplier is: With MPC = 0.8, the value of the multiplier is: The IS Curve

The IS Curve Fiscal policy Changes in federal government purchases and taxes intended to achieve macroeconomic policy objectives. The multiplier for government purchases equals: Estimating an exact number for the multiplier is difficult because many things happen in the economy that can affect real GDP. So, isolating the effect of a change in government purchases is not an easy task, and the debate over the size of the multiplier will likely continue.

The IS Curve Constructing 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.

Deriving the IS Curve Figure 18.3 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 r1to 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).•

The IS Curve The Output Gap 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. Output gap The percentage difference between real GDP and potential GDP. Figure 18.4 Output Gap The output gap is negative during recessions because real GDP is below potential GDP.•

The IS Curve Figure 18.5 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 = YP, is also the point where the output gap is zero.

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. Aggregate demand shock A change in one of the components of aggregate expenditure that causes the IS curve to shift. Figure 18.6 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.•

18.2 Learning Objective Explain the significance of the MP curve and the Phillips curve.

The MP Curve and the Phillips Curve We assume that the Fed chooses a target for the federal funds rate according to the Taylor rule. Recall the expression for the Taylor rule from Chapter 15: 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.

The MP Curve and the Phillips Curve The MP Curve Figure 18.7 The MP Curve The MP curve is a horizontal line at the real interest rate determined by the Fed. When the Fed increases the real interest rate from r1 to r2, the MP curve shifts up from MP1 to MP2, the economy moves up the IS curve, and the value of the output gap changes from 1 to 2. When the Fed decreases the real interest rate r1 to r3, the MP curve shifts down from MP1 to MP3, the economy moves down the IS curve, and the value of the output gap changes from 1 to 3.•

The MP Curve and the Phillips 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.

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: where = the current inflation rate = the expected inflation rate = the current unemployment rate * = the natural rate of unemployment = a 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

The MP Curve and the Phillips Curve The Phillips Curve Figure 18.8 The PhillipsCurve The Phillips curve illustrates the short-run relationship between the unemployment rate and the inflation rate. Point A represents the combination of a 4% unemployment rate and a 4% inflation rate in one year. Point B represents the combination of a 7% unemployment rate and a 1% inflation rate in another year.•

The MP Curve and the Phillips Curve The Phillips Curve Figure 18.9 Shifts in 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.•

The MP Curve and the Phillips Curve Okun’s Law and an Output Gap Phillips Curve The Phillips curve shows the short-run relationship between the inflation rate and the unemployment rate. There 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. Okun’s law A statistical relationship discovered by Arthur Okun between the output gap and the cyclical rate of unemployment. Substituting the output gap, , for cyclical unemployment, , in our Phillips curve equation will capture the effect of changes in the output gap on the inflation rate: The coefficient b in the equation represents the effect of changes in the output gap on the inflation rate.

The MP Curve and the Phillips Curve Okun’s Law and an Output Gap Phillips Curve Using Okun’s Law to Predict the Cyclical Unemployment Rate Figure 18.10 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.•

The MP Curve and the Phillips Curve Okun’s Law and an Output Gap Phillips Curve Figure 18.11 The Output Gap Version of the 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 inflation or a positive supply shock shifts the Phillips curve down.•

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 and the level indicated by Okun’s law widened to about 1.5%. The MP Curve and the Phillips Curve

18.3 Learning Objective Use the IS–MP model to illustrate macroeconomic equilibrium.

Equilibrium in the IS–MP Model Figure 18.12 Equilibrium in the IS–MP Model In panel (a), the IS curve and the MPcurve 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.•

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

Equilibrium in the IS–MP Model Using Monetary Policy to Fight a Recession Figure 18.13 Expansionary Monetary Policy In panel (a), a demand shock causes the IS curve to shift to the left, from IS1 to IS2. Real GDP falls below potential GDP, so the economy has a negative output gap at , and moves into a recession. Panel (b) shows that a negative output gap pushes the economy down the Phillips curve, lowering the inflation rate from to . The Fed lowers the real interest rate, shifting the monetary policy curve from MP1 to MP2 and moving the economy down the IS curve. Real GDP returns to its potential level, so the output gap is again zero. In panel (b), the inflation rate rises from back to .•

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.

Equilibrium in the IS–MP Model An Increasing Risk Premium During the 2007–2009 Recession Figure 18.14 During the financial crisis of 2007–2009, the default risk premium soared, raising interest rates on Baa-rated bonds relative to those on Aaa-rated bonds and 10-year U.S. Treasury notes.•

Equilibrium in the IS–MP Model Figure 18.15 Expansionary Monetary Policy in the Face of a Rising Risk Premium During the recession of 2007–2009, the collapse in spending on residential construction shifted the IS curve from IS1to IS2, and real GDP fell below potential GDP at . The Fed responded by lowering the real interest rate from r1 to r2, but the increase in the risk premium caused the real interest rate actually to increase to r3, pushing the economy into a deeper recession at .•

Making the Connection Trying to Hit a Moving Target: Forecasting with “Real-Time Data” The Fed relies on forecasts from macroeconomic models to guide its policymaking. The Fed uses models similar to the IS–MP model and relies on data gathered by a variety of federal government agencies. GDP is measured quarterly by the Bureau of Economic Analysis (BEA), part of the Department of Commerce. The advance, preliminary, and final estimates of a quarter’s GDP are not released until about one, two, and three months after quarter-end and are still subject to revisions. Benchmark revisions occur in even later years. The start of 2001 may prove why these revisions matter. Indicators showed that the U.S. economy might be headed for recession after the dot-com stock market bubble had burst. Though the advance estimate of the first quarter’s GDP showed a fairly healthy increase in real GDP of 1.98% at an annual rate, current BEA data indicate that real GDP actually declined by 1.31%. So, in addition to the other problems the Fed faces in conducting monetary policy, the data it uses to make its forecasts may be subject to many revisions.

Making the Connection Trying to Hit a Moving Target: Forecasting with “Real-Time Data” Equilibrium in the IS–MP Model

18.3 Solved Problem Using Monetary Policy to Fight Inflation We saw in Chapter 15 that Fed Chairman Paul Volcker took office in August 1979 with a mandate to bring down the inflation rate. Use the IS–MP model to analyze how the Fed can change expectations of inflation to permanently reduce the inflation rate. Be sure that your graphs include the IS curve, the MP curve, and the Phillips curve. Also be sure that your graphs show the initial effect of the Fed’s policy on the output gap and the inflation rate. Finally, be sure to illustrate how the economy returns to long-run equilibrium at a lower inflation rate. Solving the Problem Step 1Review the chapter material. Equilibrium in the IS–MP Model

18.3 Solved Problem Solved Problem Using Monetary Policy to Fight Inflation Step 2Describe the policy the Fed would use to reduce the inflation rate and illustrate your answer with a graph. To lower expected inflation, the Fed can cause a decline in real GDP by raising the real interest rate. The Phillips curve tells us that if real GDP falls below potential GDP, the inflation rate will decline. Equilibrium in the IS–MP Model

18.3 Solved Problem Solved Problem Using Monetary Policy to Fight Inflation Step 3Show how after the Phillips curve shifts down the Fed can return the economy to potential output at a lower inflation rate. If the inflation persists at , households will eventually lower their expectation of the inflation rate from to . Once that happens, the Fed can lower the real interest rate from r2 back to r1, returning the economy to potential GDP. Equilibrium in the IS–MP Model

18.4 Learning Objective Discuss alternative channels of monetary policy.

Are Interest Rates All That Matter for Monetary Policy? Economists refer to the ways in which monetary policy can affect output and prices as the channels of monetary policy. In the IS–MP model, monetary policy works through the channel of interest rates: Through open market operations, the Fed changes the real interest rate, which affects the components of aggregate expenditure, thereby changing the output gap and the inflation rate. We call this channel the interest rate channel. An underlying assumption in this approach is that borrowers are indifferent as to how or from whom they raise funds and regard alternative sources of funds as close substitutes. As we will see next, bank loans play no special role in this channel.

Are Interest Rates All That Matter for Monetary Policy? The Bank Lending Channel Bank lending channel A description of the ways in which monetary policy influences the spending decisions of borrowers who depend on bank loans. In this channel, a monetary expansion increases banks’ ability to lend, and increases in loans to bank-dependent borrowers increase their spending. In the interest rate channel, an increase in output occurs because a lower federal funds rate causes other interest rates to fall. Both channels are similar in one respect: An increase in bank reserves leads to lower loan interest rates, lower bank loan rates, and lower interest rates in financial markets.

Are Interest Rates All That Matter for Monetary Policy? In the bank lending channel, an expansionary monetary policy causes aggregate expenditure to increase for two reasons: (1) the increase in households’ and firms’ spending from the drop in interest rates, and (2) the increased availability of bank loans. In other words, if banks expand deposits by lowering interest rates on loans, the amounts that bank-dependent borrowers can borrow and spend increases at any real interest rate. Therefore, in the bank lending channel, an expansionary monetary policy is not dependent for its effectiveness on a reduction in interest rates. Similarly, a contractionary monetary policy is not dependent for its effectiveness on an increase in interest rates.

Are Interest Rates All That Matter for Monetary Policy? The Balance Sheet Channel: Monetary Policy and Net Worth Monetary policy may also affect the economy through its effects on firms’ balance sheet positions. Economists have attempted to model this channel by describing the effects of monetary policy on the value of firms’ assets and liabilities and on the liquidity of balance sheet positions—that is, the quantity of liquid assets that households and firms hold relative to their liabilities. According to these economists, the liquidity of balance sheet positions is a determinant of spending on business investment, housing, and consumer durable goods. Balance sheet channelA description of the ways in which interest rate changes resulting from monetary policy affect borrowers’ net worth and spending decisions. The balance sheet channel emphasizes that even if monetary policy has no effect on banks’ ability to lend, the decline in borrowers’ net worth following a monetary contraction reduces aggregate demand and output.

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN