Chapter 30 Flashcards

Chapter 30. Linking Interest Rates and Output Using IS-MP Analysis

Chapter Objective

• Analyze the links between spending, interest rates, financial markets, and output that shape the business cycle.

Key Concepts

• Aggregate Expenditure: Role in driving short-run fluctuations in output.
• IS Curve: Relationship between the real interest rate and output.
• MP Curve: Summarizes how the real interest rate is determined.
• IS-MP Framework: Forecast economic conditions and response to monetary and fiscal policy.
• Macroeconomic Shocks: Effects using the IS-MP framework.

Key Terms

• Aggregate expenditure
• Financial shocks
• Fiscal policy
• IS curve
• Macroeconomic equilibrium
• Monetary policy
• MP curve
• Multiplier
• Risk premium
• Risk-free interest rate
• Spending shocks

Chapter Summary

• Importance of the interest rate for the economy.
• Presents the IS-MP model for understanding economic fluctuations and predicting the impact of monetary and fiscal policies.

30.1. Aggregate Expenditure

Learning Objective

• Assess the role of aggregate expenditure in driving short-run fluctuations in output.

Aggregate Expenditure and Short-Run Fluctuations

• In the short run, changes in demand drive changes in output.
• Aggregate expenditure: the sum of everyone’s spending plans.
• Aggregate expenditure refers to the total amount of goods and services that people want to buy across the whole economy.
• Aggregate expenditure is the sum of four components: AE = C + I + G + NX
  • Consumption: The buying of goods and services by households
  • Planned investment: The purchasing of new capital by businesses
  • Government purchases: The buying of goods and services by the government
  • Net exports: The spending by foreigners on American-made exports less the spending by Americans on foreign-made imports
• Planned investment: Spending on new capital by businesses, excluding unplanned changes in inventories.
• Output adjusts to meet aggregate expenditure.
  • If output > aggregate expenditure, businesses cut back production.
  • If output < aggregate expenditure, businesses increase production.
• Macroeconomic equilibrium: when the quantity of output that suppliers collectively produce is equal to the quantity of output that buyers collectively want to purchase.
• Macroeconomic equilibrium occurs when total output (GDP) equals aggregate expenditure: Y = C + I + G + NX
• Demand conditions determine output in the short run.

The Demand-Driven Short Run and the Supply-Driven Long Run

• In the short run, actual output may fail to meet potential.
• Weak aggregate expenditure can lead the economy to adjust to an equilibrium in which actual output falls short of potential output.
• Economic slump as an equilibrium: businesses don’t want to produce output that people won’t buy, and people don’t want to spend more because the economy is weak.
• Actual output can exceed the economy’s potential, but this is not sustainable.
• Output can exceed potential only if available resources are more than fully employed.
• When actual output exceeds potential output, this can spark inflation.
• Output gap focuses on the balance between the short-run demand and long-run supply of output.
• Potential output: the economy’s maximum sustainable rate of output.
• Output gap measures the gap between actual and potential output, as a percentage of potential output: Output gap = {(Actual\ output - Potential\ output) \over Potential \ output} \times 100
  • If actual output > potential, the output gap is positive.
  • If actual output < potential, the output gap is negative.
• Focusing on the output gap is helpful because it provides a way to disentangle the roles of the demand- and supply-side determinants of output.
• Supply side determines potential output.
• Actual output deviates from potential output due to demand-side factors.
• Equilibrium output describes the level of output at the point of macroeconomic equilibrium.

30.2. The IS Curve: Output and the Real Interest Rate

Learning Objective

• Use the IS curve to analyze the relationship between the real interest rate and output.

• The real interest rate may be the most important price in the economy.

• It represents the opportunity cost of spending.

• Policy makers adjust it to influence the economy.

  • The Federal Reserve raises the interest rate when it wants to induce people to spend less.
  • And when the Fed wants to stimulate more spending, it cuts the interest rate, which reduces the opportunity cost of spending money today.

Lower Interest Rates Boost Aggregate Expenditure

• Spending decisions depend on the real interest rate because of the opportunity cost principle: The opportunity cost of spending money today is saving that money and earning interest.
• The lower the real interest rate is, the lower the opportunity cost of spending.
• Lower interest rates boost investment. Money you spend on new equipment or structures is money that is not in the bank earning interest.
• Thus, the opportunity cost of investing in new capital is lower when real interest rates are lower.
• As a result, low real interest rates lead to more investment spending.
• Lower interest rates boost government purchases. Low interest rates reduce the interest payments the government pays on its debt.
• Low interest payments mean that there’s more money left in the government budget for spending on roads, bridges, and other forms of aggregate expenditure. As a result, lower interest rates can lead to an increase in government purchases.
• Lower interest rates boost net exports. A low real interest rate in the United States leads international money managers to send their funds to other countries that offer better returns.
• This means foreign investors will demand fewer U.S. dollars, and American investors will supply more U.S. dollars. This increased demand and decreased supply leads the dollar to become cheaper. So, the initial effect of a lower interest rate is that it takes fewer foreign currencies to buy an American dollar.
• This cheaper dollar increases exports and reduces imports.

The IS Curve Describes the Link Between the Real Interest Rate and the Output Gap

• Lower interest rates boost aggregate expenditure. Consumption, investment, government purchases, and net exports all increase when the real interest rate is lower.
• Therefore, aggregate expenditure — which is the sum of each of these forms of spending — is higher when the real interest rate is lower.
• A rise in aggregate expenditure is matched by a rise output. Businesses adjust their output to meet demand, so that output adjusts until it’s equal to aggregate expenditure.
• As a result, a lower real interest rate that boosts aggregate expenditure will lead to a higher level of output.
• Higher output translates to a more positive output gap. When actual output rises even as potential output is unchanged, the output gap becomes more positive.
• The IS curve illustrates how lower real interest rates lead to a more positive output gap.
• The IS curve is like a macroeconomic demand curve. The IS curve is similar to a demand curve. It shows this year’s demand for all types of output. You can think of it as showing the macroeconomic demand for output.
• The IS curve is downward-sloping, like a typical demand curve. That’s because a lower real interest rate decreases the opportunity cost of making purchases this year, leading people across the whole economy to respond by buying more goods and services.

How to Use the IS Curve

• Locate the real interest rate on the curve.
• The corresponding level of GDP is your forecast.
• If other things change, so should your forecast.
• A change in the real interest rate leads to a movement along the IS curve. A change in the real interest rate leads the economy to move from one point on the IS curve to another point on the same curve.
• The point of the IS curve is to illustrate how the output gap responds to changes in the real interest rate, and so changes in the real interest rate lead to a movement along the IS curve.

30.3. The MP Curve: What Determines the Interest Rate

Learning Objective

• Use the MP curve to summarize how the real interest rate is determined.

The Federal Reserve Sets the Risk-Free Interest Rate

• Eight times a year, policy makers meet at the Federal Reserve in Washington, D.C., to decide how to set the interest rate.
• The Fed sets the nominal interest rate to influence the real interest rate. When the Federal Reserve announces that it’s setting the interest rate at 3%, it’s actually setting the nominal interest rate, but we’ll describe the Federal Reserve as setting the real interest rate because in practical terms, that’s what it is doing.
• The Fed's policy tool is a specific interest rate called the federal funds rate, which is the interest rate on a set of overnight loans that are almost certain to be repaid the next day.
• You can think of the Federal Reserve as effectively setting the risk-free interest rate.
• Changes in the risk-free interest rate then percolate through the rest of the economy.

The Financial Sector Adds a Risk Premium

• The interest rate on any loan reflects the risk-free rate plus a risk premium.
• Banks and other lenders demand to be paid extra for taking on these risks. The extra interest that they charge to account for risk is called the risk premium.
• As a result, the real interest rate reflects two influences: It’s the risk-free rate (which is set by the Fed) plus the risk premium (which is determined by financial markets).
• Real\ interest\ rate = Risk-free\ real\ interest\ rate + Risk\ premium
• The risk premium is determined in financial markets. The buyers and sellers of risk — mainly big banks and other financial institutions — trade risk.
• The risk premium is the price at which lenders are willing to bear the risk associated with lending you money. This price is determined by the forces of supply and demand, and so it reflects changing financial conditions and sentiments in financial markets.

The MP Curve

• The MP curve stands for monetary policy because we use it to illustrate the current real interest rate, which is largely shaped by monetary policy.
• The MP curve illustrates how changes in the risk premium affect the real interest rate.
• The MP curve illustrates the current real interest rate, so it is horizontal.
• If the interest rate changes — either because the Fed changes monetary policy or changes in financial markets shift the risk premium — the MP curve will shift to illustrate this.
• You can measure the risk premium using interest rate spreads. Here’s a simple trick you can use to track the risk premium: Calculate the difference between the interest rate at which you can borrow and the risk-free interest rate (for loans of the same duration). This difference, which is called an interest rate spread, is an estimate of the risk premium.
• The MP curve is simple because monetary policy is simple. The MP curve is pretty simple: you just draw a horizontal line to show what the current interest rate is. That’s because the Federal Reserve simply announces where it wants to set the interest rate, and the MP curve reflects that.

30.4. The IS-MP Framework

Learning Objective

• Forecast economic conditions and how they’ll respond to monetary and fiscal policy.

• The IS curve illustrates how the output gap depends on the real interest rate. And the MP curve tells you what the real interest rate will be. Put them together, and you’ll have a complete story of what determines the state of the economy.

IS-MP Equilibrium

• The intersection between IS and MP curves determines the macroeconomic equilibrium.

Fluctuating Demand and Business Cycles

• Strong aggregate expenditure leads to an economic boom and full employment.
• Optimistic spending plans lead to a macroeconomic equilibrium with an output gap of zero, which means that GDP is at its highest sustainable level. In this booming economy, output is high, unemployment is low, and the economic outlook is sunny enough that continued economic optimism is warranted.
• Insufficient spending can lead to an economic bust and unemployment.
• Pessimism leads to a decrease in aggregate expenditure at any given real interest rate and level of income. This decrease in spending causes the IS curve to shift left. This lower level of aggregate expenditure yields a new macroeconomic equilibrium at a much lower level of output. The output gap is now negative, which means that the economy is producing below its potential. The result is an economic bust, in which people have lower incomes and unemployment is widespread.
• Changes in aggregate expenditures create macroeconomic fluctuations. The economy shifts from between periods of boom to bust, due to changes in aggregate expenditure shifting the IS curve. Many of the ups and downs of the business cycle reflect shifts in aggregate expenditure.
• Recessions can be individually rational and collectively terrible. The economy can be in macroeconomic equilibrium even when output is far below its potential and unemployment is widespread. It is a macroeconomic equilibrium in which the economy produces less than its potential. If nothing changes, the economy will get stuck in this rut. That’s because the economy is in a bust, and unfortunately, this unhappy outcome is also an equilibrium.
• Each person is individually making the best decision they can, but those decisions add up to a collectively terrible outcome in which the economy is stuck producing less than potential — and less than required to employ everyone.

Analyzing Monetary Policy

• Monetary policy shifts the MP curve. When the Fed changes the real interest rate, it shifts the MP curve. Cutting the real interest rate shifts the MP curve down and leads to a new equilibrium with higher GDP at a lower real interest rate.

Analyzing Fiscal Policy and the Multiplier

• The government can also influence the economy through fiscal policy, adjusting its own spending and tax policies. When the federal government adjusts fiscal policy, it shifts the IS curve.
• An increase in spending has a multiplied effect on aggregate expenditure. As this initial boost in spending reverberates though the economy, it illustrates the importance of the interdependence principle for understanding macroeconomic developments. This interdependence arises because one person’s spending is another person’s income. It means that extra spending on schools stimulates extra spending in the fitness, food, and childcare industries. As the initial burst of government purchases ripples through the economy, it has a multiplied effect, leading to an even larger boost to aggregate expenditure.
• The multiplier summarizes the effect of an initial burst of spending on output.
• The multiplier measures how much extra GDP is generated by each extra dollar of spending. For instance, if the multiplier is 2, then an initial $1 boost to spending will generate a total of $2 in additional spending and greater output. When people have a greater propensity to spend any additional income they receive, the ripple effects of an initial burst of spending will be larger, leading the multiplier to be larger. You can use it to forecast the effects of changes in spending as follows:
• \Delta GDP = \Delta Spending \times Multiplier
• The multiplier determines how far the IS curve shifts. The multiplier is relevant to our IS-MP analysis because it determines how far the IS curve shifts following an initial burst of spending. The IS curve shifts by an amount equal to the initial change in spending times the multiplier. This shift in the IS curve leads to a new equilibrium, which involves higher GDP but no change in the real interest rate.

30.5. Macroeconomic Shocks

Learning Objective

• Use the IS-MP framework to forecast the effects of macroeconomic shocks.

Spending Shocks Shift the IS Curve

• Shifts in the IS curve are driven by spending shocks, which change the level of aggregate expenditure associated with a given real interest rate and level of income.
• Spending shock 1: Consumption increases when people feel more prosperous. Any development that makes people feel more prosperous leads to an increase in consumption. This means that consumption will shift in response to changes in the following factors:
  • Wealth: When the stock market booms or house prices rise, stockholders and homeowners feel more prosperous and spend some of their newfound wealth. Consumption will increase.
  • Consumer confidence: When you feel confident that your income will grow in the future, you might ramp up your spending in advance. As a result, consumption increases when an improved economic outlook boosts consumer confidence.
  • Taxes and government assistance: When the government cuts your taxes or when it increases government assistance payments, you’ll have more disposable income. And so consumption increases.
  • Inequality: People with low incomes tend to spend a larger share of their income. It follows that redistributing income from rich people to poor people tends to increase consumption.
• Spending shock 2: Investment increases when it’s profitable for businesses to expand. As a manager, you’ll invest in new machinery when you believe that it will be profitable to expand your production. As a result, investment will shift in response to changes in the following factors:
  • An expanding economy: When the economy is expanding, so is the demand for your products. To keep up with demand, investment in new equipment increases when the economy is expanding more rapidly.
  • Business confidence: Because capital investments tend to last for years, assessments about whether to buy new equipment depend not only on today’s profits but also on expected future profitability. That’s why investment rises when managers are more confident about their long- term profitability.
  • Corporate taxes: Corporate taxes lower after-tax profits, reducing the return on investing in new equipment. As a result, investment falls in response to higher corporate taxes.
  • Lending standards and cash reserves: If your business cannot borrow money at a reasonable interest rate, you’ll buy new equipment only when your company has the cash to do so. So investment increases when loans are easier to get or when businesses have large cash reserves.
  • Uncertainty: If you’re uncertain about the economic outlook, remember that you usually have the option to postpone major investments until the outlook is clearer. Lower uncertainty leads managers to restart these shelved projects, leading to an increase in investment.
• Spending shock 3: Government purchases increase in response to fiscal policy. For example, Congress may pass legislation to spend more on roads and bridges, invest in pandemic preparedness, or purchase new military equipment. In addition, some government programs — known as automatic stabilizers — automatically increase spending when the economy is weak.
• Spending shock 4: Net exports increase due to global factors. Net exports rise when people in other countries want to buy a lot of American-made goods and services. They shift in response to the following:
  • Global economic growth: When foreign economies do well, their consumers and businesses buy more goods, including more American-made goods, leading net exports to rise.
  • The exchange rate: When the U.S. dollar becomes cheaper, our goods become cheaper to foreign buyers, leading exports to rise. A cheaper U.S. dollar also means that foreign goods become more expensive (in dollars) for American buyers, leading imports to fall. Both forces — rising exports and falling imports — cause net exports to increase.
  • Trade barriers: Exports increase when there are fewer barriers for American businesses in foreign markets, while imports increase when there are fewer barriers for foreign businesses in the United States. Because trade agreements typically reduce barriers on both, their effect on net exports is unclear.
• Anything that shifts any component of aggregate expenditure shifts the IS curve. The IS curve shifts in response to an increase in any component of aggregate expenditure (C, I, G, and NX).

Financial Shocks Shift the MP Curve

• When the Federal Reserve adjusts the risk-free real interest rate or shifts in financial markets change the risk premium, the real interest rate will shift, leading the MP curve to shift. We call these changes in borrowing conditions that shift the MP curve financial shocks.
• Financial shock 1: Changes in monetary policy. When the Federal Reserve decides to raise its benchmark interest rate, interest rates rise throughout the rest of the economy. This higher real interest rate shifts the MP curve up.
• Financial shock 2: Financial market risks shift the risk premium. A rise in the risk premium raises the real interest rate, which shifts the MP curve up. The risk premium will shift in response to changes in the following risk factors:
  • Default risk: When there’s an increased risk that borrowers will default, lenders demand a larger risk premium, which leads the MP curve to shift upward.
  • Liquidity risk: When banks need cash, they can usually get it by selling some of their loans to other lenders. Liquidity risk arises when there aren’t enough buyers willing to pay a reasonable price. A rise in liquidity risk increases the risk premium, which shifts the MP curve upward.
  • Interest rate risk: The long-term interest rate you offer today might turn out to be a bad deal if future interest rates or inflation are unexpectedly higher. As a result, this greater uncertainty increases the risk premium, shifting the MP curve up.
  • Risk aversion: When lenders become more risk-averse, they’ll be willing to make a loan only if they can charge a higher risk premium, shifting the MP curve up.
• Any change in the real interest rate shifts the MP curve. The MP curve shifts whenever the real interest rate shifts.

Forecasting Macroeconomic Outcomes

• To assess the likely effects of any change in economic conditions, ask yourself the following:
  • Step 1: Is there a spending shock (which shifts the IS curve) or a financial shock (which shifts the MP curve)?
  • Step 2: In which direction and how far does this shift the IS or MP curve?
  • Step 3: What happens to output in the new equilibrium?