ECON 3020: Part 3: CP 10: IS-MP

What is the effect of a demand shock on the IS curve?

-A positive demand shock shifts the IS curve to the right, a negative demand shock shifts it to the left. -There also could be a positive and negative demand shock at the same time, and the movement of the IS curve shift depends on the magnitude of those shocks.

What are fiscal and monetary policy?

-Monetary Policy: the actions that central banks take to manage the money supply and interest rates to pursue macroeconomic policy objectives -Fiscal Policy: Changes in government taxes, purchases of goods and services, and transfer payments intended to achieve macroeconomic policy objectives.

What are the Fed's policy goals?

-Price stability -High employment -Economic growth.

What assumptions are made in order to derive the MP curve?

-TSE and DP are constant -The expected inflation rate is constant

The IS-MP model consists of what 3 parts?

-The IS curve: A curve in the IS-MP model that shows the combination of the real interest rate and aggregate output that represents equilibrium in the market for goods and services. -The MP curve: A curve in the IS-MP model that represents Federal Reserve monetary policy. -The Phillips curve: A curve that represents the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.

What will happen if the Fed decreases the short-term nominal interest rate target?

A downward shift in the MP curve.

What happens if there is a change in one of the autonomous variables in AE?

Any change in an autonomous variable will shift the AE curve and lead to a multiplied effect.

What happens to spending as current disposable income increases?

As disposable income increases, spending increases.

Can the Fed control the long-term real interest rate?

Because the Fed has good control over the short-term nominal interest rate, it controls the long-term real interest rate as well, provided that term structure effects, the default-risk premium, and the expected inflation rate all remain unchanged.

What will be the effect if the term premium increases?

If term premium increases TSE increases, thus i-LT increases.

What has the Fed focused on recently for monetary policy, the money supply or interest rates?

Interest rate

What does the 45-degree line represent?

It shows all of the points that are of equal distances from the axis, that is where all points where AE=Y

What would be the effect on iLT if investors expect lower short-term rates in the future?

TSE decreases, thus i-LT decreases.

What is the TSE?

Term Structure Effect, two factors that explain the difference b/w SR & LR nominal interest rates

What assumptions are made about the effects of income on spending?

That of the four components of aggregate expenditure— C, I, G, and NX—changes in real GDP affect only C, consumption.

How does the Federal Funds rate move compared to other short-term nominal interest rates?

The Fed explicitly targets the federal funds rate, but other short-term interest rates usually move closely with the federal funds rate.

What will happen if one of these 4 MP variables changes?

This will result in a shift in the MP curve.

What assumption is made about wages and prices?

both constant

How will i-LT be affected if the Fed increases i, assuming TSE is constant?

i increases, thus i-LT will increase

How do changes in r affect AE?

inverse relationship

How do long-term nominal interest rates differ from short-term, if both the term structure & risk structure are considered?

long-term is short term + TSE + default-risk premium

What is the difference between short-term and long-term nominal interest rates?

long-term is short-term + TSE

How do economists measure economic fluctuations that occur during the business cycle?

output gap

What key interest rate does the Fed focus on?

short term nominal interest rate

Do expectations of the future affect current interest rates?

yes

Does the Fed control long-term real interest rates, r?

yes

How do central banks tend to adjust targets during recessions? Expansions?

-During recessions central banks decrease their interest rate target to help increase output and employment -During expansions central banks increase their interest rate target to keep inflation down.

What has been the level of the Federal Funds rate since the financial crisis? How have long-term rates responded? Why?

-During the financial crisis, the Fed reduced the federal funds rate to nearly zero and indicated that it would remain near zero for several years. -But the long-term real interest rate did not fall to zero because of the term structure effect and the default-risk premium.

What 4 variables determine the MP curve?

-FED's target short run nominal interest rate -Term Structure effect -Default-risk effect, DP -Expected inflation rate

What is the effect on the IS curve from a change in r? In another factor?

-If r changes: movement along IS curve -If any other factor that affects AE changes: curve shifts right or left

Who developed the multiplier analysis? To explain what event?

-Keynes and colleagues -To explain the great depression

What can cause the MP curve to shift? The IS curve to shift?

-The MP curve describes how Federal Reserve policy, acting through financial markets, determines the real interest rate. A change in the federal funds rate by the federal reserve will shift the MP curve up or down. A decrease in the federal funds rate will shift it down and an increase will shift it up.

How does planned AE compare to actual AE? If planned is not equal to actual AE?

-if planned AE>Y, inventories increase, firms decrease production until AE=Y (vice versa)

Does the Fed target Ms or interest rates?

The Federal Reserve and other central banks have interest rate targets and adjust the money supply to keep interest rates at those targets.

What 3 components of aggregate expenditure does the real interest rate affect? How?

-Investment -Consumption -Net exports -inverse relationship

What 2 factors explain the difference between short-term and long-term nominal interest rates?

-Investors' expectations of future short-term interest rates, as given by the term structure -Term premium: the additional interest that investors require in order to buy a long-term bond rather than a comparable sequence of short-term bonds.

How does the Fed respond to changes in the inflation rate?

-It will adjust the federal funds rate to either slow down inflation or cause inflation. -Lowering the interest rate may lead to an increase in inflation and increasing the interest rate may decrease inflation.

What market does the IS curve represent?

-The IS curve shows the effect of changes in the real interest rate on aggregate expenditure, holding constant all other factors that might affect the willingness of households, firms, and governments to spend. -Therefore, 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. These other factors that lead to changes in aggregate expenditure are called demand shocks.