Macro 18: IS-MP Analysis: Interest Rates and Output

The risk-free real interest rate is currently 3.5%, inflation is 1%, and the risk premium is 1.5%. The real-interest rate is A. 2%. B. 4.5%. C. 5.0%. D. 6.0%.

Real interest rate = Risk-free real interest rate + Risk premium = 3.5% + 1.5% = 5%

Aggregate Expenditure

Describes Spending Plans Aggregate expenditure is the total amount of goods and services that people want to buy across the whole economy. AE = C + I + G + NX

Short-Run versus Long-Run Drivers

In the short run, actual GDP may fail to meet potential output. When actual GDP is greater than potential, the economy will overheat. The output gap focuses on the balance between supply and demand

IS relation

In the short-run, decrease in interest rate will increase the output gap(become more positive)

Aggregate Expenditure and Interest Rates: Lower interest rates

Lower interest rates boost ▪ consumption. ▪ investment. ▪ government purchases. ▪ net exports. AE will go up: in equilibrium GDP=AE will go up; In the short-run, the potential GDP is unchanged, GDP - potential GDP will increase, thus increasing the output gap(become more positive)

Analyzing Monetary Policy

The Federal Reserve changes the real interest rate. Monetary policy shifts the MP curve. The shift in the MP curve leads to a new equilibrium. Macroeconomic equilibrium is currently at a real interest rate of 5%, and actual output is 8% below potential output. The Fed wishes to close the gap, so it will A. increase the federal funds rate. B. decrease the federal funds rate.

The IS curve

The IS curve illustrates how lower real interest rates raise spending and hence GDP, leading to a more positive output gap If the interest rate falls from 5% to 3%, A. the IS curve shifts to the right. B. the IS curve shifts to the left. C. we move to the right along the IS curve. D. we move to the left along the IS curve All the macro-equilibrium points at different interest rate

Analyzing Fiscal Policy

The government can also influence the economy through fiscal policy. Fiscal policy involves government spending and taxes. When the government adjusts fiscal policy, it shifts the IS curve. The shift in the IS curve leads to a new equilibrium. Expansionary fiscal policy(rightward shift); Multiplier>1 The Multiplier Determines the Effectiveness of Fiscal Policy An increase in spending has a multiplied effect on aggregate expenditure. (The multiplier determines how far the IS curve shifts.) The multiplier is a measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending. ΔGDP = ΔSpending × Multiplier The economy is in a recession, so the government reduces taxes. This causes the IS curve to A. shift to the right. B. shift to the left.

Monetary Policy

The process of setting interest rates in an effort to influence economic conditions is called monetary policy. In the United States, the Federal Reserve executes monetary policy

9. For each of the following cases, draw an IS curve to show how each of the factors affects the IS curve. (a) The United States enters into a new trade agreement to increase exports to partner nations. (b) The government widens the income tax brackets to effectively lower taxes. (c) The government institutes a larger exemption from taxes for both single and married taxpayers.

a) b) c) Expansionary fiscal policy: IS curve shift to the right

Forecasting the Effects of Macroeconomic Shocks

A spending shock is any change in aggregate expenditure at a given real interest rate and level of income. Spending shocks shift the IS curve. Positive spending shock: IS curve shift to the right

11. Suppose the economy is currently producing 4% below potential GDP. The government increases spending by $5 trillion, and this causes GDP to rise by $15 trillion. The economy then arrives at potential GDP. Using this information, answer the following questions. (a) What is the multiplier in the economy? (b) What effect will be seen on the IS-MP framework?

ANSWER: (a) The multiplier effect is 3. (b) The IS curve will shift right until the output gap is 0%.

12. Assume that your current actual GDP is at potential GDP. Explain how each of the following changes affects the output gap in an economy. (a) The stock market experiences a decline, which reduces wealth. (b) Government spending rises. (c) The U.S. dollar depreciates.

ANSWER: (a) The reduction in wealth reduces consumption. This negative spending shock shifts the IS curve to the left and causes the output gap to become negative. (b) This increase in government spending shifts the IS curve to the right and causes the output gap to become positive. (c) The depreciation of the U.S. dollar will encourage exports and increase net exports. This will shift the IS curve to the right and cause a positive output gap.(NE becomes larger)

10. For each of the following cases, draw an MP curve to show how each of the factors affects the MP curve. (a) Default rates on bank loans increase. (b) The Federal Reserve raises the federal funds rate. (c) The Federal Reserve lowers the federal funds rate.

ANSWER: a) b) Rise of Ir c) Decline on Ir

The economy is currently in macroeconomic equilibrium. Consumers become less confident in the economic outlook and decrease their consumption spending. Businesses will A. increase production. B. decrease production.

Answer: B. decrease production.

Financial Shocks

Any changes in borrowing conditions that change the real interest rate at which people can borrow are called financial shocks. Financial shocks shift the MP curve.

7. For each of the following scenarios, identify the component of AE that is affected, and holding everything else equal. (a) You and your friends spend spring break on the beaches of Miami. (b) Your business installs large production assembly machines in your factory. (c) Your parents increase the amount the save each month because interest rates have risen in the economy.

ANSWER: (a) consumption; (b) investment; (c) consumption Financial investment is not included in I of AE; I in AE refers to physical investment.

8. Using the following data, calculate the aggregate expenditure in the economy.

ANSWER: C+I+G+NE = $16.23 trillion

Equilibrium versus Potential GDP

Equilibrium GDP describes the level of GDP at the point of macroeconomic equilibrium. Equilibrium: Y = AE Potential GDP is the economy's highest sustainable level of production and is determined by available inputs. Across the whole economy, businesses will adjust their production so that total output matches total spending.

Spending shock components

Spending Shock One: Consumption Consumption increases if people feel more prosperous. Causes include ▪ increases in wealth. ▪ increases in consumer confidence. ▪ increases in government assistance. ▪ reductions in taxes. ▪ reductions in inequality. Spending Shock Two: Investment Investment increases if it is profitable to expand production. Causes includes ▪ an expanding economy. ▪ increases in business confidence. ▪ increases in investment tax credits. ▪ reductions in corporate taxes. ▪ easier lending standards and increased cash reserves. ▪ reduced uncertainty. Spending Shock Three: Government Government purchases increase in response to fiscal policy. Causes include ▪ spending bills. ▪ automatic stabilizers. but not transfer payments (at least not directly). Spending Shock Four: Net Exports Net exports increase in response to global factors. Causes include ▪ increases in global GDP growth. ▪ reduced value of the U.S. dollar. ▪ reduced trade barriers in foreign markets. ▪ increased trade barriers in U.S. markets.

The MP Curve

The MP curve illustrates the current real interest rate, which is shaped by monetary policy and the risk premium.

Financial Shocks Components

Financial Shock One: Monetary Policy Changes in monetary policy can raise interest rates by increasing ▪ the risk-free rate. ▪ expected future interest rates.(Borrow more now-drive Ir up) Financial Shock Two: Risk A higher risk premium will raise interest rates due to increased ▪ default risk. ▪ liquidity risk. ▪ interest rate risk. ▪ risk aversion.

Risk-Free Interest Rate & the Risk Premium.

The interest rate on a loan that involves no risk is called a risk-free interest rate. The federal funds rate, set by the Fed, is effectively a risk-free interest rate. The extra interest that lenders charge to account for the risk of loaning money is called a risk premium. Real interest rate = Risk-free real interest rate + Risk premium

Importance of the Interest Rate

The real interest rate ▪ represents the opportunity cost of spending. ▪ is the price that determines this year's aggregate expenditure. ▪ is a lever policy makers use to influence the economy.

The Federal Reserve sets the nominal interest rate to influence the real interest rate.

If inflation is 2%: the Fed sets the nominal interest rate at 5% = the Fed sets the real interest rate at 3% We'll describe the Fed as setting the real interest rate.

Fluctuating Demand and Business Cycles

▪ Aggregate expenditures play an important role in determining macroeconomic equilibrium. ▪ Recessions and expansions can be explained as declining and increasing expenditures.

Achieving Macroeconomic Equilibrium

▪ Output adjusts to meet aggregate expenditure. ▪ Macroeconomic equilibrium occurs when the quantity of output that buyers collectively want to purchase is equal to the quantity of output that suppliers collectively produce. Y = C + I + G + NX GDP/Income = AE Aggregate expenditure drives short-run fluctuations in output

Booms and Busts

When Consumers become pessimistic IS curve will shift to the left. ▪ Strong aggregate expenditure leads to a booming economy and full employment. ▪ Insufficient demand can lead to an economic slump and unemployment. ▪ Changes in aggregate expenditures create macroeconomic fluctuations. Consumers are increasingly optimistic about the future of the economy, so you predict that the A. IS curve will shift to the left. B. IS curve will shift to the right. C. MP curve will shift up. D. MP curve will shift down.

The IS-MP Framework

Putting them together provides a story about the state of the economy.