Economic Policy

4. Lecture

IS-MP: A Short Run Macroeconomic Model

IS Curve

.Keynes(1936),TheGeneralTheoryofEmployment,Interest,andMoney:
.AggregateDemand:Thetotalamountofoutputdemandedintheeconomy.

.Hearguedthatshort-
runchangesinaggregateoutputweredeterminedbychangesinaggregatedemand.Theconceptofagg
regatedemandisacentralelementintheaggregatedemand-aggregatesupply(AD/AS)
model,thebasicmacroeconomicmodelforexplainingshort-runfluctuationsinaggregateoutput
.To understand aggregatedemand:
.
TheISCurve:IScurvedescribestherelationshipbetweenrealinterestratesandaggregateoutpu
twhenthemarketforgoodsandservices(moresimplyreferredtoasthegoodsmarket)isinequilibr
ium.
Planned Expenditure

.
PlannedExpenditure:Thetotalamountofspendingondomesticallyproducedgoodsandservicesth
athouseholds,businesses,thegovernment,andforeignerswanttomake.
.
ActualExpenditure:Actualexpenditureistheamountthattheyactuallydospend,whichequalsth
etotalamountofoutputproducedintheeconomy.
.
AggregateDemand:Thetotalamountofoutputdemandedintheeconomy,asbeingthesameasplannede
xpenditure.

AggregateDemand= PlannedExpenditure

.
Thus,plannedexpenditureexplainsthelevelofaggregateoutputwhenthegoodsmarketisinequil
ibrium.
Planned Expenditure

.Thetotalamountofplannedexpenditure(aggregatedemand)isthesumoffourtypesofspending:

.Consumption expenditure (C), the total demand for consumer goods andservices
(e.g., hamburgers, iPods, rock concerts, visits to the doctor, etc.)
.Planned investment spending (I), the total planned spending by businesseson
new physical capital (e.g., machines, computers, factories) plusplanned spending on

new homes
.Government purchases (G), the spending by all levels of government ongoods and
services (e.g., aircraft carriers, government workers, red tape),not including
transfer
payments
.Net exports (NX), the net foreign spending on domestic goods and services,equal to

exports minus imports.

The Planned Expenditure: ......= C + I + G + NX

The Components of Expenditure

.Consumption Expenditure:
.
Consumptionexpenditureisrelatedtodisposableincome,thetotalincomeavailableforspendin
g,equaltoaggregateincomeminustaxesT,(YT)

.ConsumptionFunction:

C = ..+ mpc* ....

C = ..+ mpc* (Y T)

.
Thetermstandsforautonomousconsumptionexpenditure,theamountofconsumptionexpendituret
hatisexogenous(independentofvariablesinthemodel,
suchasdisposableincomeorinterestrates).Autonomousconsumptionisrelatedtoconsumersop
timismabouttheirfutureincomeandhouseholdwealth,whichinduceconsumerstoincreasespendi
ng.
.
mpc:Themarginalpropensitytoconsume,reflectsthechangeinconsumptionexpenditurethatres
ultsfromanadditionaldollarofdisposableincome.Keynesassumedthatmpcwasaconstantbetwee
nthevaluesof0and1.If,forexample,a$1.00increaseindisposableincomeleadstoanincreasein
consumptionexpenditureof$0.60,thenmpc=0.6.
The Components of Expenditure

.ConsumptionExpenditureandReal InterestRate:
.Keynesassumedthatconsumptionexpenditureislinearlyrelatedtoincomeonly.
Consumptionexpenditureshouldalsobenegativelyrelatedtorealinterestrates:whenthereali
nterestrateishigher,therealreturntosavingisalsohigher,andsoyouwillspendless.

.
Wedescribetheresultingnegativerelationshipbetweenconsumptionexpenditureandtherealin
terestrate,r,byamendingtheconsumptionfunctionasfollows:

C = ..+ mpc* (Y -T) -cr

withcbeingaparameterthatreflectshowresponsiveconsumptionexpenditureistotherealinter
estrate.

.
Thisequationsaysthatconsumptionexpenditureismadeupofthreecomponents:autonomousconsu
mption,themarginalpropensitytoconsumetimesdisposableincome,andatermthatindicatestha
thowmuchconsumptiondecreasesinresponsetoariseintherealinterestrate.
Planned Investment Spending

.Fixedinvestmentisplannedspendingbyfirmsonequipment(machines,
computers,airplanes)andstructures(factories,officebuildings,shoppingcenters)
andplannedspendingonnewresidentialhousing.
.
Inventoryinvestmentisspendingbyfirmsonadditionalholdingsofrawmaterials,parts,andfin
ishedgoods,calculatedasthechangeinholdingsoftheseitemsinagiventimeperiodsay,ayear.
.InvestmentFunction:

I = ..-dr

. ..:autonomousinvestment, that is completely exogenous (unexplained by

variables in his modelsuch as output or interest rates).
.disaparameterreflectinghowresponsiveinvestmentistotherealinterestrate.

.
Thisequationsaysthatinvestmentispositivelyrelatedtobusinessoptimism,asrepresentedby
autonomousinvestment,andisnegativelyrelatedtotherealinterestrate.
Net Exports, GovermentPurchases and Taxes

NX = ....-xr

.
wherexisaparameterthatindicateshownetexportsrespondtotherealinterestrate.Thisequati
ontellsusthatnetexportsarepositivelyrelatedtoautonomousnetexportsandarenegativelyre
latedtothelevelofrealinterestrates.
.Realinterestratereactnetexportthroughtheexchangerate:
.
changesinrealinterestratechangesinreturncapitalflowchangesinexportandimportprice
schangesinnetexport

.GovermentPurchases and Taxes:

.GovermentPurchases : G = ..
.Taxes T = ..
Goods Market Equilibrium

.
Keynesrecognizedthatequilibriumwouldoccurintheeconomywhenthetotalquantityofoutputpr
oducedintheeconomyequalsthetotalamountofplannedexpenditure(aggregatedemand).

..=......

.
Whenthisequilibriumconditionissatisfied,plannedspendingforgoodsandservicesisequalto
theamountthatisproduced.
.ISCurve:
Goods Market Equilibrium

.11-......
>0.
.
ThefirsttermofISequationtellsusthatincreasesinautonomousconsumption,investment,gove
rnmentpurchases,ornetexports,oradecreaseintaxes,leadstoanincreaseinoutputatanygiven
realinterestrate.
.
ThefirsttermtellsusaboutshiftsintheIScurve.Thesecondtermtellsusthatanincreaseinreal
interestratesresultsinadeclineinoutput,
whichisamovementalongtheIScurve.
IS Curve
Why the IS Curve Has Its Name and Its Relationship withthe Saving-Investment
Diagram

.
Toillustrate,welookatthesituationinwhichgovernmentpurchasesandnetexportsarezero(G=0
andNX=0).Thengoodsmarketequilibriumoccurswhen

Y = C + I

.SubtractingCfrombothsidesoftheprecedingequationyieldsthefollowing:

Y C = I

.Andsincesaving,S,isequaltoYC:

S = I

.Hence goods market equilibrium occurs when I = S and this is why

the IS curve hasits name.
Why the IS Curve Has Its Name and Its Relationship withthe Saving-Investment
Diagram

.
Atanygivenleveloftherealinterestrater,whenthereisanincreaseinaggregateoutputY,consu
mptionincreasesbylessthanYbecausethemarginalpropensitytoconsumeislessthanone.Thus,a
tanygivenlevelofr,anincreaseinYwillleadtoanincreaseinYC=S.Asweseeinpanel(a),whenou
tputrises,thesavingcurveshiftstotherightfromS1toS2.Panel(a)demonstratesthatasequili
briumoutputrisesfromY1toY2,therealinterestratefallsfromr1tor2.Panel(b)thenplotsthec
ombinationsofrandYderivedfromequilibriumpoints,like1and2inpanel(a),whichshowsthemov
ementalongthedownward-slopingIScurvethatwesawinFigure.
Why the IS Curve Has Its Name and Its Relationship withthe Saving-Investment
Diagram
Factors that Shift the IS Curve

.Ifweincreasegovernmentpurchase, thenwhat?
.Ifgovernmentraisestaxes, thenwhat?
Monetary Policy and Aggregate
Demand

.Theshort-
runmodeloftheaggregateeconomythatwearebuildingstepbystepwillallowustoanalyzehowacen
tralbankspolicydecisionsaffecttheeconomy.
.
Westartthischapterbyexplainingwhymonetarypolicymakerssetinterestratestorisewheninfl
ationincreases,leadingtoapositiverelationshipbetweenrealinterestratesandinflation,w
hichiscalledthemonetarypolicy(MP)curve.
.
ThenusingtheMPcurvewiththeIScurve,wederivetheaggregatedemandcurve,akeyelementinthea
ggregatedemand/aggregatesupplymodelframeworkusedintherestofthiscoursetodiscussshort
-runeconomicfluctuations.
Monetary Policy

.CentralBanksuseaveryshort-terminterestrateastheirprimarypolicytool.
.Theinterestrateisovernightinterestrateatwhichbankslendtoeachother.
.Weneedrealinterestrate:..=..-....
.r:realinterestrate;i:nominalinterestrate;....:expectedinflation.
.
changesinnominalinterestratechangesinrealinterestrate(onlyifactualandexpectedinfla
tionremainunchangedintheshort-run)
.Pricesarestickyintheshort-run.

.Centralbankcandeterminetherealinterestrateintheshort-
runbutnotinthelongrun,becausepricesareflexibleinthelong-run.Inthelong-
run,realinterestrateisdeterminedbytheinteractionofsavingandinvestment.
The Monetary Policy Curve

.Wewillexaminehowmonetarypolicyreactstoinflation.
.
Themonetarypolicy(MP)curveindicatestherelationshipbetweentherealinterestratethecent
ralbanksetsandtheinflationrate.Wecanwritethiscurveasfollows:

r = ..+ ....

where is the autonomous component of the real interest rate set by the monetary
policyauthorities, which is unrelated to the current level of the inflation rate,
while is
theresponsiveness of the real interest rate to the inflation rate.

.To make our discussion of the monetary policy curve more concrete,
figurewhichis writtenan example of a monetary policy curve MP in
which ..= 1and ..= 0.5.
.
AtpointAwhereinflationisat1%,theFederalReservesetstherealinterestrateat1.5%,whileat
pointB,whereinflationis2%,theFedsetstherealinterestrateat2%,andatpointC,whereinflat
ionis3%,theFedsetstherealinterestrateat2.5%.ThelinegoingthroughpointsA,B,andCisthem
onetarypolicycurveMP,anditisupwardsloping,indicatingthatmonetarypolicyraisesrealint
erestrateswhentheinflationraterises.
The Monetary Policy Curve
The Taylor Principle: Why the Monetary Policy Curve Hasan Upward Slope

.
ToseewhytheMPcurvehasanupwardslope,weneedtorecognizethatcentralbanksseektokeepinfla
tionstable.Inordertostabilizeinflation,monetarypolicymakersfollowtheTaylorprinciple
,namedafterJohnTaylorofStanfordUniversity,inwhichtheyraisenominalratesbymorethanany
riseinexpectedinflationsothatrealinterestratesrisewhenthereisariseininflation,asthe
MPcurvesuggests.
.
ToseewhymonetarypolicymakersfollowtheTaylorprinciple,inwhichhigherinflationresultsi
nhigherrealinterestrates,considerwhatwouldhappenifmonetarypolicymakersinsteadallowe
dtherealinterestratetofallwheninflationrose.
.Theresultwouldbethatinflationwouldcontinuallykeeprisingandspinoutofcontrol.
Shifts in the MP Curve

.
Incommonparlance,theCentralBankissaidtotightenmonetarypolicywhenitraisesrealinteres
trates,andtoeaseitwhenitlowersrealinterestrates.Itisimportant,however,todistinguish
betweenchangesinmonetarypolicythatshiftthemonetarypolicycurve,whichwecallautonomous
changes,andtheTaylorprinciple-
drivenchangesthatarereflectedasmovementsalongthemonetarypolicycurve,
whicharecalledautomaticadjustmentstointerestrates.
.
Centralbanksmaymakeautonomouschangestomonetarypolicyforvariousreasons.Theymaywishto
changetheinflationratefromitscurrentvalue.
.Forexample,tolowerinflationtheycouldincrease ..byonepercentagepoint,
andsoraisetherealinterestrateatanygiveninflationrate,whatwewillrefertoasanautonomou
stighteningofmonetarypolicy.Thisautonomousmonetarytighteningwouldshiftthemonetarypo
licycurveupwardbyonepercentagepointfromMP1toMP2inthefollowingFigure,therebycausingt
heeconomytocontractandinflationtofall.
Shifts in theMonetary PolicyCurve
Shifts in the MP Curve

.
Thebanksmayhaveinformationaboveandbeyondwhatishappeningtoinflationthatsuggestsinter
estratesmustbeadjustedtoachievegoodeconomicoutcomes.
.
Forexample,iftheeconomyisgoingintoarecession,monetarypolicymakerswouldwanttolowerre
alinterestratesatanygiveninflationrate,anautonomouseasingofmonetarypolicy,inorderto
stimulatetheeconomyandalsotopreventinflationfromfalling.Thisautonomouseasingofmonet
arypolicywouldresultinadownwardshiftinthemonetarypolicycurve,saybyonepercentagepoin
tfromMP1toMP3inFigure.