Summary

• The long-run model determines potential output and the long-run rate of inflation.

• The short-run model determines current output and current inflation.

• In any given year, output consists of two components:

– The long-run potential output

– Short-run output

• Short run output

– Is the percentage difference between actual and potential output.

– Is positive when the economy is booming.– Is negative when the economy is slumping.

• Recession:– Our Definition:

• A period when actual output falls below potential• Short-run output becomes negative • (Ỹ < 0)

– Usual Definition• (Roughly) 2 Quarters of negative GDP.• Declared by the NBER Business Cycle Dating Committee.• (ΔY < 0)

• Short-run fluctuation – The difference in actual and potential output,

expressed as a percentage of potential output– Referred to as “detrended output” or short-run

output:

Ỹ < 0

Ỹ < 0

Recession Ends

Ȳ

ΔY<0

ΔY>0

ΔY<0 but Ỹ > 0

ΔY>0 but Ỹ < 0

• A recession:– Begins when actual output falls below potential,

and short-run output becomes negative.– Ends when short-run output starts to rise and

become less negative.• During a recession:

– Output is usually below potential for approximately two years, which results in a loss of about $2,400 per person.

– Between 1.5 million and 3 million jobs are lost.

Measuring Potential Output

• There is no directly observable measure of potential output in an economy.

• Ways to measure potential output:– Assume a perfectly smooth trend passes

through quarterly movements of real GDP.– Take averages of the surrounding actual

GDP numbers.

9.3 The Short-Run Model

• Short-run model features:– Open economy exists where global booms

and recessions impact the local economy.– The economy will exhibit long-run growth

and fluctuations.– Central Bank manages monetary policy to

smooth fluctuations.

• The short-run model is based on three premises:

1. The economy is constantly being hit by shocks:• Shocks: factors that cause fluctuations in output or

inflation.

2. Monetary and fiscal policies affect output:• Policymakers may be able to neutralize shocks to

the economy.

3. There is a dynamic trade-off between output and inflation:• The Phillips curve is the dynamic trade-off between

output and inflation.

Philips curve

The Empirical Fit of the Phillips Curve

• Empirically, the slope is approximately one-half.

– Meaning: if output exceeds potential by 2 percent, the inflation rate increases one percentage point.

How the Short-Run Model Works

• Assume policymakers can select short-run output through monetary policy

• Example:– 1979: inflation was increasing because of

oil prices– Monetary Policy: raise interest rates– What happens?– Recession!

Important thing about the Philip Curve

• This is about accelerating and decelerating inflation. This is a change in the change of the price level

• Is the Philips Curve fixed?– Supply Shocks.– Expectations.

Okun’s law

Okun’s Law

Natural rate of unemployment

Current rate of unemployment

Short-runoutput

Cyclical unemployment

Okun’s Law 1960 Recession

Okun’s Law 1969 Recession

Okun’s Law 1980/1981 Recession

Okun’s Law 1990 Recession

Okun’s Law Great Recession

11.1 Introduction

• In this chapter, we learn– The first building block of our short-run

model: the IS curve• describes the effect of changes in the real

interest rate on output in the short run.– How shocks to consumption, investment,

government purchases, or net exports—“aggregate demand shocks”—can shift the IS curve.

– A theory of consumption called the life-cycle/permanent-income hypothesis.

– That investment is the key channel through which changes in real interest rates affect GDP in the short run.

• The Federal Reserve exerts a substantial influence on the level of economic activity in the short run.– Sets the rate at which people borrow and

lend in financial markets

• The basic story is this:

• The IS curve– The IS curve captures the relationship

between interest rates and output in the short run.

– There is a negative relationship between the interest rate and short-run output.

– An increase in the interest rate will decrease investment, which will decrease output.

11.2 Setting Up the Economy• The national income accounting identity

– Implies that the total resources available to the economy equal total uses

– One equation with six unknowns

Production Imports

Consumption

Investment Governmentpurchases

Exports

• We need five additional equations to solve the model:

Consumption and Friends• Level of potential output is

given exogenously.– Consumption C,

government purchases G, exports EX, and imports IM depend on the economy’s potential output.

– Each of these components of GDP is a constant fraction of potential output.• the fraction is a parameter

• Potential output is smoother than actual GDP.– A shock to actual GDP will leave potential

output unchanged• The equation depends on potential output.

– Shocks to income are “smoothed” to keep consumption steady.

The Investment Equation

The share of potential output that goes to investment

A term weighting the difference between the real interest rate and the MPK

Real interest rate

Marginal Product of Capital (MPK)

• The MPK– Is an exogenous parameter– Is time invariant

• If the MPK is low relative to the real interest rate– Firms should save money and not invest in

capital

• If the MPK is high relative to the real interest rate– Firms should borrow and invest in capital

• In the short run, the MPK and the real interest rate can be different.– Installing capital to equate the two takes time.

1. Divide the national income accounting identity by potential output.

2. Substitute the five equations into this equation.

11.3 Deriving the IS Curve

3. Recall the definition of short-run output. Simplifies the equation for the IS curve:

• The gap between the real interest rate and the MPK is what matters for output fluctuations.– Firms can always earn the MPK on new

investments.• The parameter

– Is

– Is called the aggregate demand shock– Will equal zero when potential output is equal

to actual output

Case Study: Why is it called the “IS Curve”?

• IS stands for “investment = savings”

• See this again in Chapters 17 and 18.

11.4 Using the IS Curve

The Basic IS Curve• When the demand shock parameter

equals zero, the IS curve has a short-run output of 0 where the real interest rate is equal to the long-run value of the MPK.

The Effect of a Change in the Interest Rate

• When the real interest rate changes, the economy will move along the IS curve.

– An increase in the interest rate• causes the economy to move up the IS

curve• Causes short-run output to decline

• When the real interest rate changes, the economy will move along the IS curve:

– The higher interest rate• raises borrowing costs• reduces demand for investment• reduces output below potential

• If the sensitivity to the interest rate were higher

– The IS curve would be flatter– Any change in the interest rate would be

associated with larger changes in output– Draw horizontal and vertical IS curves.

An Aggregate Demand Shock• Suppose that information technology

improvements create an investment boom.– The aggregate demand shock parameter will

increase.– Output is higher at every interest rate and the

IS curve shifts right.– For any given real interest rate Rt, output is

higher when Demand shock parameter

Case Study: Move Along or Shift?A Guide to the IS Curve

• A change in R shows up as a movement along the IS curve.– The IS curve is a graph of R versus

short-run output.

• Any other change in the parameters of the short-run model causes the IS curve to shift.

A Shock to Potential Output

• Shocks to potential output– Change actual output by the same amount in

our setup– Do not change short-run output

• Some shocks to potential output may change other parameters. Earthquake, for example:– Reduces actual and potential output by the

same amount– Leads to an increase in short-run output

because it also increases the MPK

Other Experiments• Imagine that Japan enters into a

recession.– The aggregate demand parameter for

exports declines.• the IS curve shifts to the left

– thus the Japanese recession has an international effect.

– We could shock any of the other aggregate demand parameters.

11.5 Microfoundations of the IS Curve

• Microfoundations– The underlying microeconomic behavior

that establishes the demands for C, I, G, EX, and IM.

Consumption

• People prefer a smooth path for consumption compared to a path that involves large movements.

• The permanent-income hypothesis– People will base their consumption on an

average of their income over time rather than on their current income.

• The life-cycle model of consumption– Suggests that consumption is based on

average lifetime income rather than on income at any given age.

• The life-cycle model of consumption:

–Young people borrow to consume more than their income.

–As income rises over a person’s life• consumption rises more slowly• individuals save more

–During retirement, individuals live off their accumulated savings.

• The life-cycle/permanent-income (LC/PI) hypothesis– Implies that people smooth their consumption

relative to their income– This is why we set consumption proportional

to potential output rather than actual output.

• Alaska:–Residents receive a refund based on

state oil revenues.–A separate refund from federal tax

revenues–A study shows that:

• consumption does not change when residents receive the oil revenue refund.

• the same individuals increase consumption when federal tax refunds are received.

Multiplier Effects

• We can modify the consumption equation to include a term that is proportional to short-run output.

• Solving for the IS curve– Will yield a similar result– Now includes a multiplier on the aggregate

demand shock and interest rate terms:• the multiplier is larger than one

• With a multiplier:– Aggregate demand shocks will increase

short-run output by more than one-for-one.– A shock will “multiply” through the economy

and will result in a larger effect.• If short-run output falls with a multiplier

– Consumption falls– Which leads to short-run output falling– Consumption falls again– “Virtuous circle” or “vicious circle”

Investment

• At the firm level, investment is determined by the gap between the real interest rate and MPK.

• In a simple model– The return on capital is the MPK minus

depreciation.• The richer framework includes:

– Corporate income taxes– Investment tax credits– Depreciation allowances

• A second determinant of investment– The firm’s cash flow

• the amount of internal resources the company has on hand after paying its expenses

What is wonky about this model?

• What does it mean to say R > r?• Can we explain this with cash flow?

Financing out of firm’s savings?– Why finance a project at r when you can

save with paper assets at R?

Government Purchases

• Government purchases can be– A source of short-run fluctuation– An instrument to reduce fluctuations

• Discretionary fiscal policy– Includes purchases of additional goods in

addition to the use of tax rates– For example, the government can use the

investment tax credit to encourage investment

• Transfer spending often increases when an economy enters into a recession.

• Automatic stabilizers– Programs where additional spending

occurs automatically to help stabilize the economy

– Welfare programs and Medicaid are two such stabilizer programs.• receive additional funding when the

economy weakens

• Fiscal policy’s impact depends on two things:1. The problem of timing

• discretionary changes are often put into place with significant delay.

2. The no-free-lunch principle• implies that higher spending today must

be paid for today or some point in the future.

• such taxes may offset the impact of the discretionary spending adjustment.

Case Study: The Macroeconomic Effects of the American Recovery

and Reinvestment Act of 2009• Economists had a wide range of opinions

about the effectiveness and costs of the stimulus.

• Congressional Budget Office (CBO) gave estimates of unemployment with and without a stimulus.– Estimated 9 percent peak without a stimulus– Actual unemployment rate with stimulus was

above this.

Net Exports

• If Americans demand more imports– The IS curve shifts left and reduces short-

run output

• If foreigners demand more American exports– The IS curve shifts right

11.6 Conclusion

• Higher interest rates

– Raise the cost of borrowing to firms and households

– Reduce the demand for investment spending

– Decrease short-run output

Summary• The IS curve

– Describes how output in the short run depends on the real interest rate and on shocks to the aggregate economy

– Shows a negative relationship between output and the real interest rate

• When the real interest rate rises, the cost of borrowing increases, leading to delayed purchases of capital.

• These delays reduce the level of investment, which in turn lowers output below potential.

• Shocks to aggregate demand can shift the IS curve. These shocks include:– Changes in consumption relative to

potential output– Technological improvements that stimulate

investment demand given the current interest rate

– Changes in government purchases relative to potential output

– Interactions between the domestic and foreign economies that affect exports and imports

• The life-cycle/permanent-income hypothesis– Individual consumption depends on average

income over time rather than current income – Serves as the underlying justification for why

we assume consumption depends on potential output

• The permanent-income theory– Does not seem to hold exactly– Consumption responds to temporary

movements in income as well.

• When we include this effect in our IS curve, a multiplier term appears.– That is, a shock that reduces the aggregate

demand parameter may have an even larger effect on short-run output.

• A consideration of the microfoundations of the equations that underlie the IS curve reveals important subtleties.

• The most important are associated with the no-free-lunch principle imposed by the government’s budget constraint.

• Depending on how government purchases are financed, they can also affect consumption and investment.– partially mitigating the effects of fiscal policy

on short-run output

Additional Figures for Worked Exercises

12.1 Introduction• In this chapter, we learn:

– How the central bank effectively sets the real interest rate in the short run, and how this rate shows up as the MP curve in our short-run model.

– That the Phillips curve describes how firms set their prices over time, pinning down the inflation rate.

– How the IS curve, the MP curve, and the Phillips curve make up our short-run model.

– How to analyze the evolution of the macroeconomy in response to changes in policy or economic shocks.

• The federal funds rate– The interest rate paid from one bank to

another for overnight loans• The monetary policy (MP) curve

– Describes how the central bank sets the nominal interest rate

• The short-run model summary:– Through the MP curve

• the nominal interest rate determines the real interest rate

– Through the IS curve• the real interest rate influences GDP in the

short run– The Phillips curve

• describes how booms and recessions affect the evolution of inflation

12.2 The MP Curve: Monetary Policy and the Interest Rates

• Large banks and financial institutions borrow from each other.

• Central banks set the nominal interest rate by stating what they are willing to lend or borrow at the specified rate.

• Banks cannot charge a higher rate.– everyone would use the central bank.

• Banks cannot charge a lower rate.– They would borrow at the lower rate and lend

it back to the central bank at a higher rate.– This is called the arbitrage opportunity.

• Thus, banks must exactly match the rate the central bank is willing to lend at.

From Nominal to Real Interest Rates• The relationship between the interest

rates is given by the Fisher equation.

Nominalinterest rate

Real interest rate

Rate of inflation

• The sticky inflation assumption– The rate of inflation displays inertia, or

stickiness, so that it adjusts slowly over time.– In the very short run the rate of inflation does

not respond directly to monetary policy.– Central banks have the ability to set the real

interest rate in the short run.

Why is there sticky inflation?

• Imperfect information• Costs of setting prices• Contracts also set prices and wages in nominal rather than real

terms.• There are bargaining costs to negotiating prices and wages.• Social norms and money illusions

– Cause concerns about whether the nominal wage should decline as a matter of fairness

• Money illusion – The idea that people sometimes focus on nominal rather

than real magnitudes

The IS-MP Diagram

• The MP curve– Illustrates the central bank’s ability to set

the real interest rate• Central banks set the real interest rate

at a particular value.– The MP curve is a horizontal line.

• The nominal interest rate– Is the opportunity cost of holding money– Is the amount you give up by holding money

instead of keeping it in a savings account– Is pinned down by equilibrium in the money

market• If the nominal interest rate is higher than

its equilibrium level– Households hold their wealth in savings rather

than currency.– The nominal interest rate falls.

• The demand for money– Is a decreasing function of the nominal

interest rate– Is downward sloping– Higher interest rates reduce the demand for

money.

• The supply of money– Is a vertical line for the level of money the

central bank provides

Changing the Interest Rate

• To raise the interest rate– The central bank reduces the money

supply – Creates an excess of demand over supply– A higher interest rate on savings accounts

reduces excess demand.– The markets adjust to a new equilibrium.

Why it instead of Mt?

• The interest rate is crucial even when central banks focus on the money supply.

• The money demand curve is subject to many shocks, which shift the curve.– Changes in price level– Changes in output

• If the money supply is constant– The nominal interest rate fluctuates– Resulting in changes in output

• The money supply schedule is effectively horizontal at a targeted interest rate.

• An expansionary (loosening) monetary policy– Increases the money supply– Lowers the nominal interest rate

• A contractionary (tightening) monetary policy– Reduces the money supply– Increases the nominal interest rate

• The economy is at potential when – The real interest rate equals the MPK. – There are no aggregate demand shocks.– Short-run output = 0.

• If the central bank raises the interest rate above the MPK– Inflation is slow to adjust.– The real interest rate rises.– Investment falls.

Example: The End of a Housing Bubble

• Suppose housing prices had been rising, but then they fall sharply.– The aggregate demand parameter declines. – The IS curve shifts left.

• If the central bank lowers the nominal interest rate in response:– The real interest rate falls as well because

inflation is sticky.– If judged correctly and without lag, the

economy would not have a decline in output.