R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 18 Monetary Theory II: The IS–MP Model LEARNING OBJECTIVES After studying this chapter, you should be able to: 18.1 Understand what the IS curve is and how it is derived 18.2 Explain the significance of the MP curve and the Phillips curve 18.3 Use the IS–MP model to illustrate macroeconomic equilibrium 18.4 Discuss alternative channels of monetary policy 18A Use the IS-LM model to illustrate macroeconomic equilibrium © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 18 Monetary Theory II: The IS–MP Model THE FED FORECASTS THE ECONOMY •In July 2010, the Federal Reserve lowered its forecasts for economic growth The Fed cited continued weakness in the housing market, a slow recovery in the labor market, and less than favorable financial conditions for growth •The Bank of England and the French government also reduced their forecasts for the growth of real GDP in 2010 and 2011 •Having some idea of the likely state of the economy in the future helps to guide policy today In preparing its forecasts, the Fed, foreign central banks, and private forecasters usually rely on macroeconomic models •AN INSIDE LOOK AT POLICY on page 574 discusses four policy options the Federal Reserve was considering in late 2010 to provide additional stimulus to the U.S economy © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: By December 2008, the Fed had driven the target for the federal funds rate to near zero Question: In what circumstances is lowering the target for the federal funds rate unlikely to be effective in fighting a recession? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 18.1Learning Objective Understand what the IS curve is and how it is derived © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 IS–MP model A macroeconomic model consisting of an IS curve, which represents equilibrium in the goods market; an MP curve, which represents monetary policy; and a Phillips curve, which represents the short-run relationship between the output gap (which is the percentage difference between actual and potential real GDP) and the inflation rate IS curve A curve in the IS–MP model that shows the combinations of the real interest rate and aggregate output that represent equilibrium in the market for goods and services MP curve A curve in the IS–MP model that represents Federal Reserve monetary policy Phillips curve A curve showing the short-run relationship between the output gap (or the unemployment rate) and the inflation rate The IS Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 Equilibrium in the Goods Market Table 18.1 The Relationship Between Aggregate Expenditure and GDP The IS Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 The IS Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 Figure 18.1 (1 of 2) Illustrating Equilibrium in the Goods Market Panel (a) shows that equilibrium in the goods market occurs at output level Y1,where the AE line crosses the 45° line The IS Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 58 Figure 18.1 (2 of 2) Illustrating Equilibrium in the Goods Market In panel (b), if the level of output is initially Y2, aggregate expenditure is only AE2 Rising inventories cause firms to cut production, and the economy will move down the AE line until it reaches equilibrium at output level Y1 If the output level is initially Y3, aggregate expenditure is AE3 Falling inventories cause firms to increase production, and the economy will move up the AE line until it reaches equilibrium at output level Y1.• The IS Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 58 Solved Problem 18.3 Using Monetary Policy to Fight Inflation Step Describe the policy the Fed would use to reduce the inflation rate and illustrate your answer with a graph To lower expected inflation, the Fed can cause a decline in real GDP by raising the real interest rate The Phillips curve tells us that if real GDP falls below potential GDP, the inflation rate will decline Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 58 Solved Problem 18.3 Using Monetary Policy to Fight Inflation Step Show how after the Phillips curve shifts down the Fed can return the economy to potential output at a lower inflation rate Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 58 18.4Learning Objective Discuss alternative channels of monetary policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 58 Economists refer to the ways in which monetary policy can affect output and prices as the channels of monetary policy In the IS–MP model, monetary policy works through the channel of interest rates: Through open market operations, the Fed changes the real interest rate, which affects the components of aggregate expenditure, thereby changing the output gap and the inflation rate We call this channel the interest rate channel An underlying assumption in this approach is that borrowers are indifferent as to how or from whom they raise funds and regard alternative sources of funds as close substitutes As we will see next, bank loans play no special role in this channel Are Interest Rates All That Matter for Monetary Policy? © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 58 The Bank Lending Channel Bank lending channel A description of the ways in which monetary policy influences the spending decisions of borrowers who depend on bank loans In this channel, a monetary expansion increases banks’ ability to lend, and increases in loans to bank-dependent borrowers increase their spending In the interest rate channel, an increase in output occurs because a lower federal funds rate causes other interest rates to fall Both channels are similar in one respect: An increase in bank reserves leads to lower loan interest rates, lower bank loan rates, and lower interest rates in financial markets Are Interest Rates All That Matter for Monetary Policy? © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 58 In the bank lending channel, an expansionary monetary policy causes aggregate expenditure to increase for two reasons: (1) the increase in households’ and firms’ spending from the drop in interest rates, and (2) the increased availability of bank loans In other words, if banks expand deposits by lowering interest rates on loans, the amounts that bank-dependent borrowers can borrow and spend increases at any real interest rate Therefore, in the bank lending channel, an expansionary monetary policy is not dependent for its effectiveness on a reduction in interest rates Similarly, a contractionary monetary policy is not dependent for its effectiveness on an increase in interest rates Are Interest Rates All That Matter for Monetary Policy? © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 58 The Balance Sheet Channel: Monetary Policy and Net Worth Monetary policy may also affect the economy through its effects on firms’ balance sheet positions Economists have attempted to model this channel by describing the effects of monetary policy on the value of firms’ assets and liabilities and on the liquidity of balance sheet positions—that is, the quantity of liquid assets that households and firms hold relative to their liabilities According to these economists, the liquidity of balance sheet positions is a determinant of spending on business investment, housing, and consumer durable goods Balance sheet channel A description of the ways in which interest rate changes resulting from monetary policy affect borrowers’ net worth and spending decisions The balance sheet channel emphasizes that even if monetary policy has no effect on banks’ ability to lend, the decline in borrowers’ net worth following a monetary contraction reduces aggregate demand and output Are Interest Rates All That Matter for Monetary Policy? © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 58 Table 18.2 Channels of Monetary Policy Most economists believe that accepting the bank lending or balance sheet channel does not require rejecting the interest rate channel’s implication that monetary policy works through interest rates Instead, the bank lending and balance sheet channels offer additional methods by which the financial system and monetary policy can affect the economy Are Interest Rates All That Matter for Monetary Policy? © 2012 Pearson Education, Inc Publishing as Prentice Hall 51 of 58 Answering the Key Question At the beginning of this chapter, we asked the question: “In what circumstances is lowering the target for the federal funds rate unlikely to be effective in fighting a recession?” As we have seen throughout this book, the recession of 2007–2009 was accompanied by a financial crisis that made the recession unusually severe The Fed realized by the fall of 2008 that its usual policy of fighting recessions primarily by lowering its target for the federal funds rate was unlikely to be effective The IS–MP model developed in this chapter provides one explanation of why this was true Although the Fed lowered the target for the federal funds rate nearly to zero, an increase in the risk premium demanded by investors caused the interest rates, such as the Baa bond rate, paid by many businesses, to rise despite the Fed’s efforts © 2012 Pearson Education, Inc Publishing as Prentice Hall 52 of 58 AN INSIDE LOOK AT POLICY Slow Growth Despite Low Interest Rates Has Fed Searching for New Options WALL STREET JOURNAL, Fed Ponders Bolder Moves Key Points in the Article At a meeting of world policymakers, Ben Bernanke described four policy options the Federal Reserve was considering to provide additional stimulus to the U.S economy: (1) resuming purchases of long-term securities, (2) lowering the interest rate banks receive for reserves they keep with the Fed, (3) promising to keep short-term interest rates low for a longer period than markets expected, and (4) raising the Fed’s inflation target In an attempt to reach a policy consensus, Bernanke weighed arguments made by Federal Reserve Bank presidents and other members of the central bank’s Board of Governors Harvard economist Martin Feldstein expressed his opinion that none of the Fed’s options was likely to significantly boost the economy or reduce the risk of deflation © 2012 Pearson Education, Inc Publishing as Prentice Hall 53 of 58 AN INSIDE LOOK AT POLICY The graph shows an initial longrun equilibrium at Y =YP A decline in aggregate expenditure shifts the IS curve to the left, producing an output gap This represents the impact of the housing and financial crises that caused the recession in 2007 The shift from MP1 to MP2 shows the effect of expansionary monetary policy in reducing the real interest rate, from r1 to r2 The graph illustrates the problem facing the Fed: It can try to reduce the real interest below r2, but even an interest rate of zero is not enough to eliminate the output gap © 2012 Pearson Education, Inc Publishing as Prentice Hall 54 of 58 APPENDIX The IS–LM Model 18A Use the IS-LM model to illustrate macroeconomic equilibrium IS–LM model A macroeconomic model of aggregate demand that assumes that the central bank targets the money supply LM curve A curve that shows the combinations of the interest rate and the output gap that result in equilibrium in the market for money © 2012 Pearson Education, Inc Publishing as Prentice Hall 55 of 58 Deriving the LM Curve Figure 18A.1 Deriving the LM Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall 56 of 58 Shifting the LM Curve Figure 18A.2 Shifting the LM Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall 57 of 58 Monetary Policy in the IS–LM Model Figure 18A.3 Expansionary Monetary Policy At the initial equilibrium at point A, real GDP is below potential real GDP Increasing the supply of real balances shifts the LM curve to the right, from LM1 to LM2 Equilibrium will move to point B with real GDP at its potential level, while the real interest rate will fall from r1 to r2. â 2012 Pearson Education, Inc Publishing as Prentice Hall 58 of 58 .. .CHAPTER 18 Monetary Theory II: The IS–MP Model LEARNING OBJECTIVES After studying this chapter, you should be able to: 18. 1 Understand what the IS curve is and how it is derived 18. 2 Explain... in the labor market, and less than favorable financial conditions for growth The Bank of England and the French government also reduced their forecasts for the growth of real GDP in 2010 and. .. CHAPTER 18 Monetary Theory II: The IS–MP Model THE FED FORECASTS THE ECONOMY •In July 2010, the Federal Reserve lowered its forecasts for economic growth The Fed cited continued weakness in the