From Goods Market (IS) to Asset Market (MP): 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—output, inflation, and interest rates—in response to changes in policy or economic shocks. The federal funds rate is the interest rate paid by one bank to another for overnight loans. The monetary policy (MP) curve describes how the central bank sets the nominal interest rate and exploits the fact that the real and the nominal interest rates move closely together in the short run when inflation is “sticky”

The short-run model is summarized as follows: Through the MP curve, the nominal interest rate set by the central bank determines the real interest rate in the economy. 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.

The MP Curve: Monetary Policy and the Interest Rates Banks and financial institutions borrow from each other from one business day to the next on the interbank federal funds market. Large banks that are willing to take risks tend to borrow from risk averse small banks Banks borrow and lend their deposits at the Fed – reserves/fed funds – to each other Conceptually, a central bank sets the nominal interest rate on overnight loans by stating that it is willing to borrow or lend any amount at the specified rate. In practice, the open market desk at the Federal Reserve Bank of New York buys and sells securities to adjust the supply of reserves in the banking system. On average, these open market operations get the overnight rate on interbank loans to hit the FOMC’s target federal funds rate. When the Fed buys a security and pays for it, it injects reserves into the banking system and eases credit conditions. When the Fed sells a security and is paid it, it removes reserves from the banking system and tightens credit conditions. BEST (Buy Ease, Sell Tighten)

From Nominal to Real Interest Rates The relationship between the nominal interest rate and the real interest rate is given by the Fisher equation. Changes in the nominal interest rate lead to changes in the real interest rate as long as they are not offset by corresponding changes to expected inflation. We assume that the rate of inflation adjusts slowly over time. In the very short run (6 months or so), we assume the rate of inflation does not respond directly to monetary policy. If the rate of inflation is sticky, it is reasonable for people to expect inflation to remain at its recent rate. When inflation is sticky, central banks can set the real interest rate in the short run. Because borrowing is done before the rate of inflation is known, it is the expected rate of inflation that affects the decision to borrow and invest in new capital stock. The ex ante real interest rate is relevant for investment decisions.

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 and the MP curve is a horizontal line. The IS-MP diagram is a graph of the IS and the MP curves. The economy is at potential when the real interest rate equals the MPK and when 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 so the real interest rate rises and investment falls.

Example: The End of a Housing Bubble Suppose housing prices had been rising, but they fall sharply. This episode implies that the aggregate demand parameter declines and 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, output would not decline In reality, policymakers are unsure of the severity of shocks and it takes 6 to 18 months for changes in the interest rate to impact the economy. The Term Structure of Interest Rates: Long-term Real Rates Matter! The yield on a long-term bond and the expected yield on short-term bonds turned over for the same duration will be equal … or else everyone would switch to the one with a higher return  Interest rates at long maturities equal an average of the short-term rates investors expect in the future. When the Fed changes the overnight rate, interest rates at longer magnitudes change because: Financial markets expect the change will persist for some time. A change in rates today often signals information about likely changes in the future. Thus, the Fed can control long-term real interest rates by adjusting the nominal overnight fed funds rate and managing expectations about future adjustments.

The Phillips Curve Redux Workers and employers negotiate wages and firms set prices based on expectations of the economy-wide inflation rate and the state of demand for their labor and product. Assume adaptive expectations: workers and firms expect the inflation rate in the coming year to equal the rate of inflation that prevailed during the last year. The Phillips curve describes how inflation evolves over time as a function of short-run output. We can add shocks to the Phillips curve to account for temporary increases in the price of inflation:

The actual rate of inflation now depends on three things: The expected rate of inflation, which equals the inflation rate from last year by adaptive expectations: An adjustment factor for the state of the economy: A shock to inflation: An oil price shock, when the price of oil rises, will result in a temporary upward shift in the Phillips curve. Price shocks to an input in production (wages, energy costs) cost-push inflation they push the inflation rate up. The effect of short-run output on is demand-pull inflation increases in aggregate demand pull the inflation rate up.

Summary 1. The IS curve describes how output in the short run depends on the real interest rate and on shocks to the aggregate economy. 2. When the real interest rate rises, the cost of borrowing faced by firms and households increases, leading them to delay their purchases of new equipment, factories, and housing. These delays reduce the level of investment, which in turn lowers output below potential. Therefore, the IS curve shows a negative relationship between output and the real interest rate. CHAPTER 10 The IS Curve

3. Shocks to aggregate demand can shift the IS curve 3. Shocks to aggregate demand can shift the IS curve. These shocks include (a) changes in consumption relative to potential output, (b) technological improvements that stimulate investment demand given the current interest rate, (c) changes in government purchases relative to potential output, and (d) interactions between the domestic and foreign economies that affect exports and imports. 4. The life-cycle/permanent-income hypothesis says that individual consumption depends on average income over time rather than current income. This serves as the underlying justification for why we assume consumption depends on potential output. CHAPTER 10 The IS Curve

5. The permanent-income theory does not seem to hold exactly, however, and 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 by 1 percentage point may have an even larger effect on short-run output because the initial reduction in output causes consumption to fall, which further reduces output. CHAPTER 10 The IS Curve

6. 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. The direct effect of changes in government purchases is to change . However, depending on how these purchases are financed, they can also affect consumption and investment, partially mitigating the effects of fiscal policy on short-run output CHAPTER 10 The IS Curve