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 18 A 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 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 4 of 58
18. 1 Learning Objective Understand what the IS curve is and how it is derived. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 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 6 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 7 of 58
The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 8 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 Y 1, where the AE line crosses the 45° line. The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 58
Figure 18. 1 (2 of 2) Illustrating Equilibrium in the Goods Market In panel (b), if the level of output is initially Y 2, aggregate expenditure is only AE 2. Rising inventories cause firms to cut production, and the economy will move down the AE line until it reaches equilibrium at output level Y 1. If the output level is initially Y 3, aggregate expenditure is AE 3. Falling inventories cause firms to increase production, and the economy will move up the AE line until it reaches equilibrium at output level Y 1. • The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 58
Potential GDP and the Multiplier Effect Potential GDP The level of real GDP attained when all firms are producing at capacity. At potential GDP, the economy achieves full employment, and cyclical unemployment is reduced to zero. So, potential GDP is sometimes called fullemployment GDP. In the context of this basic macroeconomic model, autonomous expenditure is expenditure that does not depend on the level of GDP. A decline in autonomous expenditure results in an equivalent decline in income, which leads to an induced decline in consumption. Multiplier effect The process by which a change in autonomous expenditure leads to a larger change in equilibrium GDP. Multiplier The change in equilibrium GDP divided by a change in autonomous expenditure. The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 58
The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 58
Figure 18. 2 The Multiplier Effect The economy is initially in equilibrium at potential GDP, YP, and then the investment component, I, of aggregate expenditure falls. As a result, the aggregate expenditure line shifts from AE 1 to AE 2. The economy moves down the AE line to a new equilibrium level of output, Y 2. The decline in output is greater than the decline in investment spending that caused it. The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 58
Solved Problem 18. 1 Calculating Equilibrium Real GDP The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 58
Solved Problem 18. 1 Calculating Equilibrium Real GDP The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 58
The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 58
Constructing the IS Curve The focus of Fed policy is establishing a target for the federal funds rate, with the expectation that changes in the federal funds rate will cause changes in other market interest rates. Therefore, we need to incorporate the effect of changes in interest rates into our model of the goods market. The real interest rate equals the nominal interest rate minus the expected inflation rate. An increase in the real interest rate causes I and C to decline. A higher domestic real interest rate also makes returns on domestic financial assets more attractive relative to those on foreign assets, raising the exchange rate. The rise in the exchange rate increases imports and reduces exports, thereby reducing NX. A decrease in the real interest rate will have the opposite effect—increasing I, C, and NX. So, a higher interest rate causes a reduction in aggregate expenditure and a lower equilibrium level of output. The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 58
Figure 18. 3 Deriving the IS Curve Panel (a) uses the 45°-line diagram to show the effect of changes in the real interest rate on equilibrium in the goods market. With the real interest rate initially at r 1, the aggregate expenditure line is AE(r 1), and the equilibrium level of output is Y 1 (point A). If the interest rate falls from r 1 to r 2, the aggregate expenditure line shifts upward from AE(r 1) to AE(r 2), and the equilibrium level of output increases from Y 1 to Y 2 (point B). If the interest rate rises from r 1 to r 3, the aggregate expenditure line shifts downward from AE(r 1) to AE(r 2), and the equilibrium level of output falls from Y 1 to Y 3 (point C). In panel (b), we plot the points from panel (a) to form the IS curve. The points A, B, and C in panel (b) correspond to the points A, B, and C in panel (a). • © 2012 Pearson Education, Inc. Publishing as Prentice Hall 18 of 58
The Output Gap With the Taylor rule (Chapter 15), the Fed has a target for the real federal funds rate and adjusts that target on the basis of changes in two variables: the inflation gap and the output gap. The inflation gap is the difference between the current inflation rate and a target rate. Output gap The percentage difference between real GDP and potential GDP. Figure 18. 4 Output Gap The output gap is negative during recessions because real GDP is below potential GDP. • The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 58
Figure 18. 5 The IS Curve Using the Output Gap This graph shows the IS curve with the output gap, rather than the level of real GDP, on the horizontal axis. Values to the left of zero on the horizontal axis represent negative values for the output gap—or periods of recession— and values to the right of zero on the horizontal axis represent positive values for the output gap—periods of expansion. The vertical line, Y = YP, is also the point where the output gap is zero. The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 20 of 58
Shifts of the IS Curve An increase or a decrease in the real interest rate results in a movement along the IS curve. Changing other factors that affect aggregate expenditure will cause a shift of the IS curve. Aggregate demand shock A change in one of the components of aggregate expenditure that causes the IS curve to shift. Figure 18. 6 Shifts in the IS Curve For any given level of the real interest rate, positive demand shocks shift the IS curve to the right and negative demand shocks shift the IS curve to the left. • The IS Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 21 of 58
18. 2 Learning Objective Explain the significance of the MP curve and the Phillips curve. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 22 of 58
The Taylor rule tells us that when the inflation rate rises above the Fed’s target inflation rate of about 2%, the FOMC will raise its target for the federal funds rate. And when the output gap is negative—that is, when real GDP is less than potential GDP, the FOMC will lower the target for the federal funds rate. The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 23 of 58
The MP Curve Figure 18. 7 The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 24 of 58
The Phillips Curve The Fed relies on an inverse relationship between the inflation rate and the state of the economy: When output and employment are increasing, the inflation rate tends to increase, and when output and employment are decreasing, the inflation rate tends to decrease. A graph showing the short-run relationship between the unemployment rate and the inflation rate has been called a Phillips curve. The position of the Phillips curve can shift over time in response to supply shocks and changes in expectations of the inflation rate. The best way to capture the effect of changes in the unemployment rate on the inflation rate is by looking at the gap between the current unemployment rate and the unemployment rate when the economy is at full employment, which is called the natural rate of unemployment. The gap between the current rate of unemployment and the natural rate represents cyclical unemployment. The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 25 of 58
The Phillips Curve Taking all of these factors into account gives us the following equation for the Phillips curve: The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 26 of 58
The Phillips Curve Figure 18. 8 The Phillips Curve The Phillips curve illustrates the short-run relationship between the unemployment rate and the inflation rate. Point A represents the combination of a 4% unemployment rate and a 4% inflation rate in one year. Point B represents the combination of a 7% unemployment rate and a 1% inflation rate in another year. • The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 27 of 58
The Phillips Curve Figure 18. 9 Shifts in the Phillips Curve An increase in expected inflation or a negative aggregate supply shock will shift the Phillips curve up. A decrease in expected inflation or a positive aggregate supply shock will shift the Phillips curve down. • The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 28 of 58
Okun’s Law and an Output Gap Phillips Curve The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 29 of 58
Okun’s Law and an Output Gap Phillips Curve Figure 18. 10 Using Okun’s Law to Predict the Cyclical Unemployment Rate Okun’s law states that the output gap is equal to negative 2 times the gap between the current unemployment rate and the natural rate of unemployment. The graph shows that Okun’s law does a good job of accounting for the cyclical unemployment rate. • The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 30 of 58
Okun’s Law and an Output Gap Phillips Curve Figure 18. 11 The Output Gap Version of the Phillips Curve The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall This Phillips curve differs from the one shown in Figure 18. 8 by having the output gap, rather than the unemployment rate, on the horizontal axis. As a result, the Phillips curve is upward sloping rather than downward sloping. When the output gap equals zero and there are no supply shocks, the actual inflation rate will equal the expected inflation rate. An increase in expected inflation or a negative supply shock shifts the Phillips curve up, and a decrease in expected inflation or a positive supply shock shifts the Phillips curve down. • 31 of 58
Making the Connection Did the 2007– 2009 Recession Break Okun’s Law? During 2009 and 2010, White House economists were criticized for their inaccurate predictions of the unemployment rate. After Congress passed the stimulus program, the unemployment rate was still much higher than the predicted peak 8%, and it went as high as 10. 0% in 2009. One reason for the faulty forecasts was that Okun’s law sharply underestimated the unemployment rate. Rising labor productivity may be an explanation. When labor productivity increases, firms can produce the same amount of output with fewer workers. Firms maintained their production levels with fewer workers—thereby leading to a larger increase in unemployment than many economists had forecast. Okun’s law has had difficulty in accounting for the unemployment rate following the last two severe recessions. The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 32 of 58
Making the Connection Did the 2007– 2009 Recession Break Okun’s Law? The graph shows that beginning in 2009, Okun’s law indicates that cyclical unemployment—the difference between the actual rate of unemployment and the natural rate of unemployment—should have been about 1% lower than it actually was. In late 2009 and early 2010, the gap between actual cyclical unemployment and the level indicated by Okun’s law widened to about 1. 5%. The MP Curve and the Phillips Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 33 of 58
18. 3 Learning Objective Use the IS–MP model to illustrate macroeconomic equilibrium. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 34 of 58
Figure 18. 12 Equilibrium in the IS–MP Model In panel (a), the IS curve and the MP curve intersect where the output gap is zero and the real interest rate is at the Fed’s target level. In panel (b), the Phillips curve shows that because the output gap is zero, the actual and expected inflation rates are equal. • Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 35 of 58
Making the Connection Where Did the IS–MP Model Come From? British economist John Maynard Keynes developed the basic ideas behind the IS curve in his 1936 book The General Theory of Employment, Interest, and Money. The IS curve first appeared in an article written by John Hicks in 1937. Hicks did not use an MP curve but an LM curve, with LM standing for “liquidity” and “money. ” The LM curve shows combinations of the interest rate and output that would result in the market for money being in equilibrium. Hicks’s approach is called the IS–LM model. The model assumes that the Federal Reserve chooses a target for the money supply. We know, however, that since the early 1980 s, the Fed has targeted the federal funds rate, not the money supply. In 2000, David Romer of the University of California, Berkeley, suggested dropping the LM curve in favor of the MP curve approach that has become more standard for analyzing monetary policy. Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 36 of 58
Using Monetary Policy to Fight a Recession Figure 18. 13 Expansionary Monetary Policy Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 37 of 58
Complications Fighting the Recession of 2007– 2009 During the 2007– 2009 recession, a smooth transition back to potential GDP did not occur. One reason is that even though we have been assuming in the IS–MP model that the Fed controls the real interest rate, in fact, the Fed is able to target the federal funds rate but typically does not attempt to directly affect other market interest rates. Normally, the Fed can rely on the long-term real interest declining when the federal funds rate declines and rising when the federal funds rate rises. The recession of 2007– 2009 did not represent normal times, however. During the financial crisis, particularly after the failure of Lehman Brothers in September 2008, the default risk premium soared as investors feared that firms would have difficulty repaying their loans or making the coupon and principal payments on their bonds. Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 38 of 58
An Increasing Risk Premium During the 2007– 2009 Recession During the financial crisis of 2007– 2009, the default risk premium soared, raising interest rates on Baa-rated bonds relative to those on Aaa-rated bonds and 10 -year U. S. Treasury notes. • Figure 18. 14 Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 39 of 58
Figure 18. 15 Expansionary Monetary Policy in the Face of a Rising Risk Premium Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 40 of 58
Making the Connection Trying to Hit a Moving Target: Forecasting with “Real-Time Data” The Fed relies on forecasts from macroeconomic models to guide its policymaking. The Fed uses models similar to the IS–MP model and relies on data gathered by a variety of federal government agencies. GDP is measured quarterly by the Bureau of Economic Analysis (BEA), part of the Department of Commerce. The advance, preliminary, and final estimates of a quarter’s GDP are not released until about one, two, and three months after quarter-end are still subject to revisions. Benchmark revisions occur in even later years. The start of 2001 may prove why these revisions matter. Indicators showed that the U. S. economy might be headed for recession after the dot-com stock market bubble had burst. Though the advance estimate of the first quarter’s GDP showed a fairly healthy increase in real GDP of 1. 98% at an annual rate, current BEA data indicate that real GDP actually declined by 1. 31%. So, in addition to the other problems the Fed faces in conducting monetary policy, the data it uses to make its forecasts may be subject to many revisions. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 41 of 58
Making the Connection Trying to Hit a Moving Target: Forecasting with “Real-Time Data” Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 42 of 58
Solved Problem 18. 3 Using Monetary Policy to Fight Inflation We saw in Chapter 15 that Fed Chairman Paul Volcker took office in August 1979 with a mandate to bring down the inflation rate. Use the IS–MP model to analyze how the Fed can change expectations of inflation to permanently reduce the inflation rate. Be sure that your graphs include the IS curve, the MP curve, and the Phillips curve. Also be sure that your graphs show the initial effect of the Fed’s policy on the output gap and the inflation rate. Finally, be sure to illustrate how the economy returns to long-run equilibrium at a lower inflation rate. Solving the Problem Step 1 Review the chapter material. Equilibrium in the IS–MP Model © 2012 Pearson Education, Inc. Publishing as Prentice Hall 43 of 58
Solved Problem 18. 3 Using Monetary Policy to Fight Inflation Step 2 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 3 Show 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. 4 Learning 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 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 MP 1 to MP 2 shows the effect of expansionary monetary policy in reducing the real interest rate, from r 1 to r 2. The graph illustrates the problem facing the Fed: It can try to reduce the real interest below r 2, 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 18 A 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 18 A. 1 Deriving the LM Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 56 of 58
Shifting the LM Curve Figure 18 A. 2 Shifting the LM Curve © 2012 Pearson Education, Inc. Publishing as Prentice Hall 57 of 58
Monetary Policy in the IS–LM Model Figure 18 A. 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 LM 1 to LM 2. Equilibrium will move to point B with real GDP at its potential level, while the real interest rate will fall from r 1 to r 2. • © 2012 Pearson Education, Inc. Publishing as Prentice Hall 58 of 58
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