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Macroeconomics 2:

Introducing the IS-MP-PC Model


Karl Whelan
School of Economics, UCD
January 21, 2013
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 1 / 34
Beyond IS-LM
As this is the second module in a two-module sequence, following
Macroeconomics 1, I am assuming that everyone in this class has seen the
IS-LM and AS-AD models.
In the rst part of this course, we are going to revisit and expand on these
models in a number of ways:
1
More Realistic: Rather than the traditional LM curve, we will describe
monetary policy in a way that is more consistent with how it is now
implemented, i.e. we will assume the central bank follows a rule that
dictates how it sets nominal interest rates. We will focus on how the
properties of the monetary policy rule inuence the behaviour of the
economy.
2
Expectations: We will have a more careful treatment of the roles
played by real interest rates and ination expectations.
3
The Zero Bound: We will model the zero lower bound on interest
rates and discuss its implications for policy.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 2 / 34
A Model With Three Elements
Our model will have three elements to it.
1
A Phillips Curve describing how ination depends on output.
2
An IS Curve describing how output depends upon interest rates.
3
A Monetary Policy Rule describing how the central bank sets interest
rates depending on ination and/or output.
Putting these three elements together, I will call it the IS-MP-PC model (i.e.
The Income-Spending/Monetary Policy/Phillips Curve model).
We will describe the model with equations.
We will also merge together the second two elements (the IS curve and the
monetary policy rule) to give a new IS-MP curve that can be combined with
the Phillips curve to use graphs to illustrate the models properties.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 3 / 34
Part I
The Phillips Curve
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 4 / 34
The Phillips Curve
What are the tradeos facing a central bank? A 1958 study by the LSEs
A.W. Phillips seemed to provide the answer.
Phillips documented a strong negative relationship between wage ination
and unemployment: Low unemployment was associated with high ination,
presumably because tight labour markets stimulated wage ination.
A 1960 study by MIT economists Solow and Samuelson replicated these
ndings for the US and emphasised that the relationship also worked for
price ination.
The Phillips curve tradeo quickly became the basis for the discussion of
macroeconomic policy.
Policy faced a tradeo: Lower unemployment could be achieved, but only at
the cost of higher ination.
However, Milton Friedmans 1968 presidential address to the American
Economic Association produced a well-timed and inuential critique of the
thinking underlying the Phillips Curve.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 5 / 34
A. W. Phillipss Graph
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 6 / 34
Solow and Samuelsons Description of the Phillips Curve
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 7 / 34
The Expectations-Augmented Phillips Curve
Friedman pointed out that it was expected real wages that aected wage
bargaining.
If low unemployment means workers have strong bargaining position, then
high nominal wage ination on its own is not good enough: They want
nominal wage ination greater than price ination.
Friedman argued that if policy-makers tried to exploit an apparent Phillips
curve tradeo, then the public would get used to high ination and come to
expect it. Ination expectations would move up and the previously-existing
tradeo between ination and output would disappear.
In particular, he put forward the idea that there was a natural rate of
unemployment and that attempts to keep unemployment below this level
could not work in the long run.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 8 / 34
The Demise of the Basic Phillips Curve
Monetary and scal policy in the 1960s were very expansionary around the
world.
At rst, the Phillips curve seemed to work: Ination rose and unemployment
fell.
However, as the public got used to high ination, the Phillips tradeo got
worse. By the late 1960s ination was still rising even though unemployment
had moved up.
This stagation combination of high ination and high unemployment got
even worse in the 1970s.
This was exactly what Friedman predicted would happen.
Today, the data no longer show any sign of a negative relationship between
ination and unemployment. If fact, the correlation is positive: The original
formulation of the Phillips curve is widely agreed to be wrong.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 9 / 34
The Evolution of US Ination and Unemployment
US Inflation and Unemployment, 1955-2012
Inflation Unemployment
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
0
2
4
6
8
10
12
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 10 / 34
The Failure of the Phillips Curve
US Inflation and Unemployment, 1955-2012
Inflation is the Four-Quarter Percentage Change in GDP Deflator
Inflation
U
n
e
m
p
l
o
y
m
e
n
t
0.0 2.5 5.0 7.5 10.0 12.5
3
4
5
6
7
8
9
10
11
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 11 / 34
Our Version of the Phillips Curve
Our version of the Phillips curve is as follows:

t
=
e
t
+ (y
t
y

t
) +

t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
1
Ination Expectations: This is given by the
e
t
term which represents the
publics ination expectations at time t. We have put a time subscript on
this variable because the publics expectations may change over time. Note
that a 1 point increase in ination expectations raises ination by exactly
one point this is because we are assuming that people bargain over real
wages and higher expected ination translates one-for-one into their wage
bargaining, which in turn is passed into price ination.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 12 / 34
Our Version of the Phillips Curve
Our version of the Phillips curve is as follows:

t
=
e
t
+ (y
t
y

t
) +

t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
2
The Output Gap: This is given by (y
t
y

t
). It is the gap between GDP at
time t, as represented by y
t
and what we will term the natural level of
output, which we term y

t
. This is the level of output at time t that would
be consistent with unemployment equalling its natural rate. We would
expect this natural level of output to gradually increase over time as
productivity levels improve. The coecient (pronounced gamma)
describes exactly how much ination is generated by a 1 percent increase in
the gap between output and its natural rate.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 13 / 34
Our Version of the Phillips Curve
Our version of the Phillips curve is as follows:

t
=
e
t
+ (y
t
y

t
) +

t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
3
Inationary Shocks: No model in economics is perfect. So while ination
expectations and the output gap may be key drivers of ination, they wont
capture all the factors that inuence ination at any time. For example,
supply shocks like a temporary increase in the price of imported oil can
drive up ination for a while. To capture these kinds of temporary factors,
we include an inationary shock term,

t
. The superscript indicates
that this is the inationary shock (this will distinguish it from the output
shock that we will also add to the model) and the t subscript indicates that
these shocks change over time.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 14 / 34
The Phillips Curve Graph with

t
= 0















Output
Inflation


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 15 / 34
The Phillips Curve as we move from

t
= 0 to

t
> 0
(An Aggregate Supply Shock)















Output
Inflation


PC (

=0)

PC (

> 0)


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 16 / 34
The Phillips Curve as we move from
e
t
=
1
to
e
t
=
2















Output
Inflation


PC (

)

PC (


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 17 / 34
Part II
The IS-MP Curve
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 18 / 34
Real Interest Rates and the IS Curve
The second element of the model is one that should be familiar to you: An
IS curve relating output to interest rates. The higher interest rates are, the
lower output is.
I want to stress, however, that the IS relationship is between output and
real interest rates, not nominal rates. Real interest rates adjust the
headline (nominal) interest rate by subtracting o ination.
Suppose I told you the interest rate was 10 percent. Is this a high interest
rate? The answer is that it really depends on ination.
Consider the decision to save. If the interest rate if 5% but ination is 2%,
then youll be able to buy 3% more stu next year because you saved and
saving seems like a good idea. In constrast, if the interest rate if 5% but
ination is 8%, then youll be able to buy 3% less stu next year even
though you have saved your money and earned interest.
Similar point applies to rms. If ination is 10%, then a rm can expect
that its prices (and prots) will be increasing by that much over the next
year and a 10% interest rate wont seem so high. But if prices are falling,
then a 10% interest rate on borrowings will seem very high.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 19 / 34
Our Version of the IS Curve
Our version of the IS curve will be the following:
y
t
= y

t
(i
t

t
r

) +
y
t
Expressed in words, this equation states that the gap between output and its
natural rate y
t
y

t
depends on two factors:
1
The Real Interest Rate:

The nominal interest rate at time t is represented by i


t
, so the real
interest rate is i
t

t
.

The equation has been constructed in a particular way so that it


explicitly denes the real interest rate at which output will, on average,
equal its natural rate.T This is denoted by r

This rate can be termed the natural rate of interest. When


y
t
= 0,
then a real interest rate of r

will imply y
t
= y

t
.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 20 / 34
Our Version of the IS Curve
Our version of the IS curve will be the following:
y
t
= y

t
(i
t

t
r

) +
y
t
Expressed in words, this equation states that the gap between output and its
natural rate y
t
y

t
depends on two factors:
2
Aggregate Demand Shocks,
y
t
:

Many other factors beyond the real interest rate inuence aggregate
spending decisions.

These include scal policy, asset prices and consumer and business
sentiment.

We will model all of these factors as temporary deviations from zero of


an aggregate demand shock,
y
t
.

Note that this shock has a superscript y to distinguish it from the


aggregate supply shock

t
that moves the Phillips curve up and
down.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 21 / 34
Monetary Policy: The LM Curve Approach
We has described how ination depends on output and how output depends
on interest rates. Can complete the model by describing how interest rates
are determined.
Traditionally, this is where the LM curve is introduced. Links demand for the
real money stock with nominal interest rates and output:
m
t
p
t
= i
t
+y
t
This can be re-arranged to give a positive relationship between output and
interest rates:
y
t
=
1

m
t
p
t
+i
t

Combined with the negative relationship between these variables in the IS


curve to determine unique values for output and interest rates. Illustrated in
a graph with an upward-sloping LM curve and a downward-sloping IS curve.
Monetary policy described as central bank adjusting the money supply m
t
in
a way that sets the position of the LM curve.
The determination of prices is then described separately in an AS-AD model.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 22 / 34
Monetary Policy: Our Approach
Instead of the LM curve approach, we will model monetary policy by
assuming that the central bank sets nominal interest rates according to a
particular rule. There are two reasons for this appraoch.
1
Realism: In practice, no modern central bank implements its monetary
policy by setting a specied level of the monetary base. Instead, they
set short-term interest rates to equal to some target level. The supply
of base money ends up being whatever emerges from enforcing the
interest rate target. This makes the LM curve (and the money supply)
of secondary interest when thinking about core macroeconomic issues.
2
Simplicity: The traditional approach uses a separate AS-AD model to
describe the determination of prices (and thus, implicitly, ination).
However, the reality is that rather than being determined independently
of ination, most modern central banks set interest rates with a very
close eye on inationary developments. In simplifying the determination
of output, ination and interest rates down to a single model, this
approach is also simpler than one that requires two dierent sets of
graphs.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 23 / 34
The Monetary Policy Rule
We rst consider a monetary policy rule of the form:
i
t
= r

(
t

)
The central bank adjusts the nominal interest rate, i
t
, upwards when
ination,
t
, goes up and downwards when ination goes down (we are
assuming that

> 0) and it does so in a way that means when ination


equals a target level,

, chosen by the central bank, real interest rates will


be equal to their natural level.
Note what the nominal interest rate will be if ination equals its target level
(i.e.
t
=

). The nominal interest rate will be i


t
= r

. In this case,
the real interest rate will be i
t

t
= r

.
Think about why a rule of this form might be a good idea. Suppose the
central bank has a target interest rate of

that it wants to achieve. Ideally,


the public will understand and set
e
t
=

.
If that can be achieved, then the Phillips curve tells us that, on average,
ination will equal

provided we have y
t
= y

t
. And the IS curve tells us
that, on average, we will have y
t
= y

t
when i
t

t
= r

.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 24 / 34
The Full Model
Thats the model. It consists of three equations.
1
The Phillips curve:

t
=
e
t
+ (y
t
y

t
) +

t
2
The IS curve:
y
t
= y

t
(i
t

t
r

) +
y
t
3
The monetary policy rule:
i
t
= r

(
t

)
I had promised a graphical representation of this model. However, this is a
system of three variables which makes it hard to express on a graph with
two axes.
To make the model easier to analyse using graphs, we are going to reduce it
down to a system with two main variables (ination and output).
We can do this because the monetary policy rule makes interest rates are a
function of ination, so we can substitute this rule into the IS curve to get a
new relationship between output and ination that we will call the IS-MP
curve.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 25 / 34
The IS-MP Curve
If we replace the term i
t
in the IS curve with the formula from the monetary
policy rule, we get
y
t
= y

t
[r

(
t

)] +(
t
+ r

) +
y
t
Now multiply out the terms in this equation to get
y
t
= y

t
r

(
t

) +
t
+r

+
y
t
Canceling terms and re-arranging, this simplies to
y
t
= y

t
(

1) (
t

) +
y
t
This is the IS-MP curve. It combines the information in the IS curve and the
MP curve into one relationship.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 26 / 34
The IS-MP Curve Graph
The IS-MP curve is
y
t
= y

t
(

1) (
t

) +
y
t
How this curve looks in a graph depends especially on the value of

, the
parameter that describes how the central bank reacts to ination.
An extra unit of ination implies a change of (

1) in output. Is this
positive or negative? Well we are assuming that > 0 so this combined
coecient will be negative if

1 > 0, i.e. the IS-MP curve will slope


downwards if

> 1 and upwards if

< 1.
Explanation: Increase in ination of x will lead to an increase in nominal
interest rates of

x so real interest rates change by (

1) x. If

> 1
then an increase in ination leads to higher real interest rates and, via the IS
curve relation, to lower output.
For now, we will assume that

> 1 so that we have a downward-sloping


IS-MP curve but we will revisit this later.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 27 / 34
The IS-MP Curve with
y
t
= 0















Output
Inflation


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 28 / 34
The IS-MP Curve as we move from
y
t
= 0 to
y
t
> 0















Output
Inflation
IS-MP (

=0)
IS-MP (

> 0)


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 29 / 34
Part III
Putting the Pieces Together
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 30 / 34
The IS-MP-PC Model Graph
We can now illustrate the full model in a single graph.
The graph features one curve that slopes upwards (the Phillips curve) and
one that slopes downwards (the IS-MP curve provided we assume that

> 1.)
The next gure provides the simplest possible example of the graph. This is
the case where both the temporary shocks,

t
and
y
t
equal zero and the
publics expectation of ination is equal to the central banks ination target.
Note that I have labelled the PC and IS-MP curves to explicitly indicate
what the expected and target rates of ination are and it will be a good idea
for you to do the same when answering questions about this model.
In the next set of notes, we will analyse this model in depth, examining what
happens when various types of events occur and focusing carefully on how
ination expectations change over time.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 31 / 34
Expected Ination Equals the Ination Target















Output
Inflation


PC (

)

IS-MP (


Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 32 / 34
A More Complicated Monetary Policy Rule
In a famous 1993 paper, economist John Taylor argued for a monetary
policy rule in which the central bank adjusted interest rates in response to
both ination and the gap between output and an estimated trend.
Within our model structure, we can amend our monetary policy rule to be
more like this Taylor rule as follows:
i
t
= r

(
t

) +
y
(y
t
y

t
)
Substituting this into the IS curve, we get
y
t
= y

t
[r

(
t

) +
y
(y
t
y

t
)] +(
t
+ r

) +
y
t
This can be re-arranged to give
y
t
y

t
=
(

1)
1 +
y
(
t

) +
1
1 +
y

y
t
This shows that broadening the monetary policy rule to incorporate interest
rates responding to the output gap doesnt change the essential form of the
IS-MP curve. As long as

> 1, the curve slopes downwards and features

t
=

when y
t
= y

t
and there are no inationary shocks.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 33 / 34
Things to Understand From This Topic
1
The evidence on the Phillips curve.
2
The Phillips curve that features in our model and how to draw it.
3
Why real interest rates are what matters for aggregage demand.
4
The IS curve that features in our model.
5
The monetary policy that features in our model.
6
How to derive the IS-MP curve.
7
What determines the slope of the IS-MP curve.
8
How the IS-MP curve changes when the monetary policy rule takes the form
of a Taylor rule.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 34 / 34

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