IS MP Model

Question 1

Real Interest Rate

Answer 1

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation. Once adjusted, it reflects the real cost of funds to a borrower and the real yield to a lender or to an investor.

The real interest rate is determined by r= Marginal Product of capital

Question 2

Real and Nominal Interest Rates

Answer 2

Interest: Additional payout that one obtains from investment

Two alternative concepts: Nominal Interest and Real Interest

R: Real Interest Rate, the “real” return on an investment, how many extra apples can we buy from a given investment?

i: Nominal Interest Rate, the “nominal” return on an investment
…. how much extra dollars do we get from an investment

Linking nominal and real interest rates: R=i-inflation

Real interest rate = nominal interest rate – inflation

Question 3

Interest Rates: Measure of Opportunity Costs

Answer 3

Historical example: Durable and shoddy T-shirts in US and UK

• UK manufacturers typically made products designed to last.
• US manufacturers made shoddy products that fail.

Are US manufacturers bad at what they do?

Suppose:
Good t-shirts last 2 years cost $15 upfront
Bad t-shirts last 1 year, cost $10

What is the total cost of owning a t-shirt over 2 years, assuming no inflation?

How do interest rates come into play into determining consumer preferences?

Question 4

The Fisher Equation

Answer 4

Describes the relationship between nominal and real interest rates under the effect of inflation.

Question 5

Nominal Interest Rates

Answer 5

The rate that is advertised by banks, debt issuers, and investment firms for loans and various investments.

Nominal Interest Rate = Real Interest Rate + Projected Rate of Inflation.

Question 6

Key Takeaways: Interest Rate

Answer 6

Interest rates represent the cost of borrowing or the return on saving, expressed as a percentage of the total amount of a loan or investment.

A nominal interest rate refers to the total of the real interest rate plus a projected rate of inflation.
A real interest rate provides the actual return on a loan (to the lender) and on a bond (to the investor).

To calculate the real interest rate, subtract the actual or expected rate of inflation from the nominal interest rate.

Nominal interest rates can indicate current market and economic conditions while real interest rates represent the purchasing power of investors.

Question 7

Potential vs Current Output

Answer 7

Question 8

Short-Run Model

Answer 8

The economy is constantly being hit by unforecastable “shocks”

Monetary policy affect the real economy in the short run:
1. Contrast with quantity theory of money
2. Contrast with fiscal theory of money

There is a dynamic tradeoff between output and inflation:
Elevated output above potential => high inflation

Question 9

ISMP Model

Answer 9

A macroeconomic tool which displays short-run fluctuations in the interest rate, inflation and output.

Question 10

IS Curve

Answer 10

Question 11

IS Curve

Answer 11

Question 12

IS Curve: The Consumption Model

Answer 12

Question 13

IS Curve: The Investment Model

Answer 13

Question 14

Goods Market Equilibrium

Answer 14

Question 15

Goods Market Equilibrium: R & Y

Answer 15

Question 16

Fiscal Policy

Answer 16

Question 17

Monetary Policy

Answer 17

Question 18

Expansionary Monetary Policy

Answer 18

Expansionary monetary policy works by expanding the money supply faster than usual or lowering short-term interest rates. It is enacted by central banks and comes about through open market operations, reserve requirements, and setting interest rates.

A central bank may deploy an expansionist monetary policy to reduce unemployment and boost growth during hard economic times.

Question 19

Monetary Policy Instruments: Discount Rate

Answer 19

Example:

Bank of Canada is a banker of commercial banks. Commercial banks hold deposits at the Central Bank (Reserves)

The restaurant operates with TD and purchases a new oven from a manufacturer that operates with HSBC for $1000

Bank of Canada made the transfer from TD to HSBC, but if TD doesn’t have $1000 on deposits, it gets an overdraft.

The rate on this loan is the discount rate (the interest rate that banks in Canada face).

Since 1998 commercial banks can borrow/lend money between them at an overnight rate.
In practice, not too far from the discount rate.
Always below the discount rate of course! …why?

Bank of Canada changes the money supply by lowing the discount rate.

Question 20

Monetary Policy Instruments: Open Market Operations

Answer 20

An open market operation is the purchase or sale of the government of Canada securities by the Bank of Canada in the open market.
Example:
Bank of Canada can increase the supply of money by buying government bonds. These transactions are called open market operations.

Open market operations that involve non-government bonds and with longer terms to maturity are called Quantitative Easing.

Question 21

Monetary Policy Instruments: Foreign Exchange Market Operations

Answer 21

Example:
Bank of Canada can also buy and sell things in the foreign exchange market (foreign moneys).

If the Bank of Canada purchases 10 billion US dollars for 12 billion CAD dollars, the money supply immediately increases by 12 billion.

If the Bank of Canada sells 10 billion dollars for 12 billion CAD dollars, the money supply immediately decreases by 12 billion.

Sometimes these operations are done to “sustain” the price of the Canadian dollar.

To sustain the price of CAD, one would like to increase demand by selling foreign reserves (US dollars).

But, if the central bank does not want the money supply to fall, Sterilize!, i.e. design an open market operation that offsets the operation in the foreign exchange market.

Question 22

Monetary Policy Instruments: Changing Reserve Requirements

Answer 22

Bank of Canada can shift the supply of money by changing reserve requirements:

RESERVE requirements: the minimum amount of reserves that commercial banks should hold with the central banks.

And increase in reserve requirements, more money on reserves, less money in circulation, and lower money supply.

Reserve requirements are instruments that is not very much used. Because uncertainty on reserve requirements may disrupt the banking sector.

Question 23

Philips Curve

Answer 23

Question 24

Philips Curve: Inflation

Answer 24

Question 25

ISMP Model Equations

Answer 25

Question 26

Personal Assessment

Answer 26

What is the IS curve? What are the key variables that determine its level?

What determines an equilibrium in this economy?

Describe the role of government policies in shifting the IS curve.

What does the Fisher equation describe? Explain.

Describe the Philips curve.

Describe the two ways in which inflation can accelerate.

Explain the rationale for which interest rate hikes are contractionary and slow down inflation.