Chapter 18: Linking Interest Rates and Output Using IS-MP Analysis PDF

Chapter 18 1. Aggregate Expenditure Linking Interest 2. The IS Curve: Output and the Real Interest Rate Rates and Output 3. The MP Curve: What Determines the Interest Using IS-MP Rate Analysis 4. The IS-MP Framework 5....

Chapter 18 1. Aggregate Expenditure Linking Interest 2. The IS Curve: Output and the Real Interest Rate Rates and Output 3. The MP Curve: What Determines the Interest Using IS-MP Rate Analysis 4. The IS-MP Framework 5. Macroeconomic Shocks Macmillan Learning, ©2023 Chapter 18 Assess the role of aggregate 1. Aggregate Expenditure expenditure in driving short-run fluctuations in output: 2. The IS Curve: Output and the Real Interest Rate  Aggregate expenditure and short- 3. The MP Curve: What Determines the Interest run fluctuations Rate  The demand-driven short run and the supply-driven long run 4. The IS-MP Framework 5. Macroeconomic Shocks Macmillan Learning, ©2023  Recall from Ch. 17 Business cycles cause actual output to deviate from potential output. 3 Macmillan Learning, ©2023  Peloton Production and Demand Peloton was a rising corporate star during the pandemic. The company’s stock soared in sales as more people opted to work out at home. Critical error: Peloton executives misjudged demand. As COVID receded, so did demand for Peloton equipment.  Thousands of bikes and treadmills stashed in warehouses or on cargo ships totaling about $1.5 Jeenah Moon/Bloomberg/Getty Images billion in unsold inventory. Peloton cut its production, reducing its output to better match demand. This chapter explores how, in the short run, changes in demand drive changes in output. 4 Macmillan Learning, ©2023  Macroeconomic equilibrium Macroeconomic equilibrium: occurs when the quantity of output that suppliers collectively produce is equal to the quantity of output that buyers collectively want to purchase.  Total production of output = aggregate expenditure Take-away: Output adjusts to meet aggregate expenditure! Measured by GDP Measures the total demand for output  If output exceeds aggregate expenditure, businesses will cut  Y = C + I + G + NX back their production.  If output is less than aggregate expenditure, businesses will Output Aggregate expenditure ramp up production. 5 Macmillan Learning, ©2023  Adjusting production to unplanned inventory changes: If people purchase less than businesses produce…  Extra output is stored as inventories.  Managers respond by cutting back production! If aggregate expenditure is greater than production for a short while…  Businesses delay delivery or sell existing inventories.  Managers respond by ramping up production! These adjustments push the economy toward the macroeconomic equilibrium. 6 Macmillan Learning, ©2023  Aggregate expenditure and short-run fluctuations Take-away of Peloton story: In the short-run, changes in demand drive changes in output.  If you can predict what’s happening to demand, then you can forecast short-run fluctuations in output! Thus, we start our analysis of business cycles by focusing on the demand side of the economy. Aggregate expenditure: the total amount of goods and services that people want to buy across the whole economy. It is the sum of four components: AE = C + I + G + NX Aggregate Consumption Planned Government Net exports Investment purchases expenditure 7 Ch. 13 Ch. 14 Ch. 16 Macmillan Learning, ©2023  Demand-driven short run, and supply-driven long run Our focus in this chapter: to explain the year-to-year fluctuations in actual output based on changes in demand side Task: In this context, short run refers to the year-to-year ups and downs of the business cycle. As opposed to…  Long-run analysis, which explains the economy’s potential output based on changes in supply side.  Potential output: level at which all resources are fully employed into the production function learned in Ch. 10 (Growth): Y = f ( L, H, K ) 8 Macmillan Learning, ©2023  In the short run, actual output may fail to Actual Output and Potential meet potential.  Why? Weak aggregate expenditure!  Businesses don’t want to produce output that people won’t buy.  Thus, at equilibrium, output is less than potential. In the short run, actual output can exceed potential (not sustainable).  Why? Strong aggregate expenditure!  Suppliers run extra overnight shifts, defer maintenance, etc.  Equilibrium: output exceeds potential. 9 Macmillan Learning, ©2023  Recall the output gap The output gap focuses on the balance between short-run demand for output (actual output) and long-run supply of output (potential output). Actual output − Potential output Output gap = ×100 Potential output Goldilocks approach:  Too cold: when output is below potential  Too hot: when output is above potential  Just right: when output equals potential 10 Macmillan Learning, ©2023  Actual and potential output The output gap fluctuates widely.  Actual output often deviates substantially from potential output.  Demand-side factors drive these fluctuations.  Our goal: explain these short- run fluctuations. 11 Macmillan Learning, ©2023  Don’t confuse equilibrium output with potential output Equilibrium (actual) output can differ from potential output.  Equilibrium output: the level of output at the point of macroeconomic equilibrium.  Macroeconomic equilibrium occurs when the quantity of output that suppliers collectively produce is equal to the quantity of output that buyers collectively want to purchase.  Total production of output = aggregate expenditure  Potential output: the economy’s highest sustainable level of production. To summarize:  Equilibrium output describes the economy’s resting point.  Potential output is where Goldilocks wishes the economy would rest. 12 Macmillan Learning, ©2023  Key take-aways: Aggregate expenditure The short-run fluctuations of the business cycle are driven by changes in aggregate expenditure.  Aggregate expenditure: the total amount of goods and services that people want to buy across the whole economy. It is the sum of four components: AE = C + I + G + NX Output adjusts to meet aggregate expenditure and moves the economy to its macroeconomic equilibrium.  Total production of output = aggregate expenditure 13 Macmillan Learning, ©2023 Chapter 18 Use the IS curve to analyze the 1. Aggregate Expenditure relationship between the real interest rate and output: 2. The IS Curve: Output and the Real Interest Rate  Lower interest rates boost 3. The MP Curve: What Determines the Interest aggregate expenditure Rate  Real interest rates and output 4. The IS-MP Framework  How to use the IS curve 5. Macroeconomic Shocks Macmillan Learning, ©2023  The big picture goal Goal: develop a framework for analyzing how interest rates affect spending and hence output, and why interest rates rise and fall.  Link what’s happening on Main Street with what’s happening on Wall Street. Our discussion centers around the real interest rate, so let’s review a bit. Recall real interest rate, r  Real interest rate is the nominal interest rate adjusted for inflation.  Represents the opportunity cost of spending.  You can spend the money now, OR you can save it, earn interest, and buy even more in the future. 15 Macmillan Learning, ©2023  How the real interest rate affects aggregate expenditure Aggregate expenditure: the total amount of goods and services that people want to buy across the whole economy. It is the sum of four components: AE = C + I + G + NX Aggregate Consumption Planned Government Net exports Investment purchases expenditure Explore how the real interest rate shapes each component separately, and then bring it all together! 16 Macmillan Learning, ©2023  Lower interest rates boost consumption AE = C + I + G + NX Your spending decisions depend on the real interest rate because…  Opportunity cost principle.  Lower interest rate means…  Lower opportunity cost of spending…  People spend more.  Lower real interest rate: People substitute toward consumption and away from saving. 17 Macmillan Learning, ©2023  Lower interest rates boost investment AE = C + I + G + NX Investment is particularly sensitive to the real interest rate.  Opportunity cost principle.  Money spent on new equipment is money NOT in the bank earning interest.  Lower real interest rates lead to more investment spending.  More investment projects are worth pursuing. 18 Macmillan Learning, ©2023  Lower interest rates boost government purchases AE = C + I + G + NX Low interest rates reduce the interest payments the government must make on its debts.  More money left in the government budget, so there’s an increase in government purchases.  More spending on roads, bridges, etc. Lower interest rates do NOT always spur more government purchases.  Sometimes use extra funds to pay down their existing debt instead. 19 Macmillan Learning, ©2023  Lower interest rates boost net exports AE = C + I + G + NX Low interest rates make the U.S. dollar cheaper, and this increases net exports. Low real interest rates lead…  Foreign investors to demand fewer U.S. dollars, and U.S. investors to supply more U.S. dollars.  Dollar becomes cheaper.  Increases exports and reduces imports.  Higher net exports. 20 Macmillan Learning, ©2023  All together: lower real interest rates yield higher aggregate expenditure (1 of 2) r r r r 4% 4% 4% 4% + + + 2% 2% 2% 2% Consumption Planned Government Net exports Investment Purchases Real interest rate, r 4% = 2% Aggregate expenditure Aggregate expenditure 22 Macmillan Learning, ©2023  All together: lower real interest rates yield higher aggregate expenditure (2 of 2) The real interest rate is the opportunity Businesses adjust output to meet cost of spending money this year demand, so in equilibrium: (rather than saving it) Output = Aggregate expenditure Aggregate expenditure = C + I + G + NX Potential output is unchanged, so changes in output translate to changes in the output gap Let’s look at the 23 IS curve now! Macmillan Learning, ©2023  It’s a price, so it goes on the vertical axis The IS curve The IS curve illustrates how lower real interest rates lead to a more positive output gap. The IS curve is like a macroeconomic It’s called the IS curve because… demand curve  It describes Investment and Spending decisions.  It illustrates the Interest Sensitivity of output.  Historically, Investment is the key form of interest-sensitive spending, and Saving is used to fund investment. It’s a quantity, so it goes on the horizontal axis 24 Macmillan Learning, ©2023  This IS curve is downward-sloping Lower real interest rates boost aggregate expenditure, which leads to a higher level of output, and hence a more positive output gap.  Lower real interest rates lead to higher aggregate expenditure.  Businesses adjust their output to meet demand, so output rises to match.  Higher output means a more positive output gap. 25 Macmillan Learning, ©2023  How to use the IS curve Real interest Forecasting the output gap: rate A change in the  If the real interest rate is 3%... real interest rate leads to a  GDP is 5% below its potential level. movement along  If the real interest rate falls to 1%... 3% the IS curve.  GDP is at its potential level (0% output gap). 1% Your forecast holds other things constant. IS curve  If other things change, so should your - 5% 0% forecast. Output gap (Output relative to potential output) 26 Macmillan Learning, ©2023  Important distinction! Changes in the real interest rate: which cause a movement along the IS curve. Changes in other factors that change aggregate expenditure at a given interest rate: which cause the IS curve to shift. 27 Macmillan Learning, ©2023  A lesson from the 1980s Late 1970s, Americans were experiencing double-digit inflation.  Federal Reserve Chair Paul Volcker pledged to remedy it. Raised interest rates:  Nominal rate = 20%  Real rate = 10% High interest rates pushed output far below its potential level.  Deepest slump since the Great Depression. 28 Macmillan Learning, ©2023  Key take-aways: The IS curve: Output and the real interest rate 29 Macmillan Learning, ©2023 Chapter 18 Use the MP curve to summarize 1. Aggregate Expenditure how the real interest rate is determined: 2. The IS Curve: Output and the Real Interest Rate  The role of the Fed 3. The MP Curve: What Determines the Interest Rate  The role of the financial sector 4. The IS-MP Framework  The MP curve 5. Macroeconomic Shocks Macmillan Learning, ©2023  How the real interest rate is determined: (1 of 2) The IS curve tells us the real interest rate has major economic consequences.  What factors determine the real interest rate?  Let’s jump to the answer, and then fill in the background: Real interest rate = Risk-free real interest rate + Risk premium  Let’s first analyze the role of Set by the Federal Reserve Determined by financial markets the Federal Reserve.  Second, we’ll incorporate the financial markets. 31 Macmillan Learning, ©2023  Christopher Aluka Berry/REUTERS/Newscom The Federal Reserve and monetary policy Policymakers meet at the Federal Reserve in Washington, D.C. eight times a year to decide how high (or low) to set the interest rate.  Consult the IS curve to assess the implications of each possible choice.  At the end, the Fed issues a statement detailing its plans. Monetary policy: the process of setting interest rates in an effort to influence economic conditions. Atlanta Fed president Raphael Bostic, pondering the IS curve. 32 Macmillan Learning, ©2023  The Fed sets the nominal interest rate to influence the real interest rate Recall, it’s the real interest rate that people respond to. When the Fed engages in  Hence, the Fed focuses on the real interest rate as well. monetary policy, its policy tool is a specific interest rate called the (nominal) federal Example: funds rate.  Suppose inflation is 3%  Let’s examine it now!  If the Fed sets the nominal interest rate at 4.5%  Then it’s also accurate to say it set the real interest rate at 1.5%.  4.5% − 3% = 1.5% 33 Macmillan Learning, ©2023  The ripple effect of the Fed’s decisions The Fed does NOT set every interest rate in the economy.  The Fed sets the federal funds rate.  Federal funds rate: the interest rate on a set of overnight loans that are almost certain to be repaid the next day.  Hence, the Federal Reserve effectively sets the risk-free interest rate. Risk-free interest rate: the interest rate on a loan that involves no risk. The Fed’s risk-free interest rate decisions percolate throughout the whole economy.  Impacts interest rates associated with savings, credit cards, car loans, home loans, etc. 34 Macmillan Learning, ©2023  How the real interest rate is determined: (2 of 2) Real interest rate = Risk-free real interest rate + Risk premium Set by the Federal Reserve Determined by financial markets  Let’s first analyze the role of the Federal Reserve.  Second, we’ll incorporate the Let’s see how other market factors financial markets. shape the real interest rate. 35 Macmillan Learning, ©2023  The financial sector adds a risk premium Whenever you lend someone money, there are risks involved. Banks and other lenders demand to be paid extra for taking on these risks.  Risk premium: the extra interest that lenders charge to account for the risk of loaning money. The risk premium is why the interest rate you pay on your credit card, car loan, or business loan is typically higher than the risk-free interest rate set by the Federal Reserve.  Riskier borrowers and riskier types of loans get charged a higher risk premium. 36 Macmillan Learning, ©2023  Why you pay different interest rates on different loans The riskier the loan, the higher the interest rate you’ll end up paying. Example: A car loan is less risky than a personal loan.  The bank can always repossess your car. Hence, the bank offers lower interest rates on car loans than on personal loans. 37 Kee Chuan/EyeEm/Getty Images Tham Macmillan Learning, ©2023  Fotog/Tetra images/Getty Images The risk premium is determined in financial markets The buyers and sellers of risk (mainly big banks and other financial institutions) meet on Wall Street to trade risk. The market for risk is just like any other market:  T-shirt Market: a buyer of T-shirts has to pay $10 to induce a supplier to produce one.  Financial Markets: a borrower has to pay their bank a risk premium to induce it to make a risky loan.  The risk premium is a price!  The price at which lenders are willing to bear the risk associated with lending money. 38 Macmillan Learning, ©2023  Real interest rate = Risk-free real interest rate + Risk premium 39 Macmillan Learning, ©2023  The MP curve The MP curve is simple because monetary policy is simple: The MP curve illustrates the current  The Fed sets the interest rate, and real interest rate. the MP curve reflects that (plus  MP stands for “Monetary Policy” the risk premium).  Somewhat misleading name. The MP curve shifts either because…  The Fed changed its monetary policy (i.e., set a new risk-free interest rate) or…  Changes in financial markets shifted the risk premium. 40 Macmillan Learning, ©2023  Key take-aways: The MP curve: What determines the interest rate 41 Macmillan Learning, ©2023 Chapter 18 Forecast economic conditions and 1. Aggregate Expenditure how they’ll respond to monetary and fiscal policy: 2. The IS Curve: Output and the Real Interest Rate  IS-MP equilibrium 3. The MP Curve: What Determines the Interest  Fluctuation demand and business cycles Rate  Analyzing monetary policy 4. The IS-MP Framework  Analyzing fiscal policy and the multiplier 5. Macroeconomic Shocks Macmillan Learning, ©2023  The IS-MP Framework Real Interest Rate A IS curve describes the output gap associated with each real interest rate. Macroeconomic B MP curve describes the real interest rate C equilibrium set by monetary policy and financial 3% B MP curve markets. C Macroeconomic equilibrium is where the two curves intersect. In this example… A IS curve  When the real interest rate is 3%... D  Then the equilibrium output gap is -5% 0% 5% −5%. D Output gap (Output relative to potential output) 43 Macmillan Learning, ©2023  Fluctuating demand and business cycles The IS curve highlights the central role of aggregate expenditure in determining macroeconomic outcomes. Booms and busts of the business cycle reflect shifting between periods of strong and weak demand Let’s explore two alternative macroeconomic equilibria: “happy” and “unhappy” equilibria. 44 Macmillan Learning, ©2023  Booms and Busts A The optimistic IS curve describes spending plans when people are optimistic about their Real Interest economic futures. Rate B Leads to a boom.  Output is at (or above) potential.  Happy equilibrium. Bust Boom D B C If people become pessimistic about their MP curve economic futures, then cutbacks occur.  Negative beliefs of people and businesses reinforce each other. C D Economy shifts to a bust. Optimistic A  Output declines to be less than potential Pessimistic IS curve IS curve output. -5% 0% Output gap  Unhappy equilibria. 45 Macmillan Learning, ©2023  Tracking waves of optimism and pessimism 46 Macmillan Learning, ©2023  John Maynard Keynes on the persistence of economic slumps An unhappy outcome (like a bust) is also an equilibrium! Businesses cut People cut back back production spending Recessions can be individually rational and collectively terrible.  Keynes: The economy can be in macroeconomic equilibrium even when output is far below its potential and unemployment is widespread.  Unlikely to change from this “unhappy” spot unless the Kick-start the economy by government intervenes. persuading people to spend money again! 47 Macmillan Learning, ©2023  Real Interest Monetary policy and the MP curve Rate Monetary policy: the process of setting interest Deep recessionary rates in an effort to influence economic conditions. equilibrium A A In the recessionary equilibrium, GDP High r Old MP curve is less than potential GDP. New equilibrium B When the Fed cuts the real interest rate, the MP curve shifts down. C Low r B New MP curve Leads economy to shift to new C Higher equilibrium: output  Higher output. IS curve  Reduces the negative output gap! -10% -5% Output gap But further action is required because of zero lower bound for nominal 48 interest rate! Macmillan Learning, ©2023  Fiscal policy and the IS curve Real Interest Rate Fiscal policy: the government’s use of spending New IS curve and tax policies to influence economic outcomes. Old IS curve  Causes aggregate expenditure to change.  Shifts the IS curve. New equilibrium Mild recessionary equilibrium B A Increased government spending 2% MP curve causes the IS curve to shift right. A  Multiplied effect!  Shifts by ∆G x Multiplier. ∆G x Multiplier Higher B Leads economy to shift to new C output equilibrium: C  Higher output. -5% 0% Output gap  Unchanged interest rate. 49 Macmillan Learning, ©2023  Key Definition Diving into the Definition An increase in spending has a multiplied Example: Consider the ripple effect of effect on aggregate expenditure. government spending on bridge repair.  Ripple effects throughout the economy.  Direct effect on companies providing steel and concrete, and companies that Multiplier: a measure of how much GDP actually do the construction work. changes as a result of both the direct and indirect effects flowing from each extra  Hire new workers. dollar of spending.  Ripple effects: Newly hired construction worker spends some of their earnings on RECALL: one person’s spending is another daycare. The childcare provider then person’s income. spends some of their extra income at Subway, and so on. 50 Macmillan Learning, ©2023  The multiplier determines how far the IS curve shifts The IS curve shifts to reflect the new level of aggregate expenditure, accounting for both the direct effect of new spending and its ripple effects. The multiplier summarizes the consequences of a rise in spending: ∆ GDP = ∆ Spending x Multiplier Example:  Multiplier = 2  Initial government spending: $150 billion  Generates a total of 2 × $150 b = $300 billion in additional spending (and hence output). 51 Macmillan Learning, ©2023  Key take-aways: The IS-MP framework The state of the economy is determined by the intersection of the IS curve and the MP curve. Changes in monetary policy cause the MP curve to shift. Changes in fiscal policy cause the IS curve to shift. 52 Macmillan Learning, ©2023 Chapter 18 Use the IS-MP framework to 1. Aggregate Expenditure forecast the effects of macroeconomics shocks: 2. The IS Curve: Output and the Real Interest Rate  Spending shocks shift the IS 3. The MP Curve: What Determines the Interest curve Rate  Financial shocks shift the MP 4. The IS-MP Framework curve 5. Macroeconomic Shocks  Forecasting macroeconomic outcomes Macmillan Learning, ©2023  Big Picture: Spending shocks shift the IS curve The IS curve reflects aggregate expenditure at Real interest rate each real interest rate. ∆Spending x Multiplier  Any change in spending will shift the IS curve. A  Increases in spending: IS curve shifts right.  Decreases in spending: IS curve shifts left. New equilibrium 3% B Remember, changes in spending have a MP curve multiplied effect! Sources of spending shocks:  Consumption, C ↑ Output Old IS curve C New IS curve  Planned investment, I  Government purchases, G -5% 0% Output gap  Net Exports, NX 54 Macmillan Learning, ©2023  Examples of IS curve shifters IS curve shifters Examples Consumption rises if people feel ↑ Wealth, ↑ Consumer confidence, ↑Government assistance, more prosperous ↓ Taxes, ↓ Inequality ↑ GDP growth, ↑ business confidence, ↑ investment tax Investment rises if it’s profitable to credits, ↓ Corporate taxes, ↑ easier lending standards and expand production more cash reserves, ↓ uncertainty Government purchases rise in Spending bills, automatic stabilizers response to expansionary fiscal policy... but not transfer payments (at least not directly) Net exports rise in response to ↑ Global GDP growth, ↓ U.S. dollar, ↓ Trade barriers in foreign global factors markets, ↑ Trade barriers to U.S. markets 55 Macmillan Learning, ©2023  Spending shock examples After an escalation in tensions, China imposed Growing business confidence led automakers to a tariff on American exports. build new car factories in the United States.  Decrease in net exports shifts IS curve left.  Increase in investment shifts IS curve right.  Result: Decrease in GDP and an unchanged  Result: Increase in GDP and an unchanged real interest rate. real interest rate. 56 Macmillan Learning, ©2023  Big Picture: Financial shocks shift the MP curve The MP curve reflects the real interest rate. Real interest rate If the real interest rate…  increases, then the MP curve shifts up  decreases, then the MP curve shifts down MP with higher rates 3% B Financial shocks: any change in borrowing conditions that change the real interest rate at Initial MP curve which people can borrow. 2% A  Shifts the MP curve MP with lower rates Sources of fiscal shocks: 1% C  Federal Reserve adjustments to the risk- IS curve free real interest rate -2.5% 0% 2.5% Output gap  Financial market adjustments changing the risk premium ↓ Output ↑ Output 57 Macmillan Learning, ©2023  Financial shocks shift the MP curve MP curve shifters Examples The risk-free interest rate rises ↑ Risk-free rate, ↑ Expected future interest rates in response to monetary policy The risk premium rises if ↑ Default risk, ↑ Liquidity risk, ↑ interest rate risk, lending becomes riskier ↑ Risk aversion 58 Macmillan Learning, ©2023  Financial shock examples To help counter inflation, the Federal Reserve Decreased concern over default risk led to a raised the federal funds rate. smaller risk premium.  Increase in interest rates shifts MP curve up.  Decrease in interest rates shifts MP curve down.  Result: Decrease in GDP and a higher real  Result: Increase in GDP and a lower real interest rate. interest rate. 59 Macmillan Learning, ©2023  Forecasting Macroeconomic Outcomes 1. Is there a spending shock (which shifts the IS curve), or a financial shock (which shifts the MP curve)? 2. In which direction, and how far does this shift the IS or MP curve? 3. What happens to output (and hence the output gap), as well as the real interest rate in the new equilibrium? 60 Macmillan Learning, ©2023  Analyzing the Covid recession and recovery (1 of 3) March 3, 2020: The Fed reads the tea leaves 1. The Fed’s interest rate cut is a financial shock 2. MP curve shifts down 3. Lower real interest rate and higher output March 13, 2020: Consumers cut their spending 1. Decreased consumption is a spending shock 2. IS curve shifts left 3. Unchanged real interest rate and lower output 61 Macmillan Learning, ©2023  Analyzing the Covid recession and recovery (2 of 3) March 18, 2020: Fear grips Wall Street 1. Perception causes the risk premium to rise 2. MP curve shifts up 3. Higher real interest rate and lower output March 23, 2020: Fed calms financial markets 1. The Fed’s backstops reduce fear for lenders 2. MP curve shifts down 3. Lower real interest rate and higher output 62 Macmillan Learning, ©2023  Analyzing the Covid recession and recovery (3 of 3) March 27, 2020: Government income support 1. Direct payments and generous unemployment benefits 2. IS curve shifts right 3. Unchanged real interest rate and higher output 63 Macmillan Learning, ©2023  Concept check: Forecasting macroeconomic outcomes Scenario: Economic growth in Asia is slowing down. Circle the appropriate option given the scenario described above. 1) What type of shock is this? spending shock (which shifts the IS curve) financial shock (which shifts the MP curve) 2) Which direction does the curve shift? Up, Down, Left, Right 3) Result: Output [increases, decreases] and real interest rates [rise, fall, remain unchanged] 64 Macmillan Learning, ©2023  Concept check: Forecasting macroeconomic outcomes Scenario: Economic growth in Asia is slowing down. Circle the appropriate option given the scenario described above. 1) What type of shock is this? spending shock (which shifts the IS curve) financial shock (which shifts the MP curve) 2) Which direction does the curve shift? Up, Down, Left, Right 3) Result: Output [increases, decreases] and real interest rates [rise, fall, remain unchanged] 65 Macmillan Learning, ©2023  Key take-aways: Macroeconomic Shocks 66 Macmillan Learning, ©2023 Chapter 18 1. Aggregate expenditure drives the 1. Aggregate Expenditure short-run fluctuations of the business cycle. 2. The IS Curve: Output and the Real Interest Rate 2. A higher real interest rate increases the output gap. 3. The MP Curve: What Determines the Interest 3. The current real interest rate is Rate shaped by monetary policy and the risk premium. 4. The IS-MP Framework 4. Monetary policy shifts the MP curve, and fiscal policy shifts the IS curve. 5. Macroeconomic Shocks 5. Three-step framework. Macmillan Learning, ©2023