Lecture 7: An Extended IS-LM Model

MIT OpenCourseWare・2 minutes read

Understanding the IS-LM model is crucial, with 2/3 of the quiz focusing on it. The real interest rate is derived from nominal rates, and expected inflation plays a significant role in shaping financial markets and investment decisions.

Insights

  • Understanding the IS-LM model is crucial for the quiz, focusing on nominal and real interest rates, inflation's impact, and financial market simplification.
  • The Federal Reserve's response to economic crises, like the Great Recession and recent challenges, showcases the importance of expected inflation, credit spreads, and unconventional measures to influence interest rates and maintain economic stability.

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Recent questions

  • What is the IS-LM model?

    A: The IS-LM model is a macroeconomic framework that analyzes the relationship between interest rates and output levels in an economy. It consists of two curves - the IS curve, representing equilibrium in the goods market, and the LM curve, representing equilibrium in the money market. The model is essential for understanding how changes in monetary policy impact output and interest rates.

  • How does inflation affect interest rates?

    A: Inflation impacts interest rates by affecting the real interest rate, which is the nominal interest rate adjusted for inflation. When inflation is high, the real interest rate decreases, making borrowing cheaper and encouraging spending. Conversely, low inflation or deflation increases the real interest rate, making borrowing more expensive and potentially slowing down economic activity.

  • What role does riskiness play in determining interest rates?

    A: Riskiness plays a crucial role in determining interest rates for different assets. Assets with higher risk levels, such as corporate bonds, require a risk premium above the safe real interest rate to compensate investors for the additional risk. The risk premium fluctuates based on factors like default probabilities and bondholder risk aversion, especially during economic cycles.

  • How do central banks influence interest rates?

    A: Central banks influence interest rates through monetary policy tools like adjusting the target federal funds rate or engaging in large-scale asset purchases. By changing interest rates, central banks aim to stimulate or cool down economic activity, impacting borrowing costs, investment decisions, and overall aggregate demand in the economy.

  • What are unconventional measures central banks may take during economic crises?

    A: During economic crises, central banks may resort to unconventional measures like purchasing long-duration US Treasury bonds, buying corporate bonds, or even buying equity in markets. These measures aim to influence interest rates and borrowing costs, especially when traditional monetary policy tools are ineffective, such as when interest rates reach the zero lower bound.

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Summary

00:00

Importance of IS-LM model and real interest rates

  • Understanding the IS-LM model is crucial, with 2/3 of the quiz focusing on it.
  • The distinction between nominal and real interest rates is essential due to the presence of inflation.
  • Inflation's impact on the framework and people's expectations of inflation are significant.
  • Financial markets are simplified to focus on cash deposits at central banks and bonds.
  • Riskiness plays a key role in determining interest rates for different assets.
  • Real interest rates are crucial for private sector decisions and real investments.
  • The net difference between borrowing costs and future goods' prices is vital for investment decisions.
  • The real interest rate is derived from nominal rates, even though real bonds are rare in the US.
  • Calculating the real interest rate involves converting nominal rates into goods' terms.
  • Expected price levels are used to compare investments in nominal and real terms.

14:29

Relationship between goods, interest rates, and inflation

  • The relationship between goods should yield similar returns, assuming equal expected returns.
  • The expression 1 + real interest rate = 1 + nominal interest rate * Pt/Pt+1 expected was derived.
  • Expected inflation, denoted as pi e t+1, represents the anticipated change in the price level from year t to t+1.
  • The real interest rate is approximately equal to the nominal interest rate minus expected inflation.
  • In the US, the nominal interest rate typically exceeds the real interest rate due to positive inflation expectations.
  • During the Great Recession, the real interest rate surpassed the nominal rate, indicating a severe economic downturn.
  • The Federal Reserve aggressively cut interest rates to combat the recession's impact.
  • Expected inflation can turn negative during deep recessions, leading to deflationary pressures.
  • Corporate bonds carry a risk premium, xt, above the safe real interest rate, reflecting the risk associated with these bonds.
  • The risk premium, influenced by default probabilities and bondholder risk aversion, fluctuates significantly during economic cycles, especially in severe recessions.

29:24

"Central bank targets inflation and credit spreads"

  • The central bank targets expected inflation and credit spreads but maintains the LM as it was.
  • The book simplifies by setting the interest rate in terms of the real interest rate, which is not favored.
  • The investment function is now based on the real interest rate adjusted by credit risk.
  • Equilibrium lecture introduces two new parameters: expected inflation and credit spread.
  • A decrease in credit spreads or an increase in expected inflation shifts the ZZ curve up, leading to an expansion in output.
  • Expected inflation and credit spreads can act as expansionary monetary policy, affecting aggregate demand.
  • In the global financial crisis, a massive decline in expected inflation and a significant increase in credit spreads led to a shift down in the ZZ curve.
  • In the IS-LM space, a rise in credit spreads or a fall in expected inflation causes the IS curve to shift left, impacting investment.
  • During the Great Recession, the central bank may lower interest rates to counter negative shocks, potentially reaching the zero lower bound.
  • Recent events show the Fed facing challenges as they try to tighten interest rates while expected inflation remains high, causing a decline in real interest rates.

43:51

Unconventional Central Bank Measures in Crisis

  • The Federal Reserve aimed to tighten financial conditions, but credit spreads were decreasing, contradicting their goal. This led to unconventional measures, including purchasing long-duration US Treasury bonds and creating a facility to buy corporate bonds to address the significant shock to corporations caused by events like the COVID pandemic.
  • Central banks engaged in large-scale asset purchases to influence interest rates not reflected in traditional monetary policy tools, such as corporate bonds. By reducing credit spreads (x), they aimed to lower borrowing costs for corporations, ultimately impacting the IS curve.
  • In extreme situations like the zero lower bound, central banks may resort to unconventional interventions like buying equity in markets, as seen in Japan and Hong Kong in the past. These creative measures are employed when traditional monetary tools are ineffective.
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