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Lecture Twelve

IS and LM Shocks, and Real and Nominal Interest Rates
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 16, 1996

• 1971-1973: Riding down the IS curve to what people then thought--wrongly--was a sustainable level of employment.
• 1973-1975: First oil shock. Investment collapses; IS curve shifts strongly to the left; monetary policy devoted to fighting inflation
• 1975-1978: IS curve moves back to the right; once again a push for unsustainable levels of activity
• 1978-1982: The Volcker deflation. Riding up the IS curve
• 1982-1989: Expanded federal deficits created by Reagan-era tax cuts shift the IS curve out to the right; easier monetary policy as well
• 1989-1992: Fears of another Iraqi-driven oil shock and other factors pull the IS curve back to the left. The Federal Reserve responds too slowly--or so we now see in retrospect--and the economy enters a recession.
• 1992-1994: Repeated monetary easing pushes the economy down and to the right as it rides down the IS curve once again, heading for full employment.
• 1994-1995: As the economy reaches what the Federal Reserve guesses to be "full employment," monetary policy is tightened slightly to keep strong investment demand from pushing the economy back into the inflationary-spiral region; the Federal Reserve pursues the elusive "soft landing."

Note that our full-employment model of chapter 3 is of use in comparing pictures across decades. What is the difference between 1979 and 1989?

• Inflation is a lot lower (as a result of the Volcker deflation)
• The federal deficit is considerably higher
• Real interest rates are considerably higher
• Gross saving is a bit lower, and net saving is substantially lower as a share of national product.

Remember how an expansion of the deficit would "crowd out" private investment and raise interest rates? Here it is in action.

• Recall also that the Federal Reserve sets interest rates, but it sets a short-run, nominal interest rate (in fact, it sets only the overnightte on federal funds--that is, commercial bank deposits at the twelve regional Federal Reserve Banks.

How much slippage?
We can see by taking a look in a little bit of detail at 1990-1996...



At the start of 1990 the economy appeared to be doing very well; unemployment in the low 5's; inflation in the high 4's, and perhaps creeping up; federal deficit too large--and threatening to rise, because no one had any stomach for cutting programs and George Bush had pinned himself to the wall with his summer of 1988 campaign promises...

Summer of 1990; Iraqi invasion of Kuwait; fear of another oil shock; let's wait and see on investment--and, in fact, if truth be told, a lot of the time we can never determine, even ex post, exactly why investment demand (or consumption spending) did what it did. But the IS curve heads left from the late summer of 1990.

Unemployment begins a rise that is going to take it from 5.2% or so all the way up to 7.7% in the summer of 1992.

Federal Reserve reacts with a lag. Let's interest rates drift downward through most of 1990, and then in late 1990--when Alan Greenspan decides that yes, the economy is in a recession after all--cuts short-term interest rates relatively rapidly. By early 1991 T-bill rates are at 5.8%, down a full two percentage points from what they were a year before. For most of 1991 Federal Reserve lets short-term interest rates continue to drift downward while it waits and sees what this relaxation of monetary policy will do to the economy. Will this riding down the IS curve offset the shocks that shifted the IS curve back to the left?

• But long-term rates don't move. July of 1991 finds long-term nominal interest rates exactly where they had been in January of 1990--and real long-term rates are higher by perhaps a percentage point, because inflation is down from between 4 and 5 percent per year to between 3 and 4 percent per year.

Why don't long term rates move?

• Long-term rates an average of future short rates.
• Need to be confident that monetary ease will continue
• No such confidence--hence the fact that the recession was seen as likely to be a transient blip was, somewhat paradoxically, a factor making it relatively long.

From late 1991 to early 1992--Federal Reserve realizes that it has misjudged the situation, and drops short-term interest rates from low 5's to high 3's.
White House panics: "playing silly games" with Alan Greenspan; delaying reappointment, et cetera. Poor Bush White House: monetary policy's pre-election impact on output essentially "baked into the cake" by August 1991 or so.

Finally some action in long-term rates--although with falling inflation, it is not clear to me that there had been much reduction in expected real long-term interest rates.

By the summer of 1992, the Federal Reserve is seeing the effects of its actions through mid-1991; doesn't like the continued rise in the unemployment rate; pedal-to-the-floor time: negative short-term real interest rates.

• Gap between short- and long-term rates extremely large: no one appears to believe that this degree of monetary ease is sustainable.
• By end of 1993, gap much smaller: perhaps the 1993 deficit-reduction program played an important role in assuring people that short-term interest rates were not about to return to their levels of the 1980s...

1994: the Federal Reserve decides that the economy is getting too near "full employment"; short-term interest rates up a bunch; long-term interest rates follow almost percentage point-by-percentage point.

1995: Short-term interest rates drift downward: a puzzled Federal Reserve finds production and employment stronger than they thought it would be; yet inflation lower than they thought it would be; and no sign of an "overheated" economy at all. Long-term interest rates come down much faster--nearly inverted yield curve--a bunch of people on Wall Street think that the Federal Reserve is behind events, that there is considerable danger in recession, and that the next move in interest rates is very likely to be sharply down...

Past members of the Federal Reserve Open Market Committee have compared the making of monetary policy to that of driving a car with the windshield painted black by looking in the rear-view mirror.

Add to that never being certain whether the steering wheel is connected to the front axle or not...

Still, widely agreed to be a better job than that of White House Chief of Staff: past occupants of that job have called it "the grease that heats up and needs to be replaced," or "javelin catcher"

• IS curve steep if A/(1-c') (what Greg Mankiw calls d/(1-b) in the appendix to his chapter 10) is large--if investment is responsive to shifts in the interest rate, and/or if the multiplier is large because the marginal propensity to consume is high.
• IS curve easy to move if the marginal propensity to consume is near one...
• LM curve steep if (e/f) is high--that is, if money demand is strongly responsive to increases in spending, and if the effect of higher interest rates at curbing money demand is small (but we suspect that neither of these are true in America today: that the LM curve is not steep)
• LM curve easy to move if f is small--if, holding Y constant, small changes in the money stock carry with them big changes in interest rates; also does not seem to be true today.

Suppose we put equations (7) and (9) together--under the assumption that i = r-- what do we get? We get (10):

(10)

Now I'm not going to demand that you regurgitate (10) on any exam. Particularly since Mankiw's textbook writes it differently--and I think oddly--on page 287; calling parameters in the investment function things like "c", which is a mnemonic or consumption if I've ever heard one. If you are going to need (10) on the midterm or the final, I will give it to you.

What I do demand is that if I show you the pieces of (10) you can tell me what they mean.

• First, note that putting equations (7) and (9) together--moving from the IS curve to AD--shrinks the multiplier. Why does the multiplier shrink? Because shifting the IS curve out moves you up the LM curve. Interest rates rise. Crowding out. We saw this in chapter 3. Here it is, back again, in an abbreviated form. And the bigger is A(e/f), the more crowding out there is.
• On top of this shrunken multiplier are our usual suspects: the deficit; the intercepts in the consumption and investment functions. There is--still--a positive impact on GDP from increasing the size of the government, holding the deficit constant. And there is a monetary policy term.

A lot of fights in the 1960s and the 1970s over equation (10)--claims that monetary policy had no impact, or that multipliers were so small that fiscal policy had little impact. Now we think--especially after looking at what the structural deficits of the 1980s seem to have done to real interest rates, that:

• Fiscal policy has a big impact, but not good for fighting the business cycle because of legislation and implementation lags.
• Doesn't matter whether "money" has a small or large effect on the economy ,because the Federal Reserve can do what it wants with relative ease
• Automatic stabilizers