CHAPTER 30 IS-MP Analysis: Interest Rates and Output
At two o’clock, things may change.
A trader sits in front of a bank of six monitors watching the clock. The Federal Reserve is about to release news of its latest decision, and it could change the economy’s trajectory. The clock strikes two. The announcement is out: The Fed has lowered interest rates, and it’s committed to reducing them as much as needed to kickstart the economy. The trader immediately buys stocks and watches the stock market soar.
The next day, Bank of America’s CEO tells regional managers that in light of the Fed’s decision, it’s time to offer lower interest rates. A week later, a lawyer in Atlanta gets an email from Bank of America, offering a mortgage at a low interest rate. The lawyer calls their spouse because they’ve been considering buying a house; with interest rates down, they decide now is the right time. A few months later, they’re homeowners. Meanwhile, a financial executive at Walmart has secured a business loan at a low interest rate from JPMorgan Chase. Walmart uses the loan to open more than 100 new Walmart stores across the country.
The interest rate might be the most important price in the economy. It tells you how expensive it is to borrow, shows you the opportunity cost of spending, and plays a key role in economic decisions. In this chapter, we’ll see why. We’ll start by examining how spending responds to changes in the interest rate. Next, we’ll delve into how interest rates help determine the economy’s total output. After that, we’ll look into how interest rates are determined. Finally, we’ll use what we’ve learned to forecast how changing market conditions affect output.
By the end, you’ll have a useful framework to analyze changing economic conditions. This framework, called IS-MP analysis, is the real deal: It’s the approach that folks in industry, government, and the Fed use to analyze the business cycle. Let’s get started.