32.2 Analyzing Macroeconomic Shocks
One of the most important uses of a macroeconomic framework like the Fed model is to forecast how the economy will respond if a macroeconomic shock knocks it off its current path. That’s going to be our next task.
A Recipe for Analyzing Macroeconomic Shocks
This task is all about exploring the consequences of a shift in the IS, MP, or Phillips curve. And it’ll be a lot simpler if you follow this simple three-step recipe:
Step one: Identify the shock so you can shift a curve.
The first thing you need to do is to identify the shock, so you can shift the relevant curve in the appropriate direction. Is this a change in borrowing conditions (a financial shock, which shifts the MP curve), a change in aggregate expenditure (a spending shock, which shifts the IS curve), or a change in production costs (a supply shock, which shifts the Phillips curve)?
As you assess which direction you should shift the curve, remember the key lessons of the past two chapters:
Step two: Find the output gap.
Once you’ve shifted the appropriate curve in the appropriate direction—or multiple curves if there are multiple shocks—the rest of this process is about analyzing the new equilibrium. And so the second step is familiar: Look at the intersection of the (new) IS and MP curves to find the equilibrium output gap and real interest rate.
Step three: Assess inflation.
Finally, trace the output gap down from the IS-MP graph to the (potentially shifted) Phillips curve to find the inflationary implications of this output gap. Remember, the Phillips curve is all about unexpected inflation, and so to forecast actual inflation, you’ll add this forecast of unexpected inflation to the latest reading of inflation expectations.
We’ll use this three-step recipe to explore the likely consequences of each of the three kinds of shocks: financial shocks, then spending shocks, and finally, supply shocks.
In each of the examples that follows, we’ll start with an economy at rest with an output gap of zero and with unexpected inflation of zero (so inflation equals expected inflation). Then we’ll forecast how the economy will respond to a shock. Economists are often a pessimistic group, and so in each case we’ll analyze adverse shocks that make economic conditions worse. To figure out the effects of a positive shock, simply move the corresponding curve in the opposite direction.
Analyzing Financial Shocks
A financial shock occurs whenever borrowing conditions change the real interest rate at which you can borrow money, thereby shifting the MP curve. An increase in the real interest rate will shift the MP curve up, while a decrease will shift it down.
The MP curve shifts in response to monetary policy and financial market risks.
Changing borrowing conditions in financial markets shift the MP curve.
The real interest rate is the sum of the risk-free interest rate set by the Federal Reserve and the risk premium determined in financial markets. This means that the MP curve will shift in response to changes in:
- Monetary policy: When the Federal Reserve raises or lowers the risk-free real interest rate, the rate borrowers pay also changes, shifting the MP curve.
- Financial market risks: Any change that makes banks more reluctant to lend money at a given interest rate will raise the risk premium, raising the interest rate that borrowers pay, shifting the MP curve. This could arise due to concerns that borrowers may not be able to repay their debt, concerns about liquidity, uncertainty about future interest rates, or rising risk aversion.
(If you feel a bit rusty on this, take a moment to review “Financial Shocks Shift the MP Curve” in Chapter 30.)
Higher interest rates lead to lower output and lower inflation.
Okay, now it’s time to figure out the consequences of an adverse financial shock that raises the real interest rate from 2% to 4%. To figure out the consequences, we’ll work through our three-step recipe in Figure 2.
Figure 2 | Financial Shocks Shift the MP Curve
Step one: Shift the curve. Higher real interest rates shift the MP curve up by 2 percentage points to a real interest rate of 4%.
Step two: Find the output gap. The new equilibrium occurs where this new MP curve cuts the IS curve. In this example, this occurs when output shrinks to be 5% below potential output.
Step three: Assess inflation. Trace this output gap down onto the Phillips curve to assess the inflationary consequences. In this case, an output gap of −5% will cause unexpected inflation to decline to −1%. Thus, if expected inflation is unchanged at 2%, actual inflation will fall to be one percentage point lower, at 1%.
You can track the effects as follow:
All told, we conclude that a financial shock that leads to higher real interest rates will also lead to lower output and lower inflation. Let’s now turn to the effects of spending shocks.
Analyzing Spending Shocks
They’re shifting the IS curve.
Spending shocks occur whenever there’s been a change in spending—in any element of aggregate expenditure—at a given real interest rate and level of income. An increase in spending will shift the IS curve to the right, while a decrease will shift it to the left.
The IS curve shifts in response to changes in aggregate expenditure.
Total spending is the sum of consumption, planned investment, government purchases, and net exports. This means that the IS curve will shift in response to changes in:
- Consumption, which may be driven by changes in wealth, consumer confidence, government assistance, taxes, or inequality.
- Planned investment, which changes in response to changes in future economic growth, business confidence, investment tax credits, corporate taxes, lending standards, cash reserves, or uncertainty.
- Government spending, which reflects the government’s fiscal policy, and the operation of automatic stabilizers.
- Net exports, which are driven by economic growth among our trading partners, trade policy, and exchange rates.
If any of this is unclear, take a moment to review the section “Spending Shocks Shift the IS Curve” in Chapter 30. You don’t need to memorize a long list of these factors; rather, make sure you recognize the types of shocks that will lead to changes in spending and hence shift the IS curve. You’re looking for any shock that will lead to a change in spending at a given real interest rate.
The IS curve shifts by the change in spending times the multiplier.
Let’s evaluate the consequences of an economic shock that reduces aggregate expenditure at any given real interest rate by $500 billion. If the multiplier is 2, then this spending shock will set off a chain reaction that will lead aggregate expenditure to decline by a total of 2 × $500 billion = $1 trillion. As a result, it will shift the IS curve to the left by $1 trillion, which is 5% of potential output (when potential output is $20 trillion).
Decreased aggregate expenditure leads to lower output and lower inflation.
We can now work through the three-step recipe in Figure 3:
Figure 3 | Spending Shocks Shift the IS Curve
Step one: Shift the curve. We’ve established that a $1 trillion cut in aggregate expenditure will shift the IS curve to the left by 5% of potential output.
Step two: Find the output gap. Analyze where this new IS curve cuts the MP curve. In this example, this occurs when output shrinks to be 5% below potential output.
Step three: Assess inflation. Trace this output gap down onto the Phillips curve to assess the inflationary consequences. In this case, an output gap of −5% will cause unexpected inflation to decline to −1%. Thus, if expected inflation is 2%, actual inflation will fall to be one percentage point lower, at 1%.
We can represent this chain of events as follows:
All told, we conclude that a negative spending shock will result in lower output, lower inflation, and no effect on the real interest rate.
Analyzing Supply Shocks
Supply shocks occur whenever there’s an unexpected change in sellers’ production costs that will lead to price changes at a given output gap. An increase in production costs will shift the Phillips curve up, while a decrease in production costs will shift the Phillips curve down.
The Phillips curve shifts in response to changes in production costs.
Rising production costs lead to rising prices and inflation, shifting the Phillips curve.
Production costs drive the pricing decisions of businesses, and hence will change the inflation rate at any given output gap. In turn, production costs shift in response to:
- Input prices: When the price of important inputs—such as oil and labor—rise, so will production costs, shifting the Phillips curve up.
- Productivity: Faster productivity growth leads to more rapid declines in production costs, shifting the Phillips curve down. When productivity growth is weaker than expected, production costs will rise more quickly than expected, shifting the Phillips curve up.
- Exchange rates: Top executives watch the value of the U.S. dollar closely, because it determines the price of imports (including imported inputs) and hence the pressure that foreign competition puts on the pricing decisions of U.S. businesses. A depreciating U.S. dollar leads imported inputs to become more expensive and makes foreign competitors less competitive, both of which lead domestic prices to rise, shifting the Phillips curve up. An appreciating dollar will shift the Phillips curve down.
(You can review any of this by rereading the section in Chapter 31 on “Supply Shocks Shift the Phillips Curve.”)
Increased production costs lead to higher inflation and no change in output.
Okay, now it’s time to figure out the broader consequences of a supply shock—a rise in production costs that shifts the Phillips curve up. We’ll work through the three-step recipe in Figure 4:
Figure 4 | Supply Shocks Shift the Phillips Curve
Step one: Shift the curve. We’ve established that higher production costs will shift the Phillips curve upward.
Step two: Find the output gap. The output gap is determined by the intersection of the IS and MP curves. Because a supply shock shifts neither of these curves, the output gap remains unchanged.
Step three: Assess inflation. Trace this output gap down to the new Phillips curve to assess the inflationary consequences. In this case, the unchanged output gap corresponds with higher unexpected inflation of +1%. Thus, if expected inflation is unchanged at 2%, actual inflation will rise to be one percentage point higher, at 3%.
You can summarize this chain of events as follows:
The bottom line of our analysis is that a supply shock leads to higher inflation, with no effect on the real interest rate, or the output gap.
A caveat: A supply shock can cause output to decline.
It’s time to add an important caveat to our analysis of supply shocks. In addition to their effect on inflation, supply shocks can disrupt both actual output and potential output. These effects are important, but they didn’t show up in Figure 4, because our framework focuses on the output gap, which is the difference between actual and potential output.
To see how supply shocks can reduce both actual and potential output, consider what would happen if oil prices were to double tomorrow. Over time, businesses would shift from being energy intensive to become more energy efficient. We’d need more hybrid cars and fewer SUV’s, and we’d shift from energy-intensive manufacturing toward more energy-efficient services. Given the change in supply conditions, this transition makes long-run sense. But in the short run, this transition creates severe disruptions, as existing factories that were profitable when oil prices were low are rendered unprofitable once they’re high. When these factories close, both actual and potential output fall. And so the initial effect is lower output (matched by lower potential output). Production will only return to its earlier levels once more energy efficient factories have been built.
As a result, a supply shock can cause not only higher inflation, but also short-run stagnation, as output declines. This combination of economic stagnation and high inflation is called stagflation. It’s a reminder that when you account for the effects of a supply shock, realize that the shock can lower output by lowering potential output even if the output gap remains unaffected.
Interpreting the DATA
How a trade war can cause a supply shock
When President Trump imposed tariffs—effectively an additional sales tax—on imported goods, proponents of the policy hoped that it would lead to a spending shock that would boost output. Their thinking was that the tariffs would lead Americans to buy fewer imported goods, and buy more American-made goods, instead. Lower imports mean higher net exports and thus higher aggregate expenditure. That is, their hope was that this spending shock would shift the IS curve to the right, which would lead to more output and a more positive output gap. At the time inflation was low, so they weren’t worried about the increase in inflation that would result from the more positive output gap.
What they didn’t count on was that China and Europe would retaliate with their own tariffs, designed to reduce American exports in roughly equal measure. When lower imports are matched by lower exports, there’s no effect on net exports, nor on aggregate expenditure. A positive spending shock was offset by a negative spending shock. As a result, the IS curve didn’t really move.
But these tariffs still had an important effect: They led to an adverse supply shock. More than half of all imports to the United States are used as inputs by American businesses in the production of their output. Tariffs raised the cost of purchasing these imported inputs. When the price of imported inputs rises, so do production costs, shifting the Phillips curve up. And indeed, over the following months, those sectors of the economy most reliant on imported inputs raised their prices more rapidly, which fed higher inflation. Ultimately then, a policy designed to generate a positive spending shock may have led to a negative supply shock, and so instead of increasing output, it only boosted inflation.
EVERYDAY Economics
What economic forecasters actually do
She’s thinking about the Fed model.
You might be thinking: Is all this curve shifting really what macroeconomists do? If you’re working as a macroeconomist—perhaps at the Fed, at the Treasury, in state and local government, at a large corporation, or a major investment bank—your job will likely include generating economic forecasts. And just as the Fed model suggests, you’ll likely rely on the IS, MP, and Phillips curves to assess what’s likely to happen. But your job will extend beyond saying whether output, inflation, or interest rates will rise or fall. You’ll have to be more precise, and say by how much. That’s a task much better suited to a computer than a pencil and paper. And so you might code the relationships that each of these curves represent into a spreadsheet, or use a statistical program to create a fully computerized model of the economy.
Even then, the stylized graphs that we’re studying remain important. It’s not unusual to see a top economist poring over tables of output from their computerized model, while sketching IS, MP, and Phillips curves in the margin, to try to make sense of it all. They’re using these graphs as an “intuition pump,” to help them explain and understand the somewhat opaque output of their computerized models. Most forecasters have a line at the bottom of their spreadsheet that says “add factor.” It’s a hack. When their computer model disagrees with the intuition they’ve sketched in the margins, they’ll use this line to add a bit to their computer-generated forecast to make it better match their curve-driven intuition.
Do the Economics
It’s time to practice using the Fed model to predict how the economy will respond as market conditions change. Each of the dozen examples that follow is inspired by a real episode that has affected the U.S. economy over recent decades. In each case, you should use the three-step recipe to forecast how real interest rates, the output gap, and inflation will respond.
Consumer confidence rose sharply following the election of a populist government.
- Increase in consumption
- → Shift IS curve to the right
- Result: Unchanged real interest rate, higher output, and higher inflation.
Concern that the economy was underperforming led the Fed to cut interest rates sharply.
- Decrease in real interest rates
- → Shift MP curve downward
- Result: Lower real interest rate, higher output, and higher inflation.
The onset of the Gulf War with Iraq led to supply disruptions that caused oil prices to rise sharply.
- Rising production costs
- → Shift Phillips curve up
- Result: Unchanged real interest rate, unchanged output gap, and higher inflation.
Rapid productivity growth due to new technology led to falling production costs.
- Falling production costs
- → Shift Phillips curve down
- Result: Unchanged real interest rate, unchanged output gap, and lower inflation.
The end of the tech boom led businesses to rethink their investment in new technology, leading to a sharp decline in investment.
- Decrease in investment
- → Shift IS curve to the left
- Result: Unchanged real interest rate, lower output, and lower inflation.
Rapidly falling house prices meant that many homeowners could no longer afford to repay their mortgages. Given this risk of not being repaid, banks were only willing to lend if they were paid a risk premium that was 2 percentage points higher.
- Increase in real interest rates
- → Shift MP curve upward
- Result: Higher real interest rate, lower output, and lower inflation.
By 2010, the worst of the recession had passed and funding for fiscal stimulus dried up, leading government purchases to contract sharply.
- Decrease in government purchases
- → Shift IS curve to the left
- Result: Unchanged real interest rate, lower output, and lower inflation.
As the financial bailout worked, banks became more willing to lend, lowering the risk premium they charged on new loans.
- Decrease in real interest rates
- → Shift MP curve downward
- Result: Lower real interest rate, higher output, and higher inflation.
Improvements in fracking technology led the price of energy to decline.
- Falling production costs
- → Shift Phillips curve down
- Result: Unchanged real interest rate, unchanged output gap, and lower inflation.
Rapid economic growth in China led to an increase in demand for American-made goods.
- Increase in net exports
- → Shift IS curve to the right
- Result: Unchanged real interest rate, higher output, and higher inflation.
As the bargaining power of workers eroded, their nominal wages unexpectedly fell.
- Falling production costs
- → Shift Phillips curve down
- Result: Unchanged real interest rate, unchanged output gap, and lower inflation.
A new Federal Reserve chair, determined to reduce inflation, raised the federal funds rate sharply.
- Increase in real interest rates
- → Shift MP curve upward
- Result: Higher real interest rate, lower output, and lower inflation.
