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Appendix

Appendix

to 1

22

to

Chapter

Chapter

The Effects of

Macroeconomic Shocks

on Asset Prices

B y explicitly including the MP and IS curves in the aggregate demand and supply

analysis, we can analyze the response of asset prices, in particular real interest

rates and stock prices, to the macroeconomic shocks we discussed in the chapter.

We start by using aggregate supply and demand analysis along with the MP and IS

curves to explain the impact of demand and supply shocks on real interest rates, infla-

tion, and aggregate output. Then, using a standard formula for valuation of stocks, we

use our results to determine the impact of these shocks on stock prices.

Rates, Inflation, and Output

Demand shocks are of two types: those that occur from shocks to monetary policy, and

those that occur from shocks to spending.

Suppose the economy is initially at point 1 in all three panels of Figure 1, where

inflation is at π1, aggregate output is at Y1 = Y P, and the real interest rate is at r1.

Suppose now that the Federal Reserve decides to autonomously ease monetary policy

by lowering real interest rates at any given inflation rate. As we can see in panel (a)

of Figure 1, this monetary policy action results in a downward shift of the monetary

policy curve from MP1 to MP2. This monetary policy shock does not cause the IS

curve to change in panel (b), although it does lead to a movement along this IS curve.

As we saw in Chapter 21, the aggregate demand curve in panel (c) shifts out to the

right from AD1 to AD2 because the lower real interest rate at any given inflation rate

leads to higher investment spending and net exports, thereby increasing equilibrium

output at each inflation rate. The rightward shift in the aggregate demand curve then

moves the economy to point 2 in all three panels, with a higher rate of inflation at

π2 and higher output at Y2, and as we can see from the IS curve in panel (b), a lower

real interest rate at r2.

As we saw in the chapter, because output is now above potential, the short-run

aggregate supply curve in panel (c) will shift up until it reaches AS3. The economy will

move to point 3, where aggregate output is now back at potential and inflation has risen

to π3. From the IS curve in panel (b), we can see that the real interest rate is back at r1

because output is back at Y1 = Y P.

W-1

W-2 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices

Figure 1

Response to an (a) MP Curve

Autonomous Real

MP1

Monetary Easing Interest

The Fed’s decision to Rate, r

MP2

lower interest rates

at any given inflation 1 3

rate shifts the mon- r1

etary policy curve in

panel (a) from MP1 r2

2

to MP2 and shifts the

aggregate demand

curve in panel (c)

to the right to AD2,

because the lower Step 1. Autonomous monetary

real interest rate at easing temporarily reduces

any given inflation p1 p2 p3

real interest rates . . .

rate leads to higher Inflation Rate, p

investment spending

and net exports. The

economy moves to (b) IS Curve

point 2 in all three Real

panels, with a higher Interest

rate of inflation at π2 Rate, r

and higher output at

Step 2. which temporarily

Y2, and as can be seen raises aggregate output

from the IS curve in 1, 3

r1 in the IS diagram . . .

panel (b), a lower

2

real interest rate at r2. r2

Because Y2 is greater

than Y P, the short-

run aggregate supply

curve will now shift

upward until it

reaches AS3, and the IS

economy will move Y1 Y2

to point 3, where ag-

gregate output is now Aggregate Output, Y

back at potential and

inflation has risen to (c) AD/AS Diagram

π3. The real interest Step 4. but permanently AS3

rate is back at r1 Inflation raises inflation. LRAS

because output is Rate, p

back at Y1 = Y P. AS1

3

p3 2 Step 3. and temporarily

p2 raises output in the

1 AD/AS diagram . . .

p1

AD2

AD1

Y = Y1 Y2

P

Aggregate Output, Y

W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-3

The conclusion from this exercise is that an autonomous monetary policy easing

reduces real interest rates and raises aggregate output temporarily but not perma-

nently. On the other hand, the inflation rate does rise permanently.

This result illustrates the point that monetary policy authorities can affect real inter-

est rates in the short run, but they do not control real interest rates in the long run.

Indeed, as we see in panel (b), the long-run real interest rate is determined by the IS

curve when output is at Y P.

Spending Shocks

Spending shocks can be caused by changes in fiscal policy (changes in taxes or govern-

ment purchases) or by autonomous changes in consumption expenditure, investment

spending, or net exports. Let’s see what happens when there is a positive spending

shock, either because government purchases increase or because business optimism

leads to an increase in investment. Because monetary policy is unchanged, the MP

curve in panel (a) of Figure 2 does not shift. The IS and AD curves in panels (b) and

(c), however, shift to the right, as we learned in Chapters 20 and 21, because increased

spending causes equilibrium output to increase at any given inflation and real interest

rate. The economy moves to point 2 in panel (c), with output and inflation higher at Y2

and π2, respectively. Because inflation is higher, we see from panels (a) and (b) that the

real interest rate has risen to r2. Then, as we saw in the previous example, the aggregate

supply curve shifts up to AS3, and the economy moves to point 3. Output returns to

potential, but notice that because inflation rises to π3, the real interest rate rises even

further to r3 in panels (a) and (b).

We can conclude that positive spending shocks lead to higher real interest rates

in both the short and long runs. Positive spending shocks lead to higher output in the

short run but not in the long run, and lead to higher inflation in both the short run

and the long run.

Rates, Inflation, and Output

Now we look at what happens when temporary and permanent supply shocks occur.

We examine a temporary supply shock resulting from a rise in oil prices (as in the

chapter) in Figure 3. The supply shock leads to an upward shift in the aggregate supply

curve from AS1 to AS2 in panel (c), but does not lead to a shift in the MP or IS curves

in panels (a) and (b). When the economy moves to point 2, where output has fallen to

Y2 and inflation has risen to π2, we see that the real interest rate has risen to r2 at point

2 on both the MP and IS curves in panels (a) and (b). Then, as we saw in the text, in

the long run the aggregate supply curve will shift back down to AS1 and the economy

will return to point 1 in all of the panels, so that inflation, output, and the real interest

rate return to their initial levels.

Our conclusion is as follows: A temporary supply shock that raises prices will

cause the real interest rate to rise in the short run but not in the long run. Although

the temporary supply shock causes inflation to rise and output to fall in the short run,

it has no long-run impact on either of these variables.

W-4 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices

Figure 2

Response to a (a) MP Curve

Positive Spending Real

MP

Shock Interest

A positive spending Rate, r

Step 5. Real interest rate

shock shifts the IS increases.

and AD curves to the

3

right, to IS2 in panel r3

(b) and to AD2 in 2

r2

panel (c). The 1

r1

economy moves

Step 4. Short-run and

to point 2, with long-run inflation increase.

output and inflation

higher at Y2 and π2,

respectively. Because

inflation is higher, we

see from panels (a) p1 p2 p3

and (b) that the real

Inflation Rate, p

interest rate in the

short run has risen

to r2. Because Y2 is (b) IS Curve

greater than Y P, the Real

short-run aggregate Interest

supply curve then Rate, r IS2

shifts up to AS3, and

the economy moves IS1

to point 3. Output 3

returns to potential, r3 2

but because inflation r2

rises to π3, the real r1

interest rate rises 1

even further to r3. Step 1. Positive

spending shock

shifts IS to right.

Y1 Y2

Aggregate Output, Y

Step 3. Short-run output AS3

Inflation LRAS

increases, but long-run

Rate, p output remains unchanged.

AS1

3

p3 2

p2 1 Step 2. and

p1

shifts AD to right.

AD2

AD1

YP = Y1 Y2

Aggregate Output, Y

W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-5

Figure 3

Response to a (a) MP Curve

Temporary Real

MP

Negative Supply Interest

Step 3. increasing real

Shock Rate, r

interest rates in the short run . . .

The temporary

negative supply shock 2

leads to an upward r2

shift in the aggregate

r1

supply curve to AS2 1

in panel (c). When

the economy moves

to point 2, where

output has fallen

to Y2 and inflation

has risen to π2, the

p1 p2

interest rate rises to

r2 at point 2 on both Inflation Rate, p

the MP and IS curves

in panels (a) and (b).

Because Y2 is less (b) IS Curve

than Y P, in the long Real

run, the aggregate Interest

supply curve will Rate, r

shift back down to

AS1 and the economy Step 4. and decreasing

will return to point 2

r2 output in the short run.

1, where inflation,

1

output, and the real r1

interest rate will

return to their initial

levels.

IS

Y2 Y1

Aggregate Output, Y

AS2

Inflation Step 2. increasing inflation and LRAS1

Rate, p lowering output in the short run . . .

AS1

2

p2 1 Step 1. A temporary

p1 negative supply shock

shifts AS upward . . .

AD1

Y2 YP = Y1

Aggregate Output, Y

W-6 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices

In Figure 4, we look at a permanent negative supply shock. In this case, in panel (c),

the long-run supply curve shifts leftward from LRAS1 to LRAS2 while the short-run

aggregate supply curve shifts up from AS1 to AS2. Again, however, neither the MP nor

the IS curve shifts in panels (a) and (b). When the economy moves to point 2 in all

three panels, inflation rises to π2, output falls to Y2, and the real interest rate rises to r2.

A permanent negative supply shock leads to higher real interest rates in both the

short and the long run. It also results in lower output in both the long and short runs,

and higher inflation in both the long and short runs.

To assess the impact of these shocks on the stock market, we use the generalized divi-

dend model, discussed in Chapter 7. The model states that the value of a share of stock

should equal the present discounted value of future dividends. We write the model as

follows:

P0 = a

∞ Dt

s t (1)

t = 1 11 + r 2

where

P0 = the current price of the stock, where the zero subscript refers to time

period zero—that is, the present

Dt = the dividend paid at time t

k e = the required return on investments in equity

Future dividends should be positively related to overall economic activity and thus to

aggregate output, while the required rate of return on stocks that we use to discount

the future dividends should move positively with the real interest rate. Armed with

these facts, we can now determine how demand and supply shocks affect stock prices.

We saw in Figure 1 that an autonomous monetary policy easing lowers real interest

rates and raises output in the short run. In Equation 1, lower real interest rates reduce

the denominator and higher output increases the numerator, thereby raising stock

prices. We get the following result: An autonomous monetary policy easing should

raise stock prices.

Spending Shocks

In Figure 2, we saw that a positive spending shock leads to both higher output

and higher real interest rates in the short run, and to higher real interest rates in

the long run. Here, the effects on stock prices are unclear. The higher output value

would increase the numerator in Equation 1 and would therefore raise stock prices,

whereas the higher real interest rate values would increase the denominator and

thereby cause stock prices to fall. The effect of a positive spending shock on stock

prices is ambiguous.

W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-7

Response to a

Real

Permanent Negative Interest

MP

Supply Shock Rate, r Step 3. increasing real

interest rates in the long run . . .

In panel (c), the

permanent negative

supply shock shifts 2

r2

the long-run supply

curve to the left to r1

LRAS2, while the 1

short-run aggregate

supply curve shifts

up to AS2. When

the economy moves

to point 2, inflation

rises to π2 while p1 p2

output falls to Y2.

The higher inflation Inflation Rate, p

rate is then associ-

ated with a higher

real interest rate r2, (b) IS Curve

as shown in panels Real

(a) and (b). Interest

Rate, r

2

r2 output in the long run.

1

r1

IS

Y2 Y1

Aggregate Output, Y

AS2

Inflation Step 2. increasing inflation LRAS2 LRAS1

Rate, p in the long run . . .

AS1

2

p2 Step 1. A permanent

1

negative supply shock

p1 shifts LRAS leftward

and AS upward . . .

AD1

Y P2 Y P1

Aggregate Output, Y

W-8 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices

In Figure 3, we saw that a temporary negative supply shock causes output to fall in

the short run and real interest rates to rise. The denominator in Equation 1 would get

larger while the numerator would get smaller, both of which would lower stock prices.

A temporary negative supply shock should cause stock prices to fall.

A permanent negative supply shock causes output to fall in both the short and long

runs, as we saw in Figure 4. Furthermore, such a shock results in a higher real interest

rate in both the short and long runs. The decrease in the numerator and increase in the

denominator of Equation 1 likely would be much larger than in the case of a temporary

supply shock, because the effects of a permanent shock are long-lasting. A permanent

negative supply shock causes stock prices to fall even more than they would if the

supply shock were temporary.

We see from our analysis in this appendix that macroeconomic shocks have an

important impact on financial markets. But this relationship works the other way, too:

We saw in Chapter 12 earlier that financial shocks can have major effects on the

macroeconomy.

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