BMAK Short-Run Models

Goethe University Frankfurt
Macroeconomics 1 (BMAK)
Wintersemester 2020/21
Prof. Michael Binder, Ph.D.
III. The Macroeconomy in the Short Run
1
1. Business Cycles: Insights from the Data and Modelling Strategy

Readings:
- Burda and Wyplosz (2017), Chapter 1
- Challe (2019), Chapter 1
- Jones (2020), Chapter 9
The following graphs of (the logarithm of) real GDP for the United States and
for Germany during the last several decades …
German Real GDP
4.7
4.6
4.5
4.4
4.3
1990q1 2000q1 2010q1 2020q1
Sources of Data: Federal Reserve Bank of St. Louis (2020); Destatis (2020)
… exhibit two main characteristics:
2
(i) an upward trend, reflecting positive long-run real GDP growth; in the
graphs below, the long-run trend values of (the logarithm of) real GDP have
been calculated using filtering techniques from statistics (that are beyond the
scope of this course):
and
3
(ii) cyclical deviations between actual real GDP and long-run trend real
GDP; the graphs below plot these deviations, specifically the logarithm of
actual real GDP minus the long-run trend value of (the logarithm of) real GDP:
The graphs highlight that there is a pattern of sustained cyclical fluctuations in

real GDP.
4
Macroeconomics 1 (BMAK) III. The Macroeconomy in the Short Run
Wintersemester 2020/21 1. Business Cycles: Insights from the Data and Modelling Strategy
This pattern is called business cycles. A business cycle consists of two

phases:
• recoveries/expansions: expanding economic activity that spreads across
the economy, normally visible through pro-longed positive output growth;
• recessions/contractions: falling economic activity that spreads across the
economy, normally visible through pro-longed negative output growth.
In stylized form, in a graph with (the logarithm of) output on the vertical axis, a
business cycle can thus be represented as follows:
5
Graph of a Stylized Business Cycle
Output
Peak
Recovery/ Recession/
Expansion Contraction
Trough
Time
6
Understanding and forecasting business cycle regularities is high on the

agenda of macroeconomists, as it is of essence for
• firms (needing to make production and personnel decisions),
• government policymakers (aiming to stabilize business cycle fluctuations,
in part to stabilize employment and to reduce macroeconomic risk), and
• financial market investors (as asset return and risk tend to be strongly
affected by business cycle fluctuations).
In our two chapters in this course on the macroeconomy in the short and
medium runs, we will build models explaining business cycles. Before
beginning to build these models, we need to know first which typical
characteristics of business cycles that are observed in the data the models
ought to match.
7
Goethe University Frankfurt III. The Macroeconomy in the Short Run
Macroeconomics 1 (BMAK) 1. Business Cycles: Insights from the Data and Modelling Strategy
Wintersemester 2020/21 Burns-Mitchell Diagrams
So-called Burns-Mitchell diagrams inform us about the typical output

dynamics over the course of the business cycle that are observed in the data
and provide insight into the typical co-movements of other key macroeconomic
and financial variables with output over the course of the business cycle that
are observed in the data.
Two steps are involved in constructing Burns-Mitchell diagrams:
1. Identifying business cycle peaks by a rule of thumb: any quarter
immediately preceeding two successive quarters with negative growth rates
of output is labelled a "peak" (unless a recession is in effect already; to this
purpose, we identify as a business cycle trough the first quarter following a
peak that is immediately preceding two successive quarters with positive
growth rates of output).
2. Plotting, for the time period from ten quarters before to ten quarters after
the peak for each quarter the average (across all business cycle episodes
considered) of each variable of interest, in percentage deviations from that
variable's grande average (across all time periods and all business cycle
episodes considered).
8
In terms of algebraic representation, constructing the Burns-Mitchell diagram

for output thus involves the following steps (with Y denoting the logarithm of
output):
- Identifying
Yi ,10 , Yi ,9 ,  , Yi ,1 , Yi ,0 , Yi ,1 ,  , Yi ,10 , i  1, 2, ..., M ,
with M denoting the number of business cycle episodes in the sample,
- calculating 1 M
Ys    Yi , s , s  10,  9,  , 10,
M i 1
(period s average of Yi,s across the M business cycle epsiodes), and
1 1 M 10
Y      Yi , s ,
M 21 i 1 s 10
(grande average of Yi,s across all M ∙ 21 periods considered), and
- plotting
Y s  Y   100%, s  10,  9,  , 10.
9
Let us illustrate these steps graphically with an example involving a sample

from, say, 2011:Q1 to 2019:Q4, for which two business cycle episodes are
identified.
10
Output
Peak for
Episode i = 2
t=0
t = 10
t=9
t=1 t=5 t=8
t=4 t=7
t=3 t=6
t=−1 t=2
t=−2
Peak for t=−3

Episode i = 1
t = 10
t=0 t=9
t=−1 t=1 t=8
t=2 t=7 t=−5
t=−5 t=−2 t=3 t=5 t=6 t=−6 t=−4
t=−6 t=−3 t=4 t=−7
t=−7 t = −8
t=−8 t = − 10 t = − 9
t=−9 t = − 4
t = − 10
2011:Q1 2012:Q1 2013:Q1 2014:Q1 2015:Q1 2016:Q1 2017:Q1 2018:Q1 2019:Q1 Time
11
Output
𝑌 , :𝑌 :
𝑌 , :𝑌 𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
: 𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 𝑌 , :𝑌 :
:
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌, :𝑌 : 𝑌 , :𝑌
𝑌 , :𝑌 : :
𝑌 , :𝑌 : 𝑌 , :𝑌 : 𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌 , :𝑌 : 𝑌 , :𝑌 𝑌 , :𝑌 :
:
𝑌 , :𝑌 : 𝑌 , :𝑌 𝑌 , :𝑌 :
:
𝑌 , :𝑌 : 𝑌 , :𝑌 :
𝑌, :𝑌 : 𝑌 , :𝑌 𝑌 , :𝑌
: : 𝑌 , :𝑌 :
𝑌 , :𝑌 :
𝑌, :𝑌 : 𝑌 , :𝑌
𝑌 , :𝑌 : :
𝑌 , :𝑌 :
𝑌, :𝑌 :
−10 −9 −8 −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 8 9 10 Quarters
Relative to Peak
12
Burns-Mitchell Diagrams for Germany and the U.S.

Real GDP, Germany Real GDP, U.S.
(Quarterly Data, 1970:Q1 to 2020:Q2) (Quarterly Data, 1970:Q1 to 2020:Q2)
Source of Data: Federal Reserve Bank of St. Louis (2020)
13
Let us turn next to the Burns-Mitchell diagrams that measure the co-
movement of output with other key macroeconomic and financial variables
over the course of the business cycle.
Illustrating the conceptual issues involved in constructing these diagrams for

the example considered above, for which two business cycle episodes were
identified for a sample from 2011:Q1 to 2019:Q4 (denoting (the logarithm of)
consumption in episode i, i = 1, 2, and, within each episode, s periods apart
from the output-based peak (s = −10, − 9, ..., − 1, 0, 1, ..., 10) as Ci,s ):
14
Consumption
𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 :
, 𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 :
𝐶 , :𝐶 :
𝐶 , :𝐶 :
𝐶 , :𝐶 :
𝐶 , :𝐶 :
𝐶 :𝐶 𝐶 , :𝐶 :
, : 𝐶 , :𝐶 :
𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 :𝐶 𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 :𝐶
, : 𝐶 , :𝐶 :
, :
𝐶, :𝐶 𝐶 , :𝐶 :
: 𝐶 , :𝐶 :
𝐶 :𝐶 𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 :
, :
𝐶 , :𝐶 : 𝐶 , :𝐶 :
𝐶 , :𝐶 :
−10 −9 −8 −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 8 9 10 Quarters
Output-Based Relative to Peak
Peak 15
In terms of algebraic representation, constructing the Burns-Mitchell diagrams for

the key variables other than output involves the following steps (denoting the
series in question as Xi,s , measured again in logarithms, unless representing a
rate):
- Considering X i ,10 , X i ,9 ,  , X i ,0 , X i ,1 ,  , X i ,10 , i  1, 2, ..., M ,

quarter of business
cycle peak
with M again denoting the number of business cycle episodes in the sample,
- calculating
1 M
Xs    X i,s , s  10,  9,  , 10,
M i 1
(period s average of Xi,s across the M business cycle epsiodes), and
1 1 M 10
X    X i ,t ,
M 21 i 1 s 10
(grand average of Xi,s across all M ∙ 21 periods considered),

and
16
- plotting
X s  X   100%, if series is measured in logarithms,

s  10,  9,  , 10.
X s  X  / X  100%, otherwise,
Some further terminology that will prove useful for the resultant Burns-Mitchell
diagrams:
• A variable is called pro-cyclical if its business cycle dynamics is positively
correlated with that of output.
• A variable is called counter-cyclical if its business cycle dynamics is
negatively correlated with that of output.
• A variable is termed to be leading if its turning points (peak and trough)
occur prior to the turning points of output.
• A variable is termed to be lagging if its turning points (peak and trough)
occur after the turning points of output.
17
Real Consumption, Germany Real Consumption, U.S.

18

Real Investment, Germany Real Investment, U.S.
19

Unemployment, Germany Unemployment, U.S.
20

Nominal (3 Months) Nominal (3 Months)
Interest Rate, Germany Interest Rate, U.S.
21
Inflation, Germany Inflation, U.S.

22
Key Business Cycle Regularities Revealed

by Burns-Mitchell Diagrams:
• average output loss from peak to trough: about 1% to 2%;

• average duration of business cycle: two to four quarters (output), but six
to ten quarters for investment and unemployment;
• consumption and investment are pro-cyclical, with investment notably

more volatile than output, and consumption notably less volatile than
output;
• unemployment is counter-cyclical;
• (short-term) nominal interest rates are pro-cyclical (possibly leading);
• rate of inflation pro-cyclical (with high volatility prior to the peak).
23
Strategy to Develop Models of Business Cycles
From the Burns-Mitchell diagrams, we have learned that business cycles

involve the systematic co-movement of core macroeconomic aggregates such
as output, consumption, investment, (un-) employment and inflation, but also
the systematic co-movement between these macroeconomic aggregates and
financial market variables (such as interest rates).
Satisfactory models of business cycles will therefore need to capture both the
"real sector" of the economy (the interaction between the aggregated
demand for goods and services from households, firms, government
institutions and foreign entities with the production of the goods and
services), and the "financial sector" of the economy (capturing how interest
rates are set through the interaction between savers, borrowers, the central
bank and commercial banks).
24
Developing a model of business cycles will require us to consider the decision

makers who contribute to the determination of the key variables in the real
and financial sectors. We will therefore
• analyze the spending decisions of households, firms, government
institutions as well as foreign entities, and
• study how financial market participants, specifically the central bank and
commercial banks, intermediate and propagate these decisions.
Our models of business cycles will consider business cycles as being initiated
by exogenous shocks to components of aggregate demand (such as shocks to
the foreign demand for domestically produced goods and services), to financial
market variables (such as shocks to risk premia on bonds), or to monetary/
fiscal policy rules: "impulses".
These impulses will then be propagated through mechanisms such as feedback

loops between aggregate demand and output produced/income generated,
and adjustments of aggregate demand due to endogenous changes in financial
market conditions: "propagation mechanisms".
25
We will begin with a short-run model of business cycles. The short run is
implicitly defined as that time period during which firms' output supply by
assumption responds one-to-one to changes in aggregate demand, with prices
being constant ("fixed").
This assumption of fixed prices is a simplifying assumption that we will lift when
later turning to a medium-run model of business cycles.
It is worth noting that empirical evidence suggests that for a period of a few
quarters:
(i) changes in aggregate demand are typically limited in size (and thus firms
can accommodate these changes through changes only in quantities
produced), and
(ii) prices respond little to shocks to aggregate demand (outside of episodes of
(close to) hyperinflation).
Thus, the short run can also be described as a period of a few quarters.
26
2. The Real Sector: Aggregate Demand and the IS-Curve
2. The Real Sector: Aggregate Demand and the IS-Curve

Readings:
- Burda and Wyplosz (2017), Chapters 6 to 8 and 15
- Challe (2019), Chapter 2
- Jones (2020), Chapters 11, 16, 17 and 20
We begin by modelling the real sector of the economy, analyzing the individual
expenditure decisions of households, firms government institutions as well as
foreign entities, and then aggregating these so as to characterize the
determinants of the four main components of aggregate demand. From the
expenditure approach of the macroeconomic accounts, we know that these four
components are
• consumption (C),
• investment (I),
• government expenditure (G), and the
• trade balance (TB).
27
Macroeconomics 1 (BMAK) 2. The Real Sector: Aggregate Demand and the IS-Curve
Wintersemester 2020/21 Aggregate Consumption
a. Aggregate Consumption
Using the same notation as in our discussion of the macroeconomic accounts,

as the baseline case for the aggregate consumption function, we will
derive in this sub-section the function
C  C( Y T , r , other factors ) , (1)

 
private sector income, in what interest rate
follows called "available income"
(setting for simplification
BPI  BSI  GT  0 )
with C /  Y  T   0 (but less than one), and C / r  0 (but small in

absolute terms).
To denote the same facts using more compact notation, we will use
C  C ( Y
T , r , other factors ). (2)
()
+
28
For the quantitative analysis of business cycles, we will require a specific

functional form for the aggregate consumption function. We will then use
the linear functional form
C C0  Cy   Y  T   Cr  r , (3)
 
  
intercept capturing all factors C y  (0,1) Cr  0
other than Y , T and r
with the parameters C0 , Cy , and Cr . Considering linear functional forms

generally considerably simplifies the algebra when carrying out quantitative
analysis.
How can the aggregate consumption functions in Equations (1) to (3) be

rationalized as representing household consumption decisions?
When faced with income fluctuations, households for whom the marginal
utility from consumption is diminishing wish to smooth their
consumption across time periods.
29
To see this, consider for simplicity a household living for two periods, which
we label the current and the future periods.
The household at the beginning of the current period determines its desired
levels of consumption by maximizing utility derived from current consumption
and discounted utility derived from future consumption:
 1 
max V  u  Ccurrent  +    u  C future  , (4)
Ccurrent , C future
 1  
where
• V denotes lifetime utility,
• u(∙) denotes period-by-period instantaneous utility, and
• ρ denotes the parameter measuring how much the household discounts
utility from consumption in the future period relative to utility from
consumption in the current period,
and with the utility maximization being subject to the budget constraints:
30
Ccurrent  1  r   Wbeginning of current period  Ycurrent  Tcurrent   

Wend of current period ,
 
initial wealth at beginning of current available income wealth set aside at end
current period, plus interest earned on (other than current interest income) of current period for
it during current period future consumption
(5)
with W denoting real wealth, and
C future   Y T 

future future  
1  r   Wend of current period
 
. (6)
future available income initial wealth at end of currrent
(other than future interest income) period, plus interest earned on
it during future period
The period-by-period budget constraints in (5) and (6) can be combined into a
single lifetime budget constraint: substituting Wend of current period from (6) into (5),
we obtain
Cfuture Yfuture  Tfuture
Ccurrent +  1 r  Wbeginning of current period  Ycurrent Tcurrent   .
 1 r   1 r 
PVC (present discounted PVR (present discounted value of resources)
value of consumption)
(7)
31
Solving the lifetime budget constraint (7) for C future , we obtain
Cfuture  1 r    PVR  Ccurrent  . (8)
Using Equation (8), we can re-write the household optimization problem (4) in
unconstrained form as
 1 
max V  u  Ccurrent  +    u 1  r    PVR  Ccurrent   , (9)
Ccurrent
1  
which in turn implies the first-order condition
V  1 r 
 u '  Ccurrent    ' 1  r    PVR  Ccurrent    0
  u
 Ccurrent  1  
 u '  C future 
32
 1 r 
 u '  Ccurrent  =    u '  C future 
 1  
(describing that the household at the optimum is indifferent between one more
unit of current consumption, and saving that unit and using the proceeds to
increase future consumption, a so-called Euler equation)
u '  Ccurrent  1 r (10)

 = .
u '  C future  1 
Note that the first-order condition (10) under a diminishing marginal utility from
consumption (that is, monotonically decreasing function u '(∙)) implies a fixed
ratio between current and future consumption that is independent of
current and future available income.
33
As an example, consider the instantaneous utility function

u  C  = log  C  , (11)
with
1 1
u 'C  = and u ''  C  =  2  0 , (12)
C C
and so marginal utility from consumption is diminishing. Substituting from (12)
into (10), we obtain
u '  Ccurrent  C future 1 r
= =
u '  C future  Ccurrent 1 
Ccurrent 1 
 = . (13)
C future 1 r
The ratio between current and future consumption is independent of current

and future available income (it increases with the rate of discounting, ρ, and
decreases with the return on saving, the interest rate r).
34
How then do households adjust consumption to changes in their available

income?
Suppose there is a one-time (that is, temporary) increase of Ycurrent  Tcurrent (note
that as business cycles are defined as cyclical deviations from the long-run growth
path of income, changes in available income that are part of business cycles are
temporary).
From Equation (10), the household will want to

• increase both current and future consumption (to maintain a fixed ratio
between current and future consumption),
and thus
• increase current consumption by less than the unit increase of Ycurrent  Tcurrent :
the marginal propensity to consume (MPC), Ccurrent /  Ycurrent  Tcurrent   Cy ,
must be positive but less than one.
35
The exact magnitude of the MPC will depend on a range of factors, including
the possible presence of
• credit constraints (when current available income is falling, can the
household borrow against his/her future available income to fund the
smoothing of current consumption?)
• uncertainty about future available income (which can cause additional
"saving for a rainy day"), and
• bounded rationality (households being short-sighted).
We will therefore leave it to empirical evidence to pin down the exact
magnitude of the MPC.
36
Let us ask next how households adjust consumption to changes in the

interest rate.
Suppose that there is an increase of the interest rate, r : This leads to both
- a substitution effect (making current consumption less attractive as
compared to future consumption, as the latter takes advantage of higher
returns on savings), and
- an income effect:
-- households who before the increase in the interest rate had positive
savings ("creditors") now have more income available (and thus can
increase current and future consumption), whereas
-- households that before the increase in the interest rate had negative
savings ("debtors") now have less income available (and thus have to
decrease current and future consumption).
• For creditors, then, the overall effect of an increase in the interest rate on
current consumption is ambiguous in sign (depending on the relative
strengths of the income and substitution effects).
37
• For debtors the overall effect of an increase in the interest rate on

current consumption is negative in sign (both the substitution and the
income effect are negative in sign).
• In the macroeconomy, that features both creditors and debtors, the

aggregate effect of an increase in the interest rate on consumption is
thus an empirical matter.
• The empirical evidence suggests that following an increase in the

interest rate, there is a small decrease of aggregate consumption in
the macroeconomy.
38
To summarize: We have provided a theoretical rationale for the consumption

function in (1),
C  C( Y T , r , other factors ) ,
  
available income interest rate
with C /  Y  T   0 (but less than one), and C / r  0 (but small in

absolute terms).
We have also seen that the "other factors" influencing (current) consumption
include variables such as households' wealth and their future available income.
39
Wintersemester 2020/21 Aggregate Investment
b. Aggregate Investment
Recall once more that "investment" in the macroeconomic accounts

concerns neither investment in financial assets nor investment in human
capital, but rather accumulation of physical capital, including purchases
of structures and equipment by firms, to be used for the production of goods
and services.
As the baseline case for the aggregate investment function, we will
I  I (
r , other factors ) . (14)
()
Thus I / r  0 , with this effect in absolute value being empirically rather

large: ceteris paribus, investment is highly sensitive to changes in the rate of
interest and thus rather volatile over the course of the business cycle.
40
For the quantitative analysis of business cycles, we will typically specialize the
aggregate investment function to
I  I0  Ir  r, (15)

 
intercept capturing all factors >0
other than r
with the parameters I0 and Ir .

How can the aggregate investment functions in Equations (14) and (15) be
rationalized as representing the investment decisions of firms?
Consider a two-period model, the two periods denoted as t and t+1, in which
a profit-maximizing firm determines its optimal level of investment in period t.
Investment in period t increases the period t+1 stock of physical capital, in
line with our specification in Chapter II. (see Equation (12) there):
K t 1  1     K t  I t .
At it is a two-period model, at the end of period t+1 the firm sells that portion
of the stock of physical capital that remains after depreciation.
41
Each period, the firm produces output according to the production function
Yt  F ( At , K t , Lt ). (16)
     
output level of stock of labor
technology physical capital
To keep notation as simple as possible, we also assume that the prices of

- one unit of physical capital, and of
- one unit of output
both in periods t and t+1 are equal to one.
The firm then aims to
42
 
 1   
max F ( At , Kt , Lt )      F ( At 1, Kt 1, Lt 1 ) 

1    Kt 1
 

It
  r   
1 
 stock of physical capital that remains 
period t value of one  after production in period t 1 
additional unit of period
t 1 revenue
 
period t value of revenue earned in periods t and t 1
 Wt   1   Wt 1 
 [ Kt  It     Lt      Lt 1 ] , (17)
Pt   1 r   Pt 1 
period t
real wage

period t value of cost of factors of production in periods t and t1
which in turn implies the first-order condition
43
 
 1   F ( At 1 , Kt 1 , Lt 1 ) Kt 1 Kt 1  It
       
1       0,
 1  r   

Kt 1
 
It
 
I t  I t

 

 
 MPKt 1 1 1  1

=MC
 MR
or, equivalently, that the firm will invest. as long as
MPK t 1  1  
MR   1  MC
1 r
MR MPK  1   (18)
  Tobin's q =  1.
MC 1 r
How then do firms adjust investment to changes in the interest rate?
44
  MPK  1     1  r  
1
 Tobin's q   =  MPK  1    0.
= 
r r 1  r 
2
I (19)
  0.
r
Economic reasoning:
• As r is rising, the revenue stream resulting from investment in physical

capital (that only accrues in the future) must be discounted at a higher
rate. For a given cost of investment in physical capital this makes
investment in physical capital less attractive.
45
The following alternative forms of intuitive economic reasoning could also

be used:
• An increase in r increases the opportunity cost of purchasing physical

capital: purchasing bonds (or other financial instruments yielding a rate
of return r) now yields a higher rate of return, and thus investment in
physical capital becomes less attractive.
• As r is rising, firms that are borrowing to purchase additional physical

capital face higher costs of borrowing, rendering investment in physical
capital less attractive.
46
Empirically, for publicly traded firms Tobin's q is often measured as
market value of firm's capital

Tobin's q  .
replacement cost of firm's capital
If the firm's market value is assessed by financial markets and expectations

formed in financial markets are fickle and volatile, then investment in
physical capital will be volatile over the course of the business cycle.
The magnitude of the sensitivity of investment to the interest rate will

depend on a range of factors, including the possible presence of
-- credit constraints (when the interest rate is falling, can the firm borrow
against its future revenue to fund current investment expenditure?), and
-- uncertainty about future revenue (which can create an incentive to wait
with investment decisions until more information arrives).
47
To summarize: We have provided a theoretical rationale for the investment

function in (14),
I  I (
r , other factors ) ,
()
and have provided reasoning why investment is rather volatile over the
course of the business cycle.
We have also seen that the "other factors" influencing (current) investment
include firms' production technology and the rate of depreciation of physical
capital.
48
Wintersemester 2020/21 Aggregate Government Expenditure
c. Aggregate Government Expenditure
Governments can generally be expected to be influenced by the

political process as well as economic considerations.
Political process:
• Interest groups (within and outside government) may compete and
induce the government to "overspend" when the macroeconomy is
expanding, leaving government with drained resources in times of
recession.
Economic considerations:
• Beyond stimulating aggregate demand in times of recession and saving
up in times of expansion ("countercyclical spending"), the idea of
constraining government spending through "fiscal rules" is to ensure
debt sustainability, for example by specifying limits for the level of public
debt (relative to GDP).
49
A baseline aggregate government expenditure function emphasizing

economic considerations is given by
G  G( 
Y  Y , D , other factors ). (20)

 
long-run government
output debt


 


(negative of)   
output gap

  
For the quantitative analysis of business cycles, for simplification we will

typically specialize the aggregate government expenditure function to
explicitly reflect only countercyclical spending:
G G0  Gy  ( Y  Y ) , (21)
 
intercept capturing all factors 0
other than Y Y
with the parameters G0 and Gy .

50
Our discussion suggests that G0 reflects factors such as the political situation
and the level of government debt. Also, it should be noted that Gy empirically
tends to be rather small.
It is important to note that governments may affect output not only directly by
controlling G, but also indirectly by influencing C, I and TB, through changes
in taxes, transfers and/or expenditure. Fiscal policy is the use of government
spending and revenue to influence aggregate economic activity, specifically
output and employment.
Fiscal policy that increases aggregate demand through an increase in

government spending is called expansionary. By contrast, fiscal policy is
called contractionary if it reduces aggregate demand.
51
Fiscal policy may affect aggregate demand because of pro-active changes

initiated by policymakers, but may also do so even in the absence of such pro-
active changes:
A fiscal stimulus entails new discretionary spending or tax cuts (and is thus
induced pro-actively).
Also part of fiscal policy are the so-called automatic stabilizers: Government
tax revenue and expenditure may change without specific action by
policymakers. For example, as output falls, for given tax rates less tax revenue is
being collected, as corporate profits and households' incomes fall. As another
example, government transfers by design often rise automatically during a
business cycle contraction.
52
Fiscal Policy: Government Expenditure

(Percent of GDP, 2000 to 2021)
Germany U.S.
Source of Data: IMF (2020; Values for 2020 and 2021: IMF Projections)
53
Fiscal Policy: Government Revenue

Germany U.S.
54
Fiscal Policy: Government Primary Net Lending/Borrowing

Germany U.S.
55
Wintersemester 2020/21 Aggregate Trade Balance
d. Aggregate Trade Balance

Let us turn to the fourth main component of aggregate demand, the
aggregate trade balance (that is, exports minus imports).
As the baseline case for the aggregate trade balance function, we will
 , other factors ) ,
TB  TB ( Y  T , Y *  T * ,  (22)
   
() (+) (+ )
where
  ( r * , other factors ),
r , (23)
   ()
with starred variables denoting the foreign equivalents of the corresponding

domestic variables, and ε denoting the (effective real) exchange rate. As we
will elaborate upon in this sub-section, a numerical increase of this exchange
rate decreases the price of domestically produced goods and services relative
to that of foreign produced goods and services, which in turn increases
exports and decreases imports.
56
For the quantitative analysis of business cycles, we will typically specialize the
aggregate trade balance and the exchange rate functions (22) and (23) to
TB  TB0  TBex  ( Y *  T * )  TBim  (Y  T )  TB   ,

   
intercept capturing all 0 0 0
factors other than
Y T * , Y T , and 
*
(24)
where
  0
  r  (r  r * ) , (25)
 
other than r and r *
with the parameters TB0 , TBex , TBim , TBε , ε0 , and εr .
57
How can the aggregate trade balance and exchange rate functions in Equations
(22) to (25) be rationalized?
Consider to this purpose first the determination of imports:
• Gross national expenditure (GNE = C + I + G) includes spending both on

domestically and foreign produced goods and services. It is sensible to expect
that as gross national expenditure increases, so will total imports.
• From our previous discussion, gross national expenditure
-- increases with income: from Equations (3), (15) and (21),
 GNE
 C y  Gy  0, (26)
 Y  T    
empirical evidence
-- decreases with the rate of interest: from Equations (3), (15) and (21),
 GNE
  Cr  I r  0. (27)
r
58
• The fraction of gross national expenditure on imported (rather than

domestically produced) goods and services primarily depends on the
relative price of domestically produced goods and services to
that of foreign produced goods and services, as measured by the
effective real exchange rate, ε .
To appreciate the notion of the effective real exchange rate, let us back up
a little, and carefully note a few definitions concerning exchange rates:
59
The bilateral nominal exchange rate measures the rate at which the
currencies of the domestic economy, i , and the foreign economy, j , can be
exchanged for one another:
units of domestic currency
eij  . (28)
one unit of foreign currency
Note: This is the so-called price quotation (which is in line with the
quotation of the price for most goods, services and assets, that is, price (in
units of domestic currency) per one unit purchased).
Example: Euro Area vs. United States (€/$)

e€/$   depreciation of the Euro against the U.S. Dollar
(more Euro needed to purchase one U.S. Dollar);
e€/$   appreciation of the Euro against the U.S. Dollar
(fewer Euro needed to purchase one U.S. Dollar).
60
The bilateral real exchange rate measures the rate at which the goods and
services of the domestic economy, i , and the foreign economy, j , can be
exchanged for one another:
eij  Pj (29)
 ij  ,
Pi
with Pi ( Pj ) denoting the domestic (foreign) price level, in domestic (foreign)
currency units.
Interpreting changes of the bilateral real exchange rate:
εij   fall in price of domestically relative to foreign produced goods and
services (when expressed in the same currency): competitiveness of
domestic economy, i, improving (relative to the foreign economy, j).
εij   rise in price of domestically relative to foreign produced goods and

services (when expressed in the same currency): competitiveness of
domestic economy, i, deteriorating (relative to the foreign economy, j).
61
Finally, the effective real exchange rate of the domestic economy, i , is

measured by the trade-weighted weighted average of the bilateral real
exchange rates between the domestic economy and all the foreign
economies, j = 1, 2, … , N , it does trade with:
N
 i    j   ij , (30)
j 1
with the weights satisfying the following condition:

N
  j  1. (31)
j 1
In what follows, we will not require the i subscript on εi , and will drop this
subscript.
62
Real External Value of the Euro

(Multilateral Index Involving 42 Foreign Economies)
Source of Data: European Central Bank (2020)
63
Wintersemester 2020/21 Aggregate Trade Balance – Exchange Rate Determination
To complete our discussion of the determination of imports, we will next use

the so-called interest parity relationship to understand the determination
of ε .
In discussing exchange rate determination, we will presume that exchange
rates are market-determined (that is, "flexible/floating"), and that there are
no restrictions to the cross-border flows of financial capital.
To determine the real exchange rate, consider the following financial
investment decision problem: A domestic financial investor seeks to
determine at the beginning of period t the optimal portofolio when having
the option to invest in either one of the following two assets:
• a (risk-free) domestic-currency-denominated government bond with
maturity one period,
• or a (risk-free) foreign-currency-denominated government bond, also with
maturity one period.
64
To keep notation as simple as possible, we also assume that it costs

- one unit of domestic currency to purchase one unit of the domestic-
currency-denominated government bond, and
- one unit of foreign currency to purchase one unit of the foreign-currency-
denominated government bond.
The domestic financial investor then aims to
max*
Bt , Bt
1

 rt   Bt
 
 1 r   B

t

* *
t 
t
1

 ,
one-period return (in domestic one-period return (in foreign domestic currency value of one unit
currency) from domestic-currency bond currency) from foreign-currency bond of foreign currency in period t 1
subject to the budget constraint:
Bt  t  Bt*  FWt ,


 
domestic currency value of one unit funds of financial investor
of foreign currency in period t (in domestic currency)
or
 FWt  Bt 
max 1  rt   Bt  1  rt    *
   t 1. (32)
Bt
 t 
65
The optimization problem in (32) implies the first-order condition
 1 
1  rt  (1  rt )       t 1  0
*
 t 
1
 1  rt   (1  rt* )   t 1 ,
t
 
interest parity relationship
 1  rt*  (33)
 t =     t 1 .
 1  rt 
Equation (33) suggests that exchange rates are driven by domestic relative
to foreign interest rates. However, we cannot pin down εt from (33) as εt+1
is also unknown. Further analysis is thus needed to determine how εt
responds to a change in rt relative to rt* .
66
To this purpose, note that interest parity in period t + 1 implies that

 1  rt*1 
 t 1 =     t 2 . (34)
 1  rt 1 
Substituting from (34) back into (33), we obtain:
 1  rt*   1  rt*1 
t =        t 2 . (35)
 1  rt   1  rt 1 
Using next interest parity in period t + 2 ,
 1  rt* 2 
 t 2 =     t 3 . (36)
 1  rt  2 
Upon substituting from (36) back into (35), we obtain:
 1  rt*   1  rt*1   1  rt* 2 
t =           t 3
 1  rt   1  rt 1   1  rt  2 
 2  1  rt* s  
=       t 3 . (37)
 s 0  1  rt  s   67
Repeating these steps to account for interest parity also in periods t + 3 , t + 4 ,

…, t + n , we eventually obtain
 n  1  rt* s 
 t =       t  n 1 . (38)
 s 0  1  rt  s 
• Note that for large values of n,  t  nmeasures
1 the long-term ahead value of
the real exchange rate.
• From empirical investigations, we know that in the long run exchange rates
tend to be driven by purchasing power parity: the nominal exchange
rate adapts to ensure that when foreign prices are expressed in domestic
currency units, they are equal to domestic prices, that is,
P*  e = P , (39)
and thus,
  e  P* / P  1 , (40)
stating that in the long run the real exchange rate is constant and equal to
one.
68
• Substituting the result in (40), that the long-term ahead value of the real
exchange rate is expected to be unity, into (38), we obtain (for large values
of n)
 n  1  rt* s    1  rt*   n  1  rt* s  
 t =           . (41)
 s 0  1  rt  s    1  rt   s 1  1  rt  s  
• We thus have the following interest parity implication: If (starting from

an initial interest parity relation) the period t domestic interest rate
increases, then in period t the domestic currency appreciates against the
foreign currency:
2
 t  1   n  1  rt* s 
    1  rt      0 . (42)
*

rt  1  rt   s 1  1  rt  s 
69
Economic reasoning for this interest parity implication:
As the period t interest rate on domestic-currency bonds of maturity one

period increases (decreases) (relative to the counterpart interest rate on
foreign-currency bonds of maturity one period, and holding constant future
interest rates on domestic- and foreign-currency bonds), then
-- the demand for domestic-currency bonds increases (decreases),
-- leading on the foreign exchange market to an increase (a decrease) of
supply of foreign currency and an increase (a decrease) of demand for
domestic currency, and
-- the current value of the domestic currency appreciates (depreciates).
70
To summarize our discussion of exchange rate determination:

We have provided a theoretical rationale for the exchange rate function in
(23),
  ( r * , other factors ).
r ,
   ()
We have also seen that the "other factors" influencing the current value of
the exchange rate include future interest rates and the relative risk of
domestic- versus foreign-currency bonds.
For the quantitative analysis of business cycles, we will typically specialize
the exchange rate function in (23) to (25),
  0
  r  (r  r * ) .
 
other than r and r *
We will leave it to empirical evidence to pin down the exact magnitudes of

the parameters ε0 and εr .
71
We can now return to considering the determination of imports. Piecing

together our arguments that the value of imports should depend on
(i) gross national expenditure, with the latter in turn increasing with domestic
disposable income (Y−T) and decreasing with the domestic rate of interest
(r), as well as
(ii) the real exchange rate (    ( r , r * , other factors ) ),
we have the following aggregate import function:
IM  IM GNE Y  T , r , other factors  ,  ( r , r * , other factors)  . (43)

Note that
IM IM  GNE IM 
    . (44)
r  GNE 
 r 
 r
 r
0 <0

< 0  <0

imports becoming more from (25)
  
from (27)
expensive for domestic
0 economy as domestic
currency depreciates

0
72
Based on empirical evidence, we henceforth assume

IM (45)
 0,
r
and can thus write the aggregate import function as
IM  IM ( 
 
Y  , other factors ) ,
T ,  (46)
(+)   
where
  ( r * , other factors ) ,

r ,
   ()
73
Moving to exports, as they are the imports of the rest of the world, they
are driven by the same set of factors as the domestic imports, but from the
foreign perspective. We thus have the aggregate export function:
EX  EX ( Y *  T * ,  , other factors ) , (47)


 
   +

exports of domestic economy
becoming less expensive for
rest of the world as domestic
currency depreciates
where
  ( r * , other factors ) .

r ,
   ()
74
Combining the aggregate import and export functions in (46) and (47), we
obtain the aggregate trade balance function specified in (22) and (23),
 , other factors )
TB  EX ( Y *  T * , 

 
   +
 IM ( 
   , other factors )
T , 
Y
(+)   
 , other factors ) ,
 TB ( Y  T , Y *  T * , 
   
      (+ )
where
  ( r * , other factors ) .
r ,
   ()
75
To summarize: We have provided a theoretical rationale for the aggregate

trade balance function in (22) and (23).
We have also seen that the "other factors" influencing the aggregate trade
balance include
• all "other factors" affecting gross national expenditure (such as
households' wealth and their future disposable incomes, firms' production
technology and the rate of depreciation of physical capital, as well as the
political situation and the level of government debt), and
• all "other factors" influencing the current value of the exchange rate
(such as future interest rates and the relative risk of domestic- versus
foreign-currency bonds).
76
Wintersemester 2020/21 The IS-Curve
e. The IS-Curve
The IS-curve ("IS " denoting investment equal to saving) renders for all
possible levels of the interest rate the level of output at which output
supply is equal to aggregate demand.
The IS-curve together with a relationship determining the interest rate,

inter alia as a function of the level of output (this relationship will come
from the financial sector), will later allow us to obtain the overall short-run
macroeconomic outcomes for output, the interest rate, the components of
aggregate demand and the exchange rate.
Let us derive and analyze the IS-curve.
77
Setting output produced equal to desired aggregate demand, we have:
Y  DD
 
output desired
produced aggregate
demand
 C0  C y  (Y  T )  Cr  r
 
 C , from (3)
(48)
 I0  Ir  r
 
 I , from (15)
 G0  G y  ( Y  Y )

 G , from (21)
 TB0  TBex  ( Y *  T * )  TBim  (Y  T )  TB   0   r   r  r *   .

  
  =  , from (25) 
 TB , from (24)
78
Note that in (48), the endogenous variables (determined model-internally

as functions of the exogenous variables and the model parameters) are:
- Y (to be determined such that output supply is equal to desired
aggregate demand),
- r (variable that from the Burns-Mitchell diagrams systematically co-varies
with output − and thus must be endogenous, too),
- C, I, G, TB, ε (variables that depend on Y and/or r).
The variables that we will keep as exogenous (being determined outside the
* * *
model), are: T , Y , Y , T , r . We thus
- specify the domestic tax revenue (T ) as "lump-sum" (that is, as fixed,
independent of the level of income),
- consider potential output ( Y ) as not affected by short-run macro-
economic outcomes, and
- abstract from influences of the domestic economy on foreign variables
(Y*, T*, r*): we think of the domestic economy as being "small" relative
to the rest of the world economy.
79
To move towards solving for the endogenous variables, let us split desired
aggregate demand into three sub-components:
- a component that is exogenous (also called "autonomous"),
- a component that is income-sensitive, and
- a component that is interest-rate-sensitive:
Y  DD
 C0  I 0  G0  TB0  TB   0  (C y  TBim )  T  G y  Y  TBex  ( Y *  T * )  TB   r  r *

A (autonomous component of desired aggregate demand)
  Cr  I
 r  TB   r   r
 
 (C y  TBim  G y )  Y ,
 
(49)
interest rate-sensitive component income-sensitive component
of desired aggregate demand of desired aggregate demand
80
Solving (49) for Y, we have
1  (C y  TBim  G y )   Y  A   Cr  I r  TB   r   r , (50)
and thus
A Cr  I r  TB   r
Y   r , (51)
1  (C y  TBim  G y ) 1  (C y  TBim  G y )
   
 IS0  IS1
The relationship in Equation (51) is called the IS-curve. Graphically, the

convention is to plot the IS-curve in a graph with r on the vertical axis and
Y on the horizontal axis. We thus re-arrange (51) as follows:
Y  IS0  IS1  r ,
 IS1  r  IS0  Y ,
IS0 1 A 1  (C y  TBim  G y )
 r  Y    Y . (52)
IS1 IS1 Cr  I r  TB   r Cr  I r  TB   r
   
 IS0r  IS1r 81
This yields the following graph of the IS-curve:

r
IS
IS  curve : r  IS0r  IS1r  Y
A 1  (C y  TBim  G y )
  Y .
Cr  I r  TB   r Cr  I r  TB   r
0 Y
82
What happens off the IS-curve? Output supply is not equal to desired
aggregate demand:
r
Point B: for a given interest rate, r, the
IS
level of output produced, Y, has to fall to
reach the IS-curve. This occurs as at
Point B the firms would produce too
much given the demand for their output.
A B
Point A: for a given interest rate, r, the
level of output produced, Y, has to
increase to reach the IS-curve. This
occurs as at Point A the firms would
produce too little to meet the demand for
their output.
0 Y
83
Workbook for the IS-Curve

The workbook IS-Curve.xlsm allows to study all the determinants of the
position and slope of the IS-curve.
IS‐Curve: Specification IS‐Curve: Graph
Parameters
IS‐Curve
Initial New 0.20
Cr 4.000 4.000 0.18

Ir 16.000 16.000 0.16
TB  1.000 1.000 0.14
r 6.000 6.000
0.12
Cy 0.600 0.600
0.10
TB im 0.050 0.050
Gy 0.150 0.150 Intereste Rate 0.08
A 9.780 9.980 0.06

C0 1.500 1.500 0.04
I0 3.000 3.000
0.02
G0 2.800 3.000
0.00
TB 0 0.000 0.000 9 10 11 12 13 14 15 16 17 18
0 1.000 1.000 ‐0.02
T 3.000 3.000 ‐0.04
TB ex 0.010 0.010 ‐0.06

Y* 100.000 100.000 ‐0.08
T* 30.000 30.000
‐0.10
r* 0.030 0.030 Output
Y 15.000 15.000
84
The IS-curve suggests two main sources of changes in short-run output:

- changes in the autonomous component of aggregate demand, A,
- changes in the interest rate, r.
Let us first turn to discussing changes in the autonomous component of

aggregate demand, A:
Suppose there is an increase in A by ∆G0 , that is, government expenditure is

rising exogenously by ∆G0.
Note from the IS-curve (51) that
Y 1
 G0   G0 . (53)
A 1  (C y  TBim  G y )
85
Note that C y  TBim  G y  (0,1) , as

• the marginal propensity to consume, Cy , is less than one
• the demand for imported consumption goods and services following an
increase in disposable income rises only by a fraction of the overall increase
in consumption expenditure (that is, some of the increase in the demand
for consumption goods and services will be on domestically produced
consumption goods and services, C y  TBim  0 );
• Gy empirically tends to be rather small.
It follows that
1
KM  . (54)
1  (C y  TBim  G y )

 (0,1)
 
>1
Keynesian multiplier
86
To understand this Keynesian multiplier, note that an increase in A by ∆G0 has

the following effects:
• From (48), output immediately increases by ∆G0 ("first-round increase": as

prices are fixed in the short run, firms increase production one-to-one with
the initial increase in desired aggregate demand).
• But if Y increases by ∆ G0, then desired aggregate demand from (49) in

turn further increases by (Cy – TBim – Gy) ꞏ ∆ G0. This in turn implies a
further ("second-round") increase of Y by (Cy – TBim – Gy) ꞏ ∆ G0 (from
(48), firms increasing production one-to-one with the further increase in
desired aggregate demand).
87
• The second-round increase of Y leads to another increase of desired

aggregate demand, from (49) by the magnitude of
(C y  TBim  G y )  (C y  TBim  G y ) ꞏ G0  (C y  TBim  G y ) 2  G0 .

  
second-round effect
Thus, from (48), firms increase production one-to-one with this further
increase in desired aggregate demand, and there is a "third-round"
increase of Y by
(Cy – TBim – Gy)2 ꞏ ∆G0 .
• ... and so forth ...
88
The total increase in Y following the increase of G0 by ∆G0 is therefore given

by
Y  G0  (C y  TBim  G y ) ꞏ G0  (C y  TBim  G y ) 2 ꞏ G0

       
first-round effect second-round effect third-round effect
 (C y  TBim  G y )3 ꞏ G0  
  
fourth-round effect
  1
   (C y  TBim  G y )t  ꞏ G0   G0 , (55)
 t 0  1  (C y – TBim – G y )
1
with being the Keynesian multiplier in Equation (54).
1  (C y – TBim – G y )
89
Graphically, we can depict the effects of an increase in A by ∆G0 as follows:
r
IS '
IS
G0
r 
Y 'Y  1  G0
1(C y –TBim – Gy )
0 Y Y' Y
90
To complete discussion of the IS-curve, let us turn to examining how

changes in the interest rate affect output. (Note that unlike the
autonomous component of aggregate demand, A, which is exogenous, the
interest rate, r, is endogenous. We postpone discussion as to how changes
in r can arise due to monetary policy decisions to the next section. For
now, our interest is only in how a given change in r affects Y.)
Graphically, the output effects of changes in r clearly are captured through

movements along the IS-curve. Analytically, from the IS-curve (51) it
follows that
Y   Cr  I r  TB   r 
 r   r . (56)
r 1  (C y  TBim  G y )
Let us first turn to the numerator on the right-hand side of (56):
91
This numerator (in  Cr  Ir ) captures that as the interest rate, r, increases,

consumption and investment expenditures decrease, reflecting the higher
cost of borrowing ("consumption and investment channels" of the
response of output to changes in the interest rate).
This numerator also captures (in TB   r ) that as the interest rate, r,
increases, we also observe an appreciation of the current value of the
domestic currency, which in turn decreases exports and increases imports
("exchange rate channel" of the response of output to changes in the
interest rate).
To understand the total magnitude with which a change in r affects Y, we

further need to take into account the denominator on the right-hand side of
(56). What explains its magnitude?
92
• Following the increase of the interest rate by ∆ r, due to the consumption,

investment and exchange rate channels there is an initial ("first round")
change of output, Y, by   Cr  I r  TB   r   r (firms decreasing production
one-to-one with the interest rate-implied decrease in desired aggregate
demand).
• But if output, Y, changes by   Cr  I r  TB   r   r , then desired aggregate

demand from (49) in turn further changes by
(C y  TBim  G y )   Cr  I r  TB   r   r

(desired aggregate demand falling as Y decreases). This in turn implies a
further ("second-round") change of Y by
(C y  TBim  G y )   Cr  I r  TB   r   r

(from (48), firms decreasing production one-to-one with the further decrease
in desired aggregate demand).
93
• The second-round change of Y leads to another change of desired

aggregate demand, from (49) by the magnitude of
(C y  TBim  G y )  (C y  TBim  G y )   Cr  I r  TB   r   r


second-round effect
  (C y  TBim  G y ) 2   Cr  I r  TB   r   r
(desired aggregate demand falling again as Y decreases again). Thus, from

(48), firms decrease production again one-to-one with this further decrease
in desired aggregate demand, and there is a "third-round" change of Y by
(C y  TBim  G y ) 2   Cr  I r  TB   r   r.
• ... and so forth ...
94
The total change in Y following the increase of r by ∆r is therefore given by

Y    Cr  I r  TB   r   r  (C y  TBim  G y )   Cr  I r  TB   r  ꞏ r
  
first-round effect second-round effect
 (C y  TBim  G y ) 2   Cr  I r  TB   r  ꞏ r

third-round effect
 (C y  TBim  G y )3   Cr  I r  TB   r  ꞏ r  

fourth-round effect
 t   Cr  I r  TB   r 
    (C y  TBim  G y )    Cr  I r  TB   r  ꞏ r   r ,
 t 0  1  (C y – TBim – G y )
1
as predicted by (56), and with being the Keynesian multiplier
in Equation (54). 1  (C y – TBim – G y )
95
As from Equations (52) and (54) the IS-curve is given by r  IS0  IS1  Y , with
r r
1  (C y  TBim  G y )  1   1 
IS r     ,
Cr  I r  TB   r C 
 r r I  TB   r   KM 
the larger the Keynesian multiplier, the flatter the IS-curve, and the larger the
output losses due to a given increase of the interest rate:
r
Y '  Y
Y Y '
r r
KM
IS '
IS
0 Y
96
Workbook for the Keynesian Multiplier and Crowding Out Effects

The workbook KeynesianMultiplierandCIFXChannels.xlsm allows to study
how changes in the autonomous components of aggregate demand and/or
the interest rate affect output in the short-run macroeconomic outcome, …
IS‐Curve and Given Interest Rate: IS‐Curve and Given Interest Rate:
Specification Graph
Parameters IS‐Curve
0.20
IS‐Curve Parameters Initial New
0.18
Cr 4.000 4.000
0.16
Ir 16.000 16.000
TB  1.000 1.000 0.14
r 6.000 6.000 0.12

Cy 0.600 0.600
0.10
TB im 0.050 0.050
0.08
Gy 0.150 0.150
Intereste Rate
A 9.780 9.980 0.06

C0 1.500 1.500
0.04
I0 3.000 3.000
0.02
G0 2.800 3.000
TB 0 0.000 0.000 0.00
9 10 11 12 13 14 15 16 17 18
0 1.000 1.000 ‐0.02
T 3.000 3.000
‐0.04
TB ex 0.010 0.010
Y* 100.000 100.000 ‐0.06
T* 30.000 30.000 ‐0.08

r* 0.030 0.030
Y 15.000 15.000 ‐0.10
Output
Interest Rate Initial New

r 0.030 0.030
97
Macroeconomics 1 (BMAK) 4. Short-Run Macroeconomic Outcomes: The IS-TR Model
Wintersemester 2020/21 Quantitative Analysis
… how these output effects may be decomposed, and how the other
endogenous variables change:
Keynesian Multiplier and Initial and New Short‐Run
Consumption, Investment as well as Macroeconomic Outcomes
Exchange Rate Channels:
Quantitative Results
Transmission Channels for Changes in Output Initial and New Short‐Run Macroeconomic Outcomes
Following Changes Exclusively in the Components of Following Changes in Any of the Model Parameters
Autonomous Demand and/or in the Interest Rate
Absolute Percentage
Keynesian Multiplier Initial New Change Change
Stimulus: Change in A 0.200 Output 15.000 15.333 0.333 2.222
Size of Multiplier 1.667 Interest Rate 0.030 0.030 0.000 0.000
Change in Output 0.333 Consumption 8.580 8.780 0.200 2.331
Investment 2.520 2.520 0.000 0.000
Interest Rate Change: Consumption Channel Government Expenditure 2.800 2.950 0.150 5.357
Change in Output 0.000 Trade Balance 1.100 1.083 ‐0.017 ‐1.515
Exchange Rate 1.000 1.000 0.000 0.000
Interest Rate Change: Investment Channel
Change in Output 0.000
Interest Rate Change: Exchange Rate Channel
Change in Output 0.000
Total Change in Output
Sum of Effects 0.333
98
Macroeconomics 1 (BMAK) 3. The Financial Sector: Monetary Policy, Bank Lending
Wintersemester 2020/21 and the TR-Curve
Prof. Michael Binder, Ph.D. Central Bank Objectives
3. The Financial Sector: Monetary Policy, Bank Lending and

the TR-Curve
Readings:
- Burda and Wyplosz (2017), Chapters 9 and 10
- Jones (2020), Chapter 12
To pin down short-run macroeconomic outcomes, we will need to

complement our analysis of the real sector of the economy (as reflected in
the IS-curve) by an analysis of its financial sector. For the financial sector,
we will analyze the roles of the central bank and the commercial banks in
determining the rate at which households and firms can borrow. Their
decision making will result in an additional relationship (in addition to the
one depicted by the IS-curve) between output and the interest rate: the TR-
curve.
99
We begin our analysis of the financial sector by considering central banks:

Modern central banks typically pursue the objective to keep inflation
low and stable, subject to contributing to an adequate level of output.
While the latter target is readily appreciated, what are the benefits of low
and stable inflation?
• When inflation is high, resources are not allocated efficiently:
-- periods of high inflation empirically are also periods of high price
volatility
-- under high price volatility, it is more difficult to identify industries for
which prices are falling in relative terms (which is an indicator for
industries involving high productivity growth), leading to less efficient
allocation of resources;
• Inflation devalues money holdings ("inflation tax"); inducing households

and firms to avoid this inflation tax implies inefficiencies ("shoe-leather
costs" of re-allocating between interest- and non-interest bearing assets).
100
Why then do central banks aim for a positive rate of inflation?

• Under positive rates of inflation, there is less risk of deflation (the latter is
costly, in part as for given nominal debt the real value of debt increases
under deflation).
• Labor markets appear to function better under positive inflation (as
employees dislike real wage cuts driven by inflation less than they dislike
nominal wage cuts).
101
Prof. Michael Binder, Ph.D. Central Bank Instruments
To control inflation, central banks (in "normal times") vary the interest rate
at which they are willing to lend to commercial banks. This is based on the
following rationale:
• If the central bank is worried that inflation is above (below) the target
rate of inflation, it will raise (lower) the interest rate at which it is willing
to lend to commercial banks.
• The more (less) costly it is for commercial banks to secure funds from the
central bank, the higher (lower) the interest rate they charge for loans to
households and firms.
• The higher (lower) the cost of borrowing for households and firms, the
less (more) they can fund consumption and investment expenditure
through borrowing.
• Aggregate output demand then will fall (increase), leading to cuts (rises)
in the production of output, and eventually also to lower (higher) real
wages and thus lower (higher) costs of production, which in turn leads to
cuts (increases) in output prices, and thus the desired control of inflation.
102
Prof. Michael Binder, Ph.D. Central Bank Instruments: ECB
To provide some institutional context, let us consider the European Central

Bank's (ECB's) interest rate operations in normal times:
Open Market Operations

• Main refinancing operations : weekly auctions for loans (maturity: one
week). Commercial banks submit bids, and the ECB chooses the volume of
funds to allocate and at which interest rate.
• Longer-term refinancing operations : monthly auctions for loans (maturity:
three months), to complement the main refinancing operations.
Standing Facilities:
• Commercial banks can deposit funds at ECB at marginal deposit rate.
• Commercial banks can borrow funds from ECB at marginal lending rate.
Standing facilities are always available, though typically are used only rarely.
103
• The ECB can either expand funds eventually available for lending by
households and firms (through provision of additional loans to
commercial banks) or contract them (through not renewing (some of)
the short-term loans to commercial banks).
• The ECB in normal times minimizes its lending risk by demanding from
commercial banks full collateral for loans in the form of high-quality
assets.
• Empirically, the marginal deposit rate is the floor for the interbank rate
of interest (EONIA), and the marginal lending rate is the ceiling for the
EONIA.
• Until late 2008, the EONIA showed at most small deviations from the
ECB's main refinancing rate. In this sense, the ECB at least until 2008
seemed to be able to steer the interbank rate of interest. (We postpone
a discussion of the global financial crisis that began in 2008 to a later
section.)
104
ECB Interest Rates and European Overnight Index Average (EONIA)

(Percent)
Source of Data: Deutsche Bundesbank (2020)
105
Prof. Michael Binder, Ph.D. Taylor Rule
• Note that the main refinancing rate is a nominal interest rate.

• The interest rate, r , that (co-) determines aggregate output demand
and appears in the IS-curve, is a real interest rate, though.
• How are nominal interest rates linked to real interest rates?
• As the real interest rate rt captures how many additional units of a good
can be consumed in period t +1 when foregoing consumption of one unit
of that good in period t , it is linked to the nominal interest rate Rt as
follows:
1
rt  Pt  (1  Rt )  1 . (57)
 
    e
Pt 1
real selling one nominal interest 
interest unit of good rate (nominal units of good obtainable in
rate in period t return on saving period t 1 for one currency
from period t to t 1) unit, as expected in period t
Transforming (57), we obtain
106
1  Rt 1  Rt 1  Rt
rt  e
 1  e
 1  e
1 (58)
Pt 1 P P P
1  t 1  1 1  t 1 t
Pt Pt Pt
 
 te
1  Rt Rt   te e
 rt  e
 1  
e  t
R   t . (59)
1 t 1 t e
under  t
sufficiently
low
Equation (59), stating that the real interest rate from period t to t+1 is
(approximately) equal to the nominal interest rate from period t to t+1 minus
the rate of inflation from period t to t+1, as expected in period t, is also
known as the Fisher equation.
107
• Returning to the ECB's main refinancing rate, what explains its

variations?
• While central banks' decision rationale typically is not tied to a fixed
formula, the ECB's and many other central banks' ("normal times")
interest rate decisions can be captured surprisingly well through the so-
called Taylor rule, featuring just four determinants for the nominal
monetary policy rate set by a central bank:
-- the "neutral" real monetary policy rate,
-- the expected rate of inflation,
-- the output gap, and
-- deviations of actual inflation from target inflation:
MP  Y Y 
R  rnMP e
   y       (    T
). (60)
   Y  
neutral 
>0  >0 inflation
real rate, (relative) target
>0 output gap
with the parameters y and  .

108
The idea underlying the Taylor rule is that the central bank
- raises the monetary policy rate if macroeconomic activity does "overheat"

(Y > Y ) , or if actual inflation is above target inflation (   T ) , and
- lowers the monetary policy rate if macroeconomic activity is "sluggish"
(Y < Y ) , or if actual inflation is below target inflation (   T ) .
If Y  Y and    T, then
R MP  rnMP   e . (61)
Y Y ,   T
MP
For now, we will treat rn as exogenous, and consider its possible deter-
minants at a later stage of the course. For the time being, we therefore have
MP MP
that rn  r0 .
109
Evidence on the (Estimated) Taylor Rule
Source: Burda and Wyplosz (2017)
110
As in the macroeconomy in the short run prices are fixed, we have that
   T   e  0. Thus, the Taylor rule in real terms in the short-run is
given by
Y Y
r MP  R MP   e  rnMP   y     (   T )
   
  Y 
 r0MP 0 0
Y Y
 r MP  r0MP   y   .
 (62)
 Y 
111
While the Taylor rule reflects modern-times central bank behavior, it is on its
own still insufficient for purposes of being combined with the IS-curve for an
overall analysis of both the real and the financial sector: The monetary
policy rate,rMP, is not the same as the real interest rate that
captures households' and firms' cost of borrowing, r : commercial
banks charge households and firms a mark-up relative to rMP .
In the reminder of this sub-section, we will derive the determinants of the

mark-ups that the commercial banks charge as:
r  r MP  r MU  r MU ( 
r RP , other factors ) , (63)

 
interest rate (+)
mark-up
linking the mark-ups to risk premia, denoted as rRP, and other factors.
Empirically, the mark-ups fluctuate over time and are affected by loan
maturity:
112
Prof. Michael Binder, Ph.D. Interest Rates
Mark-Ups on the Monetary Policy Rate in the Euro Area

(Percent, Loans to Non-Financial Corporations and Households,
Short-Term Loans: Maturity Up to One Year, Long-Term Loans: Maturity Over One Year)
113
Prof. Michael Binder, Ph.D. Commercial Bank Lending
What is driving the mark-ups? In determining how much to lend to a

household or firm, a commercial bank considers:
• the expected loan return,
• the loan risk:
-- borrowers may default and the loan collateral (if any) may not provide
full cover for all the loan payments a defaulting borrower still does owe,
-- given loan risk, even a commercial bank operating under perfect
competition (that is a "price taker", leaving determination of r to the
credit market) needs to charge a mark-up on its loans,
• its ability to bear risk, measured by its equity.
To understand the role of equity, consider the balance sheet of a typical

commercial bank:
114
Assets Liabilities
Reserves Deposits
(including cash and reserves at (including customers' checking and
central bank) saving accounts)
Securities Borrowings
(including bonds and asset-backed (including funds borrowed from
securities) central bank and from other
commercial banks)
Loans Other Liabilities

(including industrial and consumer
loans)
Other Assets Capital (Equity)
115
• For a given amount of equity, the larger the volume of loans granted, the
higher the bank's leverage (that is, the larger the extent to which the
bank's loans are funded by debt rather than equity).
• Debt, by virtue of its servicing costs being tax-deductible, typically offers

a less expensive source of funding for the bank than equity.
• Too much leverage can be perilous, however:

-- In times of distress, the fixed servicing obligations that debt imposes
on the bank may not be covered anymore by the cash flow generated
by the loans granted.
-- At the extreme, the bank becomes insolvent, equity is wiped out and
the bank fails.
• There also tend to be regulatory constraints such as minimum

requirements for bank capital or a cap on bank leverage.
116
We model the commercial bank as determining its loans-supplied-to-equity-

ratio so as to maximize its expected loan net return, subject to taking into
account loan risk in a mean-variance-type format:
 
 s 2

 Lo s s
MP Lo  Eq 1  Lo  2 
max  r   r     
  Eq     LR , (64)
Lo s Eq Eq 2
 bank risk   loan 
 aversion return 
 risk 
where Los denotes loans supplied, Eq denotes equity, and where for
simplicity we assume that the commercial bank has secured all its non-
equity funds allocated to loan supply at cost rMP, and do not further
differentiate between loans to households and (different types of) firms.
117
Note that (64) is an example of a mean-variance preference function. Such

a preference function holds, for example, for a financial investor with
negative exponential utility and normally distributed wealth:
 
 
u W    exp  
 


W

 W  ,   0, W  N  W ,  2  .  (65)
 absolute risk
coefficient of

 aversion 
Under (65), it holds that (the proof is beyond the scope of this course)
  W  2 W 
E u W     exp            ,
    2 
expected utliity
and hence maximizing expected utility is equivalent to maximizing the

objective function

 W    2  .
W
(66)
2
118
We obtain the following first-order condition for the optimization problem

in Equation (64):
r  r MP 2 Lo s
    LR  2  0. (67)
Eq Eq
Solving Equation (67) for LS, we obtain the commercial bank's loan supply:
Eq
Lo s  2
 ( r  r MP
). (68)
   LR

 
 1/ 
119
To obtain the real interest rate, r, that clears the credit market, it remains
to combine loan supply with loan demand.
Recalling that we modelled both consumption and investment expenditure

as a negative function of the real interest rate, r , we model loan demand
as
Lo D  ALo  Lor  r , (69)

  
autonomous component >0
of loan demand
with the parameter Lor denoting the interest-rate sensitivity of loan

demand.
120
Notes:
(i) The exogenous determinants of loan demand in ALo include, for

example, loan demand from abroad.
(ii) We do not model loan demand as a function of income, though we had
modelled consumption expenditure to be income-sensitive. As their
incomes rise, households
-- may take on more debt without increasing their debt-to-income
ratios, but also
-- may want to use the additional income to pay down debt, so as to be
able to take on more debt when their incomes fall (and thus smooth
consumption).
The overall effect of income changes on loan demand is therefore
ambiguous, and we do not model it.
121
To obtain the market-clearing real interest rate, r , at which the commercial

banks lend to households and firms, it remains to equate loan supply to
loan demand. Setting Lo S = Lo D , from Equations (68) and (69) we obtain
1
 (r  r MP )  ALo  Lor  r , (70)

which in turn yields
r MP    ALo
r , (71)
1    Lor
with υ from Equation (68) given by:
2
   LR
 . (72)
Eq
122
From (71) and (72), the mark-up, r MU = r − r MP , that the commercial banks
charge for their loans to households and firms is a function of
2
• the risk associated with these loans (measured through  LR ),
• the degree of risk aversion ( χ ) of the commercial banks, and
• the amount of equity (Eq) that the commercial banks hold.
Also from (71), additional factors that affect this mark-up include the
autonomous component of loan demand (ALo), and the interest rate sensitivity
of loan demand (Lor).
Focusing on the riskiness of loans, how does the component of the mark-up
that is due to this risk (henceforth called the risk premium, r RP) respond to
2
an increase of  LR ?
123
From Equations (71) and (72) we have
r  r   ALo  1 
2
 
      Lor   r    A   
MP Lo
  LR
2
    LR
2
 1    Lor  1    Lor   Eq
 
 1   Lo r   A  
MP Lo
    A  Lor     0. (73)
 1    Lor   1    Lor  Eq
  
 r 
  
 Lo D
An increase in the riskiness of loans therefore leads to a higher mark-up, and,

as anticipated in Equation (63), we have linked the mark-ups that the
commercial banks charge to a risk premium and other factors, such as the
determinants of commercial bank equity and of the autonomous component
of loan demand:
r MU  r MU ( 
r RP , other factors ) .
(+)
124
Based on (62) and (63), as the baseline case for the determination of the
real interest rate in the financial sector, we consider the financial sector real
interest rate function
r  r (
r MP , 
r RP , other factors ) , (74)
(+) (+)
explicitly accounting for the monetary policy rate and the risk premium, and
relegating variables other than the risk premium that affect the mark-up
between the real interest rate and the monetary policy rate to the "other
factors" in Equation (74).
125
Prof. Michael Binder, Ph.D. The TR-Curve
For the short-run quantitative analysis of business cycles, we will typically

specialize the financial sector real interest rate function to
 Y Y 
r  r MP  r RP  r0MP   y     r0
RP
, (75)
 Y 
with the parameters r0MP,  y and r0RP (that is, for the time being, we will treat
the risk premium as exogenous). The relationship in (75) is called the TR-
curve.
126
Depicting the TR-curve graphically:
r , r MP  Y Y  RP
TR : r  r MP  r RP  r0MP   y     r0
 Y 
 Y Y 
Monetary Policy Rate : r MP  r0MP   y   
 Y 
0 Y
127
Workbook for the TR-Curve

The workbook TR-Curve.xlsm allows to study all the determinants of the
position and slope of the TR-curve.
TR‐Curve: Specification TR‐Curve: Graph
Parameters TR‐Curve
0.20
Initial New
0.18
r 0MP 0.020 0.020
0.16
r 0RP 0.010 0.020 0.14
y 0.500 0.500 0.12
Y 15.000 15.000 0.10
0.08
Intereste Rate
0.06
0.04
0.02
0.00
9 11 13 15 17
‐0.02
‐0.04
‐0.06
‐0.08
‐0.10
Output
128
Prof. Michael Binder, Ph.D. The LM-Curve
A note on modelling and terminology: Historically, financial sector

outcomes in models of the macroeconomy in the short run have been
captured through the so-called LM-curve.
The LM-curve posits that

• as the demand for money increases (decreases) with increases
(decreases) of income,
• central banks, aiming to maintain a money supply target, raise the
interest rate,
• as money demand then drops back down to the level of money supply: as
the interest rate raises, so does the opportunity cost of holding money
rather than holding interest-bearing assets, causing a decline of the
demand for money.
129
Graphically, the LM-curve plotted in the same diagram as the TR-curve also
is upward sloping:
LM
r2
r1
0 Y1
Y
Y2
130
The LM-curve thus
-- does not distinguish between the monetary policy rate and the interest
rate at which households and firms can borrow, and
-- depicts central banks that rather than targeting inflation and output (as is
modelled by the Taylor rule), target the level of money supply.
The standard in modern macroeconomic analysis has been shifting to

carrying out TR-curve based analyses, reflecting observed current central
bank behavior as well as the role of financial sector institutions such as
commercial banks.
131
4. Short-Run Macroeconomic Outcomes: The IS-TR Model

Readings:
- Burda and Wyplosz (2017), Chapters 11 and 12
• We are now in a position to consider the determination of short-run

macroeconomic outcomes as implied by the decision making in the real
and financial sectors.
• We will obtain (short-run) output, Y, and the interest rate, r , by

combining the TR-curve (describing the relationship between r and Y in
the financial sector) with the IS-curve (describing the relationship
between Y and r in the real sector).
• Once we have determined output and the interest rate, we can then also
determine the other key macroeconomic aggregates, including
consumption, investment, government expenditure, the trade balance
and the exchange rate.
132
The baseline IS-TR model consists of the specifications of desired aggregate

demand that entered the IS-curve, as well as the financial sector real interest
rate function underlying the TR-curve:
- consumption, from Equation (3):
C  C0  C y   Y  T   C r  r ,
- investment, from Equation (15):
I  I0  Ir  r,
- government expenditure, from Equation (21):
G  G0  G y  ( Y  Y ),
- the trade balance, from Equations (24) and (25):
TB  TB0  TBex  ( Y *  T * )  TBim  (Y  T )  TB   0   r  (r  r * )  ,
133
which together yielded the IS-curve in Equation (51):

A Cr  I r  TB   r
Y    r,
with, from Equation (49):
A  C0  I 0  G0  TB0  TB   0  (C y  TBim )  T  G y  Y  TBex  ( Y *  T * )  TB   r  r * ,
and
- the real interest rate, from the TR-curve in Equation (75):
 Y Y 
r  r0MP   y    r
 0 .
RP
 Y 
The variables that we will continue to keep as exogenous, that is, are
determined outside the model, are: T , Y , Y * , T * , and r * .
134
Having obtained the IS- and TR-curves, we can graph both:

r
IS
TR
r IS-TR model
0 Y Y
The short-run macroeconomic outcome occurs at the intersection of the IS-

and TR-curves: it is the one combination of output and real interest rate
that is compatible with the short-run outcomes in both the real and the
financial sector.
135
To appreciate better how the IS-TR model explains the functioning of the
macroeconomy in the short run, let us consider what happens following an
increase in foreign income, Y*.
Note at the outset, though, that the IS-TR model is a static model (all
variables appearing in the model are dated the same time period), and thus
the model
• pins down the overall changes in the outcomes that occur following any
exogenous change, such as an increase in foreign income,
• but is not specific about the adjustment dynamics, such as in which
sequence the various variables adjust.
In what follows, we graph and then discuss the economic rationale of one
specific adjustment path, a path that entails a useful separation of the
overall changes into a sequence of effects.
136
Wintersemester 2020/21 Adjustment to Exogenous Changes
Set of adjustments following an increase in foreign income, Y* :

r
IS '
TR
IS
C
r'
B
r
A
Y*
0 Y
Y Y'
Y
137
 Starting from the original outcome at Point A, the increase in Y* causes

the IS-curve to shift to the right.
• At the initially market-clearing interest rate, r, output first rises due to

the increase in desired aggregate demand (the increase in Y* implies
higher exports for the domestic economy, TBex ꞏ ∆Y*)
• Output also rises because of the Keynesian multiplier effect (chain of
effects running from higher output to higher desired aggregate
demand to higher output etc.). This implies that the rightward shift of
the IS-curve is larger than the initial increase in output, that is, is
larger than TBex ꞏ ∆Y* : From the IS-curve, we know that for a given
interest rate the increase in output taking into account the Keynesian
multiplier effect is equal to
TBex  Y *
,
1  (C y  TBim  G y )
bringing us to Point B.
138
 At Point B, we are off the TR-curve, however: The financial sector needs
to adjust.
• As output has increased from Point A to Point B, the interest rate

according to the central bank's Taylor rule now is too low (reflecting
future risks to price stability due to overheating of macroeconomic
activity).
• Simultaneous clearing of the real and financial sectors is restored as
we move from Point B to Point C: The central bank raises the interest
rate to a higher level that is in line with the Taylor rule.
• As the interest rate increases, the movement from Point B to Point C

also involves a partial reduction in output:
‐ households decrease consumption expenditure, reducing desired
aggregate demand (first crowding-out effect: consumption
channel),
139
‐ firms decrease investment in physical capital, also reducing desired

aggregate demand (second crowding out effect: investment
channel),
‐ the domestic currency's current value appreciates (per the interest
parity implication), implying that imports increase and exports
decrease, that is, the trade balance decreases, further reducing
desired aggregate demand (third crowding out effect:
exchange rate channel).
• The new short-run outcome simultaneously clearing the real and

financial sectors occurs at Point C – involving a higher level of output,
a higher domestic interest rate and an appreciated current value of
the domestic currency.
140
Quantitative Analysis of the IS-TR Model

A key virtue of having algebraic equations for the IS- and TR-curves is that we
can calculate the magnitudes of the changes in output and the interest rate (as
well as in consumption, investment, government expenditure, the trade balance
and the exchange rate). Re-writing the TR-curve, (75),
 Y Y 
r  r  y  
0
MP
  r0
RP
,
as
 Y 
Y 

Y  Y     r  r0MP  r0RP ,  (76)
 y 
to obtain the interest rate in the short-run macroeconomic outcome, we equate
output as predicted by the TR-curve, (76), to output as predicted by the IS-
curve, (51):
A  (Cr  I r  TB   r )  r Y 
Y   Y      r  r0MP  r0RP   Y . (77)
1  (C y  TBim  G y )  
   y

from IS -curve (51)
from TR-curve re-written as (76)
141
Note that (77) is one equation in one unknown, namely r. We can thus use
Equation (77) to solve for r :
A  r0MP  r0RP  Y Cr  I r  TB   r 

 Y  1        r
 y
1  (C y  TBim  G y )     y 1  (C y  TBim  G y ) 
A  r0MP  r0RP 
 Y  1  
1  (C y  TBim  G y )  y
 r    .
(78)
Cr  I r  TB   r Y

1  (C y  TBim  G y )  y
Equation (78) gives us the IS-TR model-implied interest rate in the short-
run macroeconomic outcome.
142
Having obtained the rate of interest, we can calculate the IS-TR model-
implied level of output in the short-run macroeconomic outcome from the
IS-curve, Equation (51),
A Cr  I r  TB   r
Y    r.
substituting for r from Equation (78).
We are then also in a position to plug back into our consumption,

investment, government expenditure, trade balance and exchange rate
functions to obtain the short-run outcomes for C, I, G, TB and ε .
143
Numerical Example:
Suppose A = 9.78, Cy = 0.6, Gy = 0.15, TBim = 0.05, TBex = 0.01,

Cr = 4, Ir = 16, Y  15 , r0MP  0.02 , r0RP  0.01 ,  y  0.5 ,
TBε = 1, εr = 6 .
Using these parameter values in Equation (78), we obtain r = 0.03. Making

use of this value of r and those of the parameters above in the IS-curve,
Equation (51), we obtain Y = 15.
*
Now suppose that Y* increases by 15: Y  15. As from Equation (49) we
have that
A  C0  I 0  G0  TB0  TB   0  (C y  TBim )  T  G y  Y  TBex  ( Y *  T * )  TB   r  r * ,
this increase in foreign income implies a change in the autonomous
component of aggregate demand by
A * * (79)
A  *
 Y  TBex  Y  0.15 .
Y
144
From Equation (78), we then have that

1
r 1  (C y  TBim  G y )
r   A   A  0.003 , (80)
A Cr  I r  TB   r Y

1  (C y  TBim  G y )  y
and from the IS-curve, Equation (51), and Equation (80) that
Y Y  r Y Y
Y   A    A   A   r
A r  A A r

 
 r
1 Cr  I r  TB   r
  A   r  0.102 . (81)
1  (C y  TBim  Gy ) 1  (C y  TBim  Gy )
Note that Equation (81) also gives us a useful decomposition of the overall
change in output:
145
• Change in output due to Keynesian Multiplier effect:

A
 0.25 .
1  (C y  TBim  G y )
• Change in output due to crowding out of consumption (consumption

channel):
Cr
  r   0.023 .
1  (C y  TBim  G y )
• Change in output due to crowding out of investment (investment

channel):
Ir
  r   0.091.
1  (C y  TBim  G y )
• Change in output due to crowding out of the trade balance (exchange

rate channel):
TB   r
  r   0.034 .
1  (C y  TBim  G y )
146
Workbook for the IS-TR Model

The workbook IS-TR-Model.xlsm allows to study how changes in the
autonomous components of aggregate demand and/or other model
parameters affect output in the short-run macroeconomic outcome, …
IS‐TR Model: Specification IS‐TR Model: Graph
Parameters IS‐TR Model
0.20
TR‐Curve Parameters Initial New

0.18
r 0MP 0.020 0.020
r 0RP 0.010 0.010 0.16
y 0.500 0.500
0.14
Y 15.000 15.000
0.12
Cr 4.000 4.000 0.10
Ir 16.000 16.000
0.08
TB  1.000 1.000
Intereste Rate
r 6.000 6.000 0.06
Cy 0.600 0.600
0.04
TB im 0.050 0.050
Gy 0.150 0.150 0.02
A 9.780 9.930
C0 1.500 1.500 0.00
9 10 11 12 13 14 15 16 17 18
I0 3.000 3.000 ‐0.02
G0 2.800 2.800
TB 0 0.000 0.000 ‐0.04
0 1.000 1.000
‐0.06
T 3.000 3.000
TB ex 0.010 0.010 ‐0.08
Y* 100.000 115.000
T* 30.000 30.000 ‐0.10
Output
r* 0.030 0.030
147
… how these output effects may be decomposed, and how the other endo-
genous variables change:
IS‐TR Model: Keynesian Multiplier Initial and New Short‐Run
and Consumption, Investment Macroeconomic Outcomes
as well as Exchange Rate Channels:
Autonomous Demand
Absolute Percentage
Keynesian Multiplier Initial New Change Change
Stimulus: Change in A 0.150 Output 15.000 15.102 0.102 0.682
Size of Multiplier 1.667 Interest Rate 0.030 0.033 0.003 11.364
Change in Output 0.250 Monetary Policy Rate 0.020 0.023 0.003 17.045
Consumption 8.580 8.628 0.048 0.556
Interest Rate Change: Consumption Channel Investment 2.520 2.465 ‐0.055 ‐2.165
Change in Output ‐0.023 Government Expenditure 2.800 2.785 ‐0.015 ‐0.548
Trade Balance 1.100 1.224 0.124 11.312
Interest Rate Change: Investment Channel Exchange Rate 1.000 0.980 ‐0.020 ‐2.045
Change in Output ‐0.091
Change in Output ‐0.034
Sum of Effects 0.102
148
As we had seen in the data, not all business cycles are alike. Business cycles
may vary
• across countries or,
• across time periods within a given country.
One reason is that the shocks (unanticipated changes) to the autonomous
components of aggregate demand that are the starting point for a business
cycle fluctuation may vary in size across countries and/or time periods.
Another reason is that the propagation of the shocks may vary in size across
countries and/or time periods.
The strength of the shock propagation can vary with the magnitude of the
parameters entering the IS-TR model. To appreciate this point, consider, say,
the sensitivity of investment to the interest rate, Ir :
How do changes in Ir affect business cycle outcomes?
149
Recalling the TR-curve (75),

y
r  r  r  y 
0
MP
Y ,
0
RP
   Y
 TR0
 TR1
both the intercept of the TR-curve, TR0 , and the slope of the TR-curve, TR1 ,
are insensitive to Ir , as
 TR0 (82)
0,
 Ir
and
 TR1
 0. (83)
 Ir
Changes in the sensitivity of investment to the interest rate, Ir , may therefore

affect business cycle outcomes only through the IS-curve.
150
Recalling the IS-curve (51), re-written in the form of Equation (52),

A 1  (C y  TBim  G y )
r   Y ,
Cr  I r  TB   r Cr  I r  TB   r
  
 IS0r  IS1r
note that the sensitivity of the intercept of the graphed IS-curve, IS0r , to Ir is
given by
 Cr  I r  TB   r 
1
 IS r
A 1
0
    A  0. (84)
 Ir  I Cr  I r  TB   r  Ir
r 
0 2
   Cr  I r TB  r 
Also, the sensitivity of the slope of the graphed IS-curve,  IS1r , to Ir is given by
 1  (C y  TBim  G y ) 
 
   IS1r  C  I  TB    1  (C  TB  G )
   r  y im y
r r
  0, (85)
 Ir  Ir (Cr  I r  TB   r ) 2
that is, a larger sensitivity of investment to the interest rate, Ir , renders the IS-
curve flatter, and a given increase in r causes larger decreases in Y. 151
Thus, the larger Ir , the stronger the investment channel: changes in r that occur
as the central bank is raising the monetary policy rate (in expansions) or is
lowering the monetary policy rate (in recessions) cause larger crowding out/in
effects.
Consider a numerical example: Instead of I r  16 , suppose that we have that

I r  34. How does this affect short-run macroeconomic outcomes?
To obtain the initial short-run interest rate prevailing under I r  34 , simply re-
place I r in Equation (78) by I r :
 Y  1  
1  (C y  TBim  G y )  y
r    0.021. (86)
Cr  I r  TB   r Y

1  (C y  TBim  G y )  y
Making use of this value of r in the IS-curve, Equation (51), we obtain Y ≈

14.739.
152
Following an increase of foreign output, Y*, again by 15, we now have from
Equation (80) (again with I r replaced by I r ) that
1
r 1  (C y  TBim  G y )
r   A   A  0.002, (87)
A 
Cr  I r  TB   r Y

1  (C  TB  G ) y im y y
and from Equation (81) (once more with I r replaced by I r ) and Equation
(87) that
1 Cr  I r  TB   r
Y   A   r  0.073 . (88)
Under the increase of the sensitivity of investment to the interest rate

considered in this numerical example, the change in output is smaller than
before, that is, the short-run expansion is weaker. Decomposing the overall
change in output:
153

A
 0.25 ,
1  (C y  TBim  Gy )
independent of the sensitivity of investment to the interest rate.

channel):
Cr
  r   0.016 ,
1  (C y  TBim  Gy )
reflecting that under increased sensitivity of investment to the interest

rate the crowding out effects due to the consumption channel are
smaller, as the central bank increases the monetary policy rate by less.
154

channel):
Ir
  r   0.137 ,
1  (C y  TBim  G y )

rate the crowding out effects due to the investment channel are larger.
• Change in output due to crowding out of the trade balance (exchange

rate channel):
TB   r
  r   0.024 .
1  (C y  TBim  G y )

rate the crowding out effects due to the exchange rate channel are
smaller, as the central bank increases the monetary policy rate by less.
155
The reason as to why in our numerical example the short-run expansion

following the increase of the sensitivity of investment to the interest rate is
weaker than before is that the larger crowding out effects under the investment
channel dominate the weaker crowding out effects under the consumption and
exchange rate channels.
As one further illustration of the effects of changes in model parameters on

business cycle outcomes, let us examine the parameter measuring the sensitivity
of the central bank's setting of the monetary policy rate to the level of output:
y .
How do changes in ϕy affect business cycle outcomes?
156
Recalling the IS-curve (51), re-written in the form of Equation (52),
A 1  (C y  TBim  G y )
r   Y ,
Cr  I r  TB   r Cr  I r  TB   r
   
 IS0r  IS1r
r
both the intercept of the graphed IS-curve, IS0 , and the slope of the graphed
IS-curve,  IS1r , are insensitive to  y , as
 IS0r (89)
0,
 y
and
   IS1r 
 0. (90)
 y
Changes in the sensitivity of the central bank's setting of the monetary policy
rate to the level of output may therefore affect the business cycle only through
the TR-curve.
157
Recalling the TR-curve (75),

y
r  r  r  y 
0
MP
Y ,
0
RP
   Y
 TR0
 TR1
note that the sensitivity of the intercept of the TR-curve, TR0 , to  y is given by
 TR0
  1  0, (91)
 y
and that the sensitivity of the slope of the TR-curve, TR1 , to  y is given by
 TR1 1
  0. (92)
 y Y
Thus, the larger  y , the steeper the TR-curve: changes in output that occur in
response to shocks to the autonomous components of aggregate demand are
met by the central bank with larger increases of the monetary policy rate (in
expansions) or decreases of the monetary policy rate (in recessions), causing
larger crowding out/in effects.
158
Consider a numerical example: Instead of  y  0.5 , suppose that we have that

 y  2. How does this affect short-run macroeconomic outcomes?
To obtain the initial short-run interest rate prevailing under  y  2 , simply re-
place  y in Equation (78) by  y :
 Y  1  
1  (C y  TBim  G y )   y
r    0.03. (93)
Cr  I r  TB   r Y

1  (C y  TBim  G y )  y
Making use of this value of r in the IS-curve, Equation (51), we obtain Y = 15.
159
Following an increase of foreign output, Y*, again by 15, we now have

from Equation (80) (again with  y replaced by  y ) that
1
r 1  (C y  TBim  G y )
r   A   A  0.005, (94)
A Cr  I r  TB   r Y

1  (C y  TBim  G y )  y
and from Equations (81) and (94) that
1 Cr  I r  TB   r
Y   A   r  0.037 .
1  (C y  TBim  Gy ) 1  (C y  TBim  Gy )
Under the increase of the sensitivity of the central bank's setting of the
monetary policy rate to the level of output considered in this numerical
example, the change in output is smaller than before, that is, the short-run
expansion is weaker. Decomposing the overall change in output:
160

A
 0.25 .
1  (C y  TBim  Gy )

channel):
Cr
  r   0.033 .
1  (C y  TBim  Gy )

channel):
Ir
  r   0.131.
1  (C y  TBim  Gy )
• Change in output due to crowding out of trade balance (exchange rate

channel):
TB   r
  r   0.049 .
1  (C y  TBim  Gy )
161
The reason as to why in our numerical example the short-run expansion

following the increase of the sensitivity of the central bank's setting of the
monetary policy rate to the level of output is weaker than before is that the
central bank adjusts the monetary policy rate more strongly to any changes in
output, causing uniformly larger crowding out effects.
162
Macroeconomics 1 (BMAK) 5. Short-Run Macroeconomic Effects of Financial Crises and
Wintersemester 2020/21 Pandemics: The Extended IS-TR Model
Prof. Michael Binder, Ph.D. The Global Financial Crisis: Key Developments
5. Short-Run Macroeconomic Effects of Financial Crises and

Pandemics: The Extended IS-TR Model
Readings:
- Jones (2020), Chapters 10 and 14
Financial Crises
In the fall of 2008, the global financial crisis started with the collapse of
Lehman Brothers, creating turmoil in financial markets, and leading to the
chairman of the U.S. Federal Reserve stating during a weekend in late
September 2008:
"If we don't do this [the Troubled Asset Relief Program], we may not have
an economy on Monday."
Preceding these events was a collapse of U.S. housing prices that was
unprecedented in magnitude:
163
Shiller Index of U.S. Real Housing Prices
Source of Data: Shiller (2020)
164
Factors driving the U.S. housing prices in the early 2000's:

• Global saving glut both in emerging market and industrial economies;
• Housing becoming available to subprime borrowers (borrowers with poor
credit records and/or high debt-to-income ratios), in part due to
combination of low interest rates and questionable lending standards;
• Following the Taylor rule, the U.S. Federal Reserve from about 2004
onwards started raising interest rates, which resulted in the default of
many borrowers with adjustable rate mortgages (in August 2007: 16% of
subprime mortgages with adjustable rates);
• A sizable fraction of subprime mortgage loans had been lumped together
by financial markets through securitization: mortgage-backed securities or
collateralized debt obligations (CDOs);
• Large share of these CDOs held by commercial and investment banks;
following the collapse of the value of these CDOs, these banks ran into
solvency problems;
165
A liquidity crisis developed: "flight to safety" (to U.S. Treasury Bills) in

financial investment decisions, reflecting vastly increased credit risk:
Credit Risk as Measured by the Spread Between 3-Month LIBOR Rate

and 3-Month U.S. Treasury Bill
(Percent)
Source: Federal Reserve Bank of St. Louis (2020)
166
"Agency [bank management knowingly gambling, expecting a bailout] and

neglected risk are the two most credible explanations of the financial crisis,
but neglected risk is most parsimonious, consistent with ratings,
expectations data, and regulator passivity in 2007. Combination of agency
and neglect of risk would lead to massive risk taking by investors failing to
appreciate exposure. This probably is the real story."
Andrei Shleifer (2011)
167
In what follows we will re-consider the risk premium measuring the mark-up
commercial banks are charging households and firms to borrow from them.
We will augment our model of the macroeconomy in the short run to

account for the fact that the value of loan collateral may drop sizably in
crisis times (as did housing prices in the U.S.), in turn sizably increasing the
lending risk (increasing the uncertain component of loan repayments),
rendering the risk premium endogenous and further propagating initial
shocks to the risk premium.
168
A second feature to consider in augmenting our model of the macroeconomy

in the short run: In responding to the global financial crisis, the U.S. Federal
Reserve
-- quickly lowered its monetary policy rate, the Federal Funds Rate,
-- but did not lower it below zero:
the so-called zero-lower bound for (nominal) interest rates that capture
costs of borrowing.
U.S. Federal Funds Rate
(Percent)

169
With time delay, we have observed a similar issue for the European Central
Bank:
ECB Main Refinancing Rate
(Percent)
Source of Data: Deutsche Bundesbank (2020)

170
• Relative to the IS-TR model, the first novel component of what we will
label the extended IS-TR Model is that we capture the zero lower
bound on RMP.
• This zero lower bound can be understood as a no-arbitrage condition: If

a commercial bank at a negative value of RMP was paid interest to
borrow, it could earn ever higher profits simply by ever increasing its
amount of borrowing (presuming for simplicity the absence of any cost
for storing the funds borrowed).
171
• As in the macroeconomy in the short run prices are fixed, recall that we
have that    T   e  0, implying rMP = RMP , and we can thus capture
the zero lower bound with the following extended monetary policy
rule:
 
  Y  Y  
r MP  max 0, r0   y  
MP
. (95)
   Y  
 
Taylor Rule
• Under (95), if output is so low that according to the Taylor rule the central
bank would choose to set a negative rMP , it is constrained by the zero
lower bound and instead sets rMP = 0.
172
• We will henceforth denote the highest level of output at which the

central bank, following the Taylor rule, would set rMP = 0 as "YZLB " .
• Whenever output is at or below YZLB, we will call the macroeconomy to
be in a "deep crisis".
• Note that YZLB can be readily obtained from the extended monetary
policy rule (95):
 Y ZLB  Y 
r 0
MP
 y   0
 Y 
Y
 Y ZLB    y  r0MP  . (96)
y
YZLB depends on the parameters and variables entering the Taylor rule in
MP
economically plausible form: For example, if the neutral real rate r0 was
to increase, then the central bank sets the monetary policy rate to be
higher than before (as long as the new zero lower bound constraint is not
binding). This in turn implies that the central bank reaches the zero lower
bound for rMP at a lower level of output.
173
Illustrating this graphically:
rMP Extended Monetary Policy Rule, (95):

 '  Y Y 
r MP  max 0,  r0MP    y   
  Y 
'
r 
0
MP
 r0MP
Extended Monetary Policy Rule, (95):

  Y  Y 
r MP  max 0, r0MP   y   
  Y 
0
' Y
Y  ZLB
Y ZLB
174
The second novel component of the extended IS-TR Model is that we add an
endogenous component to the risk premium that drives the mark-up
between
-- the interest rate, r , at which households and firms can borrow from the
commercial banks to fund (part of) their consumption and investment
expenditure, and
-- the monetary policy rate, rMP , set by the central bank.
Suppose we are in a "deep crisis" in which the probability that households

and/or firms that are borrowing may default on their loans increases, and the
value of the loan collateral falls. The loan risk then rises, and so does the risk
premium:
175
Recall from Equations (71) and (72) that
r MP    ALo
r ,
1    Lor
with υ given by
2
   LR
 ,
Eq
implying that (see also Equation (73))
  r  r MP   r RP r
   0.
  LR
2
  LR   LR
2 2
176
We capture the endogenous adjustment of the risk premium in "deep

crisis" times through the following specification:
  
r RP  r0RP  ry  Y  Y ZLB  I Y  Y ZLB ,

 (97)
>0

endogenous component of risk premium
where I denotes the indicator function:
1 if Y  Y ZLB

I Y  Y ZLB   
ZLB
. (98)
 0 if Y  Y
Note that the specification in Equation (97) implies that within deep crises, the
endogenous component of the risk premium rises by ry for any unit decrease of
output. The following graph illustrates this:
177
Depicting the risk premium, rRP, graphically:
  
r RP  r0RP  ry  Y  Y ZLB  I Y  Y ZLB 
0
YZLB Y

rRP  r0RP  ry  Y YZLB  rRP  r0RP
178
Taking into account both

-- the zero lower bound on the monetary policy rate, and
-- the endogenous component of the risk premium in "deep crisis" times,
we now have the following financial sector real interest rate function (the
extended TR-curve):
  Y  Y   RP
r  max 0, r0   y     r0  ry  Y  Y   I Y  Y  .
MP ZLB ZLB
 (99)

   Y     
RP

r
 r MP
The extended TR-curve features a discontinuity at that level of output for

which the Taylor rule suggests switching from a positive to a zero monetary
policy rate, YZLB :
179
When Y > YZLB , the extended TR-curve (99) reduces to
 Y Y  RP
r  r0MP   y     r0 ,
 Y 
the standard TR-curve given by (75): the interest rate at which households
and firms can borrrow is the sum of the monetary policy rate and the
exogenous component of the risk premium.
When Y ≤ YZLB , the extended TR-curve (99) implies that

r  r0RP  ry  Y YZLB .  (100)
The monetary policy rate then is constrained at the zero lower bound, and
the interest rate at which households and firms can borrrow is the sum of
the exogenous and endogenous components of the risk premium.
180
Depicting the extended TR-curve graphically:
r, rMP
 Y Y  RP Extended TR-Curve, (99)
r  r0MP   y     r0
 Y 
Extended Monetary
Policy Rule, (95)

r  r0RP  ry  Y YZLB 
r0RP
0
YZLB Y
r MP  0  Y Y 
r MP  r0MP   y   
 Y 
181
Workbook for the Extended TR-Curve

The workbook Extended-TR-Curve.xlsm allows to study all the
determinants of the position and slope of the extended TR-curve.
Extended TR‐Curve: Specification Extended TR‐Curve: Graph
Parameters Extended TR‐Curve
0.20
Initial New
r 0MP 0.020 0.020
r 0RP 0.010 0.020 0.15
y 0.500 0.500
Y 15.000 15.000
ry 0.008 0.008 0.10
Interest Rate
0.05
Initial New
ZLB
Y 14.400 14.400 0.00
9 11 13 15 17
‐0.05
‐0.10
Output
182
The extended IS-TR model combines the extended TR-curve with the
standard IS-curve.
Thus, the components of desired aggregate demand in the real sector in
the extended IS-TR model are the same as in the IS-TR model, and are
still given by:
C  C0  C y  (Y  T )  Cr  r (see Equation (3)),

I  I0  Ir  r (see Equation (15)),
G  G0  G y  (Y  Y ) (see Equation (21)),
TB  TB0  TBex  ( Y *  T * )  TBim  (Y  T )  TB   0   r   r  r *   ,


=
(see Equations (24) and (25)).
183
Desired aggregate demand is thus still given by (49),
DD  A   Cr  I r  TB   r   r   C y  TBim  Gy   Y ,
implying in turn that all combinations of output and the interest rate at
which aggregate demand is equal to output supply are still represented by
the IS-curve in (51),
A Cr  I r  TB   r
Y    r.
The extended IS-TR model combines the standard real-sector IS-curve (51)
with the financial-sector extended TR-curve (99),
  Y  Y   RP
r  max 0, r0MP   y      r0  ry   Y  Y ZLB
  I  Y  Y ZLB
 .

   Y     
RP

r
 r MP
184
Short-run macroeconomic outcomes in the extended IS-TR model can thus

be depicted …
… either as a "normal business cycle" outcome:
r
IS
Extended TR
Y Y
"normal business cycle" outcome (along the
upward-sloping portion of the extended TR-curve)
185
... or as a "deep crisis" outcome:
r
IS
Extended TR
Y Y
"deep crisis" outcome (along the
downward-sloping portion of the extended TR-curve)
Note: The downward-sloping branch of the extended TR-curve from (100) has slope – ry .
Empirically, ry is too small to warrant concerns that a scenario could arise in which the
downward-sloping branch of the extended TR-curve does not intersect with the IS-curve.
186
Can the extended IS-TR model explain severe recessions, such as the one
that followed the onset of the global financial crisis, and if so, what are its
novel propagation channels relative to the IS-TR model?
To address these questions, let us examine within the extended IS-TR

model the short-run macroeconomic effects of the two shocks that seemed
so important for the global financial crisis:
-- a collapse in housing prices, implying C0 , coupled with
RP
-- an increase in the exogenous component of the risk premium, r0 .
187
r
Extended TR '
IS
Extended TR
IS '
C0 r0RP
r'
D
B A
r
C
0
Y' YZLB Y Y
Y
188
The decrease in housing prices and the associated decrease in C0 cause the
following adjustments:
• The IS-curve shifts to the left, the magnitude of the leftward shift
determined by the size of the decrease in C0 as well as the size of the
Keynesian Multiplier.
Note: The shift from Point A to Point B is of the same magnitude as for
the IS-curve in the IS-TR model, as it is for a given value of the interest
rate.
• At Point B, we are off the extended TR-curve: As output has decreased

from Point A to Point B, the monetary policy rate according to the
central bank's Taylor rule is too high (the central bank aiming to
stimulate macroeconomic activity).
189
• If there was no shock to the exogenous component of the risk premium, the
macroeconomy would move from Point B to Point C. At Point C, simultaneous
clearing of the real and financial sectors would be restored, with the central
bank's easing of monetary policy reducing the recessionary impact of the
decrease in C0 (crowding in effects).
• However, given that there is also an increase of the exogenous component of
RP
the risk premium, r0 (shifting the extended TR-curve up), the borrowing
cost for households and firms is actually increasing, leading to crowding out
effects.
• At Point D, the intersection of the new IS-curve with the new extended TR-
curve, the interest rate is given by r ' > r. The increase in the interest rate is
also due to the endogenous component of the risk premium rising. The
RP
crowding out effects following the increase of r0 cause output to fall below
YZLB , and the endogenous component of the risk premium then begins to
become positive and rise, leading to further crowding out effects.
190
• As the interest rate at which households and firms can borrow increases,
-- households decrease consumption expenditure, reducing desired
aggregate demand (crowding out through the consumption channel),
-- firms reduce investment in physical capital, also reducing desired
aggregate demand (crowding out through the investment channel),
-- the domestic currency's spot value appreciates (financial investors
moving their funds to the domestic economy, increasing the demand
for domestic currency, as per the interest parity implication),
-- in turn, imports increase and exports decrease, that is, the trade
balance decreases, reducing desired aggregate demand even further
(crowding out through the exchange rate channel).
191
• The simultaneous new clearing of the real and financial sectors occurs at
Point D – involving a lower level of output and a higher domestic
interest rate.
• The overall decrease in output, Y, in the extended IS-TR model is

(potentially much) more severe than in the IS-TR model, because
-- the central bank's attempts to stimulate monetary policy through
lowering the monetary policy rate are constrained by the zero lower
bound,
-- the risk premium can rise endogenously, further increasing the cost
of borrowing for households and firms, and in turn further decreasing
desired aggregate demand through the consumption, investment and
exchange rate channels.
192
Prof. Michael Binder, Ph.D. Quantitative Analysis
Quantitative Analysis of the Extended IS-TR Model
Let us combine the extended TR-curve with the IS-curve:
If r
MP
 0, (77) still holds :
A   Cr  I r  TB   r   r
Y 
Y   Y      r  r0MP  r0RP   Y .
1   C y  TBim  Gy   
 y
 
from IS -curve (51) from extended TR -curve when r MP  0: (75)
If r
MP
 0 , we have :
 
A   Cr  I r  TB   r    r0RP  ry  Y  Y ZLB  
  
 r 
Y  . (101)
1   C y  TBim  G y 
  
from IS -curve (51) and extended TR -curve when r MP  0: (99)
193
Let us first turn to the case where rMP > 0 ("normal business cycle"
outcome):
The short-run rate of interest is then still given by (78) :
 Y  1  
1   C y  TBim  G y  
 y 
r .
Cr  I r  TB   r Y

1   C y  TBim  G y   y
Having obtained the short-run rate of interest when rMP > 0, we can also
calculate short-run output from the IS-curve, (51),
A Cr  I r  TB   r
Y    r.
1  (C y  TBim  Gy ) 1  (C y  TBim  G y )
substituting for r from Equation (78).
194
We are then also in a position to plug back into our consumption,

investment, government expenditure, trade balance and exchange rate
functions to obtain the short-run outcomes for C, I, G, TB and ε for the
case where rMP > 0.
Turn second to the case where rMP = 0 ("deep crisis" outcome): In this
case, the short-run level of output can be obtained by solving (101) for Y :
195
A   Cr  I r  TB   r    r0RP  ry  Y  Y ZLB  

Y 
1   C y  TBim  G y 
  Cr  I r  TB   r   ry  A   Cr  I r  TB   r    r0RP  ry  Y ZLB 

 1   Y 
 1   C y  TBim  G y   1   C y  TBim  G y 
A   Cr  I r  TB   r    r0RP  ry  Y ZLB 

1   C y  TBim  G y 
 Y  , (102)
 Cr  I r  TB   r   ry
1
1   C y  TBim  G y 
where the level of YZLB is given by (96):

Y
Y ZLB
   y  r0MP  .
y
196
The short-run rate of interest immediately follows from the extended TR-
curve under rMP =0, Equation (100):
r  r0RP  ry  Y  Y ZLB  , (103)
with YZLB again given by (96).
We are then once again in a position to also plug back into our
consumption, investment, government expenditure, trade balance and
exchange rate functions to obtain the short-run outcomes for C, I, G, TB
and ε for the case where rMP = 0.
197
Numerical Example:
Suppose A = 9.78, Cy = 0.6, Gy = 0.15, TBim = 0.05, TBex = 0.01,
Cr = 4, Ir = 16, Y  15 , r0MP  0.02 , r0RP  0.01 ,  y  0.5 ,
ry = 0.005, TBε = 1, εr = 6 .
A new complication arising now is that (in general) we do not know prior to
our calculations whether the short-run outcome is a "normal business
cycle" outcome or a "deep crisis" outcome.
One approach to resolving this complication is as follows:
198
Step 1 :
Conjecture that we are in a "deep crisis" outcome. (We make this
conjecture as the algebra to solve the model is a bit less involved for the
"deep crisis" outcome than for the "normal business cycle" outcome).
Based on this conjecture, calculate the implied level of output from
Equations (102) and (96):
A   Cr  I r  TB   r    r0RP  ry  Y ZLB 

1   C y  TBim  G y 
Y Conjecture
 ,
 Cr  I r  TB   r   ry
1
1   C y  TBim  G y 
where
Y
Y ZLB    y  r0MP  .
y
199
Step 2:
If the conjectured level of output calculated in Step 1 was less than or
equal to YZLB,
Y Conjecture  Y ZLB ,
then indeed we are in the "deep crisis" outcome, for which it then must
also hold that rMP is constrained to be at the zero lower bound, that is,
from the Taylor rule in Equation (62) we have that
 Y Conjecture
Y 
r MP MP
 r0   y     0.
 Y 
We can then calculate the outcomes for all variables based on the relations
that hold for the "deep crisis" case, including in particular that
Y  Y Conjecture .
200
Step 3:
If, however, the conjectured level of output calculated in Step 1 was larger than
YZLB,
Y Conjecture  Y ZLB ,
then a contradiction has arisen, and the outcome must be a "normal business
cycle" outcome, so that we need to calculate all outcomes based on the relations
that hold when rMP > 0 :
In particular, we can need to calculate short-run output from the IS-curve,
(51),
A Cr  I r  TB   r
Y    r,
with the short-run interest rate, r , from Equation (78) given by
 Y  1  
1   C y  TBim  G y  
 y 
r .
Cr  I r  TB   r Y

1   C y  TBim  G y   y
201
Implementing this procedure for our numerical example:

• Presume at first that we are in the "deep crisis" outcome, where rMP = 0:
From Equations (96) and (102) we obtain YConjecture ≈ 16.272. However,
YZLB = 14.4 and the Taylor rule (see Equation (62)) for Y ≈ 16.272 would
imply that rMP ≈ 0.062, both contradictions to us being in a "deep crisis"
outcome.
• We then must be in the "normal business cycle" outcome, where rMP > 0:
Using our parameter values in Equation (78), we obtain r = 0.03. Using
this result in the IS-relationship, we obtain Y = 15. This in turn from the
RP
Taylor rule implies that rMP = 0.02 = r  r0 .
Now suppose
C0  0.7 and thus A '  9.08, and that r0RP  0.04 and thus (r0RP ) '  0.05.
202
• Presume at first that we are in the "deep crisis" outcome, so that (rMP) ' = 0:
From Equations (96) and (102) we now obtain Y Conjecture ≈ 12.570 and YZLB =
14.4. Also, for Y ' ≈ 12.570, the Taylor rule would imply that (rMP) ' ≈ − 0.061.
So we are indeed in the "deep crisis" outcome. From Equation (103), we obtain
r ' ≈ 0.059.
Let us decompose the overall change in output that has occurred:
• Starting point for such a decomposition is again the IS-curve, Equation (51):
A Cr  I r  TB   r
Y    r.
RP
• Following the change in both C0 (and thus A) as well as r0 , the standard
comparative statics analysis (see, for example, Equation (81)) would seem to
apply:
Y Y
Y   A   r .
A r
203
RP
• Note, however, that before the change in C0 and r0 , it held that Y > YZLB ,
and that after the change in C0 and r0RP , it holds that Y ' < YZLB .
• The short-run macroeconomic outcome thus has switched from a "normal

business cycle" outcome (along the upward-sloping portion of the extended
TR-curve) to a "deep crisis" outcome (along the downward-sloping portion of
the extended TR-curve).
• As the extended TR-curve is not differentiable at YZLB , the overall change in

the interest rate, r , can thus not be obtained using differentiation-based
techniques only.
• The following graphical analysis-based decomposition provides one means to

calculate r :
204
r Extended TR '
IS
IS ' Extended TR
C0 r0
RP
'
r '   r0RP   ry  Y '  Y ZLB 
D
'
r   r0RP 
C
r  r MP  r0RP A
' B
r   r MP   r0RP

0
0 Y' YZLB Y Y
What is ∆r ?
RP '
r Point D from Point A
  r MP  r
 
0  r0
RP
   ry  Y '  Y ZLB  .

r Point B from Point A r Point C from Point B r Point D from Point C
205
• From Point A to Point B: The monetary policy rate has decreased from rMP > 0
to  r   0 . The associated change in the interest rate is
MP '
r B
Point A  r
from Point B  r A  
Point r  r  r 
Point 0
RP MP
0
RP
  r MP .
 Point B
Point A
(104)
• From Point B to Point C: The exogenous component of the risk premium has
increased from r0
RP
to r0 RP '
 
. The associated change in the interest rate is
'
r Point C from Point B  r Point C  r Point B 

r 

 
0
RP

r0RP
 
 r0RP .
Point C Point B
(105)
206
• From Point C to Point D: The endogenous component of the risk premium has
increased from 0 to  ry  Y '  Y
ZLB
 
. The associated change in the interest rate
is
r Point D from Point C  r Point D  r Point C
' '
  r0RP   ry  Y '  Y ZLB    r0RP    ry  Y '  Y ZLB  .
  
Point D Point C
(106)
207
Equations (81), (104), (105) and (106) give us the following decomposition
of the overall change in output:
Y A
 A    1.167 .
A 1  (C y  TBim  Gy )
• Change in output due to crowding in of consumption, investment and

the trade balance caused by the decrease of the monetary policy rate to
zero:
Y Cr  I r  TB   r
   r MP       r MP   0.867 .
r 1  (C y  TBim  G y )
208
• Change in output due to crowding out of consumption, investment and

the trade balance caused by the increase of the exogenous component
of the risk premium:
Y Cr  I r  TB   r
 r0RP    r0RP   1.733 .
r 1  (C y  TBim  G y )
• Change in output due to crowding out of consumption, investment and

the trade balance caused by the increase of the endogenous component
of the risk premium:
Y Cr  I r  TB   r
   ry   Y '  Y ZLB       ry   Y '  Y ZLB    0.396 .
r 1  (C y  TBim  G y )
209
Workbook for the Extended IS-TR Model (Financial Crises)

The workbook Extended-IS-TR-Model-FinancialCrises.xlsm allows to study
how changes in the autonomous components of aggregate demand and/or
other model parameters affect output in the ("deep crisis" or "normal business
cycle") short-run macroeconomic outcome, …
Extended IS‐TR Model (Financial Crises): Specification Extended IS‐TR Model (Financial Crises): Graph
Parameters Extended IS‐TR Model
0.20
TR‐Curve Parameters Initial New

r 0MP 0.020 0.020
r 0RP 0.010 0.050
y 0.500 0.500 0.15
Y 15.000 15.000
ry 0.005 0.005
IS‐Curve Parameters Initial New 0.10

Cr 4.000 4.000
Ir 16.000 16.000
TB  1.000 1.000
Interest Rate
r 6.000 6.000 0.05

Cy 0.600 0.600
TB im 0.050 0.050
Gy 0.150 0.150
A 9.780 9.080 0.00
C0 1.500 0.800 9 10 11 12 13 14 15 16 17 18
I0 3.000 3.000
G0 2.800 2.800
TB 0 0.000 0.000
‐0.05
0 1.000 1.000
T 3.000 3.000
TB ex 0.010 0.010
Y* 100.000 100.000
‐0.10
T* 30.000 30.000 Output
r* 0.030 0.030
210
… how these output effects may be decomposed, and how the other
endogenous variables change:
Extended IS‐TR Model (Financial Crises): Keynesian Multiplier Initial and New Short‐Run
and Consumption, Investment as well as Exchange Rate Channels: Macroeconomic Outcomes
Autonomous Demand and/or Exogenous Component of Risk Premium Absolute Percentage
Initial New Change Change
Keynesian Multiplier Output 15.000 12.570 ‐2.430 ‐16.199
Stimulus: Change in A ‐0.700 Interest Rate 0.030 0.059 0.029 97.163
Size of Multiplier 1.667 Monetary Policy Rate 0.020 0.000 ‐0.020 ‐100.000
Change in Output ‐1.167 Consumption 8.580 6.306 ‐2.274 ‐26.509
Investment 2.520 2.054 ‐0.466 ‐18.507
Intererest Rate Implied Changes in Output Government Expenditure 2.800 3.164 0.364 13.017
endog. comp. Trade Balance 1.100 1.047 ‐0.053 ‐4.855
r MP r 0RP of r RP r Exchange Rate 1.000 0.825 ‐0.175 ‐17.489
Interest Rate Change: Consumption Channel
Change in Output 0.133 ‐0.267 ‐0.061 ‐0.194
Interest Rate Change: Investment Channel
Change in Output 0.533 ‐1.067 ‐0.244 ‐0.777
Change in Output 0.200 ‐0.400 ‐0.091 ‐0.291
Sum of Intererest Rate Implied Changes in Output
Change in Output 0.867 ‐1.733 ‐0.396 ‐1.263
Sum of Effects ‐2.430
211
Prof. Michael Binder, Ph.D. The COVID-19 Pandemic
Pandemics
The COVID-19 pandemic has impacted macroeconomies through a variety

of supply and demand shocks that have affected different sectors of the
economy in heterogeneous manner:
• Some sectors (such as, say, the hygiene products industry) were
struggling to keep up with demand, and were limited by constraints on
expanding supply in the short run.
• A sizable number of other sectors (such as, say, the hospitality and
airline industries) faced a near collapse of demand, and had to lay off
employees to reduce excess capacity.
Modelling a macroeconomy with such heterogeneous production sectors
would be well beyond the scope of this course. Rather, we model the
outbreak of the pandemic in simplified form as the following combination
of aggregate demand and supply shocks:
212
• An aggregate demand shock occurring in the form of a shock to consumption

demand (households reducing their overall consumption expenditure in
response to lockdown restrictions and/or social distancing choices made out of
fear of infection). To study the impact of such a shock, we augment our
specification of the aggregate consumption function as follows:
C  1     C0  C y  Y  T   Cr  r  , (107)
where ι   0, 1 denotes the fraction of consumption expenditure not

occurring due to lockdowns and/or social distancing (for a given level
of available income, the interest rate and the other factors (in C0 ) driving
consumption expenditure).
213
• Mirroring these effects on domestic consumption, we also take account of

corresponding effects of foreign lockdown restrictions and/or foreign social
distancing on the exports:
TB  TB0  TBex  1   *   ( Y *  T * )  TBim  1     (Y  T )  TB   0   r   r  r *   ,

(108)
where ι*   0, 1 denotes the fraction of exports not occurring due to
lockdowns and/or social distancing abroad.
214
• An aggregate supply shock to the level of output produced, as lockdowns

and social distancing in the workplace, as well as firms' liability concerns
lower the level of productivity at which firms can produce. To study the
impact of such a shock to productivity, we augment the model with a
short-run production function:
Y  f0  f1  L   z . (109)

    labor productivity
intercept capturing all factors hours
other than L and z
Remember that in the short-run model firms' output supply by assumption

responds one-to-one to changes in aggregate demand. Thus, in response
to a, say, negative productivity shock (z decreasing), to maintain a given
aggregate demand-implied level of output, firms (for given f0) must
increase labor hours employed.
215
• Having allowed for changes in the level of productivity, we need to re-

consider the specification of the short-run Taylor rule in (62),
 Y Y 
r MP
r n
MP
 y   ,
 Y 
MP
specifically the neutral real rate rn . This rate is best viewed as reflecting
the determinants of the rate of return on savings expected to prevail
when the macroeconomy is along its long-run trend path. These
determinants will include fundamentals such as technology and
demographics. In particular, the higher the level of firms' productivity,
ceteris paribus the higher their demand for loans to fund purchases of
physical capital, and the higher the rate of return on savings. We then
have:
rnMP  rnMP ( z , other factors ) ,

(110)
+
that is,
 rnMP /  z  0. (111)
216
For our quantitative analysis, we will typically specialize the specification

of the neutral real rate in (110) to
rnMP  r0MP  z   z  z  , (112)

  
other than z
with the parameters r0MP and z .
217
Embedding these augmentations, we have the following extended IS-TR

model as applicable to a pandemic:
The components of desired aggregate demand are given by:
C  1      C 0  C y  Y  T   C r  r  , (see Equation (107)),
I  I0  Ir  r (see Equation (15)),
G  G0  G y  (Y  Y ) (see Equation (21)),
TB  TB0  TBex  1   *   ( Y *  T * )  TBim  1     (Y  T )  TB   0   r   r  r *   ,
(see Equation (108)).

Desired aggregate demand is thus given by
DD  AP  1     Cr  I r  TB   r   r + 1      C y  TBim   G y   Y , (113)

with
AP  1     C0  I 0  G0  TB0  TB   0  1     (C y  TBim )  T
(114)
 G y  Y  TBex  1     ( Y  T )  TB   r  r .
* * * *
218
From (113), the IS-curve becomes
Y 
AP

1     Cr  I r  TB   r  r ,
(115)
1  1      C y  TBim   G y  1  1      C y  TBim   G y 
AP 1  1      C y  TBim   G y 
 r    Y. (116)
1     Cr  I r  TB   r 1     Cr  I r  TB   r
From (99), the TR-curve is given by
  Y Y   RP
r  max 0, rnMP   y      r0  ry   Y  Y ZLB
  I  Y  Y ZLB
,
  Y 
but where now, from (112), we have
rnMP  r0MP  z   z  z  ,
and, from (96),
Y
Y ZLB    y  rnMP  .
y
219
Let us examine with this variant of the extended IS-TR model the short-run
macroeconomic effects of the combination of aggregate demand and supply
shocks that we have argued to have occurred at the outbreak of the COVID-
19 pandemic:
-- an increase in the fraction of consumption expenditure and/or exports not
occurring due to lockdowns and/or social distancing domestically and/or
abroad,  /  * , and
-- a decrease of productivity in the short-run production function (108), z .
The workbook Extended-IS-TR-Model-Pandemics.xlsm calculates the effects
of these shocks for an economy that, mirroring the situation of the Euro Area
in early 2020, initially is in a deep crisis outcome:
220
Workbook for the Extended IS-TR Model (Pandemics)

The workbook Extended-IS-TR-Model-Pandemics.xlsm allows to study how
combinations of aggregate demand and supply shocks that occur at the
(renewed) outbreak of a pandemic affect output and the interest rate in the
short-run macroeconomic outcome, …
Extended IS‐TR Model (Pandemics): Specification Extended IS‐TR Model (Pandemics): Graph
Parameters Extended IS‐TR Model
TR‐Curve Parameters Initial New 0.20
z 1.000 0.960
z 1.000 1.000
r 0MP 0.020 0.020
r 0RP 0.050 0.050 0.15
y 0.500 0.500
Y 15.000 15.000
ry 0.005 0.005
z 1.000 1.000
0.10

Cr 4.000 4.000
Ir 16.000 16.000 Interest Rate
TB  1.000 1.000 0.05
r 6.000 6.000
Cy 0.600 0.600
TB im 0.050 0.050
Gy 0.150 0.150
0.00
AP 9.180 9.133 9 10 11 12 13 14 15 16 17 18
C0 1.500 1.500
I0 2.400 2.400
G0 2.800 2.800
TB 0 0.000 0.000 ‐0.05
0 1.000 1.000
T 3.000 3.000
TB ex 0.010 0.010
Y* 100.000 100.000
T* 30.000 30.000 ‐0.10
Output
r* 0.030 0.030
 0.000 0.150
* 0.000 0.100
221
… and how the other endogenous variables change:
Initial and New Short‐Run
Macroeconomic Outcomes
Initial and New Short‐Run Macroeconomic Outcomes
Following Changes in Any of the Model Parameters
Absolute Percentage
Initial New Change Change
Output 12.783 10.587 ‐2.196 ‐17.176
Interest Rate 0.058 0.075 0.017 29.229
Monetary Policy Rate 0.000 0.000 0.000 0.000
Consumption 7.137 4.889 ‐2.248 ‐31.497

Investment 1.471 1.199 ‐0.272 ‐18.471
Government Expenditure 3.133 3.462 0.329 10.513
Trade Balance 1.042 0.980 ‐0.062 ‐5.957
Exchange Rate 0.831 0.730 ‐0.102 ‐12.251
222
Turning to a detailed graphical analysis of the type of effects depicted in the

workbook:
r
Extended TR Extended TR '
IS ' IS
, *
z
r'
C
B A
r
r0RP
0
Y' Y YZLB (YZLB ) ' Y
Y
223
The lockdown/social distancing-implied cuts in consumption expenditure

and the decrease of productivity cause the following adjustments:
• The IS-curve shifts to the left, the magnitude of the leftward shift in part
determined by the size of the increases in ι and/or ι*. From (116), both
the intercept and the slope of the IS-curve are a function of ι ; the
intercept is also a function of ι*. The graph depicts (as in the workbook)
the case of the IS-curve becoming steeper.
• If there was no shock to productivity, the macroeconomy would move

from Point A to Point B. As at Point A output is below YZLB , the decrease
of output set off by lower aggregate demand causes the endogenous
component of the risk premium to rise, increasing the cost of borrowing
for households and firms, and in turn further decreasing desired
aggregate demand through the consumption, investment and exchange
rate channels (crowding out effects).
224
• However, the productivity shock also shifts the extended TR-curve. Note that
Y  Y ZLB   r0  z   z  z  
MP
Y ZLB Y
     y  rn   /  z 
MP
    z  0, (117)
z   y  rn z y
MP

and so the kink of the extended TR-curve shifts right as z decreases. Given
that the endogenous component of the risk premium then begins to become
positive at a higher level of output, at Point B it is higher than before the
productivity shock, leading to further crowding out effects through the
consumption, investment and exchange rate channels.
• At Point C, the intersection of the new IS-curve with the new extended TR-
curve, the interest rate is given by r ' > r. The increase of the interest rate is
fully due to the rise of the endogenous component of the risk premium. Notice
that at all stages of the adjustment process the central bank cannot stimulate
economic activity through lowering the monetary policy rate, as it is
constrained by the zero lower bound.
225
Quantitative Analysis
As all outcomes in our graphical analysis are deep crisis outcomes, let us
focus on these. Combining under rMP = 0 the extended TR-curve (99) with
the IS-curve (115), we have:
AP  1     Cr  I r  TB   r    r0RP  ry  Y  Y ZLB  

Y  , (118)
1  1      C y  TBim   G y 
where from (96) and (112)
Y ZLB 
Y
y

  y   r0MP  z   z  z   . (119)
The short-run level of output can be obtained by solving (118) for Y :
226
AP  1     Cr  I r  TB   r    r0RP  ry  Y  Y ZLB  

Y  ,
1  1      C y  TBim   G y 
 1     C  I  TB     r 
 r
AP  1     Cr  I r  TB   r    r0RP  ry  Y ZLB 
 1  r r  y
 Y 
 1  1      C y  TBim   G y   1  1      C y  TBim   G y 
  
AP  1     Cr  I r  TB   r    r0RP  ry  Y ZLB 

1  1      C y  TBim   G y 
 Y  , (120)
1     Cr  I r  TB   r   ry
1
1  1      C y  TBim   G y 
with YZLB given by (119):
Y ZLB 
Y
y

  y   r0MP  z   z  z   . 
227
The short-run rate of interest immediately follows from Equation (100):

r  r0RP  ry  Y  Y ZLB  , (121)
with YZLB again given by (119).
We are then once again in a position to also plug back into our
consumption, investment, government expenditure, trade balance and
exchange rate functions to obtain the short-run outcomes for C, I, G, TB
and ε.
228
Numerical Example:
Suppose C0 = 1.5, Cy = 0.6, T = 3, Cr = 4, ι = 0, I0 = 2.4, Ir = 16, G0 = 2.8,
Gy = 0.15, TB0 = 0, Y * = 100, T * = 30, TBim = 0.05, ι* = 0, TBex = 0.01,
TBε = 1, ε0 = 1, εr = 6, r * = 0.03, r0MP  0.02 , z  1 , z = 1, z  1 ,  y  0.5 ,
Y  15 , r0RP  0.03, ry = 0.005.
p
These parameter values imply that A  9.18. Calculating the initial short-run
outcome:
Presume that we are in the "deep crisis" outcome, so that rMP = 0: From
Equations (119) and (120) we obtain YConjecture ≈ 13.889 and YZLB = 14.4.
Also, the Taylor rule (see Equations (62) and (112)) for Y ≈ 13.889 would
imply that rMP ≈ − 0.017. So we are indeed in the "deep crisis" outcome.
From Equation (103), we obtain r ≈ 0.033.
229
Now suppose
  0.15,  *  0.1 and z  0.04.
These parameter values imply that
( A p ) '  9.133 and (rnMP ) '  0.02.
Presume that we are in the "deep crisis" outcome, so that (rMP) ' = 0: From
Equations (119) and (120) we now obtain Y Conjecture ≈ 11.502 and YZLB = 15.6.
Also, for Y ' ≈ 11.502, the Taylor rule would imply that (rMP) ' ≈ − 0.137. So we are
indeed in the "deep crisis" outcome. From Equation (103), we obtain r ' ≈ 0.050.
230
Macroeconomics 1 (BMAK) 6. Fiscal and Monetary Policy Options in "Deep Crises"
Wintersemester 2020/21 Fiscal Policy
6. Fiscal and Monetary Policy Options in "Deep Crises"

Readings:
- Jones (2020), Chapters 10 and 14
What stabilization measures could policy decision makers pursue when the
macroeconomy is in a "deep crisis"? A first option would appear to be
expansionary fiscal policy, such as an increase of government
expenditure through an increase of G0 :
r
IS '
IS Extended TR
G0
A
r
r'
B
0
Y Y Y' Y 231
• Note that expansionary fiscal policy initiated in a "deep crisis" outcome will
be particularly effective as long as output remains below its zero lower
bound level, YZLB, as then
-- no crowding out through the consumption, investment or exchange rate
channels takes place, and
-- the endogenous component of the risk premium falls as output is
increasing (reflecting lower rates of default and increasing values of
collateral as the economy is beginning to recover), causing crowding in
effects.
• Output following an increase in government expenditure thus overall
increases in such a setting even more than the Keynesian multiplier would
suggest.
However, there is still the issue as to how the additional government
expenditure is to be funded.
232
• In a "deep crisis" outcome, the government budget is likely to be

strained as is, given low tax revenue and high levels of government
transfers.
• When fiscal policy makers increase government expenditure at the cost

of taking up additional debt, this may have adverse consequences for
the sovereign debt rating, and thus cause a rise of the cost at which the
government can borrow.
• This in turn may severely limit the "fiscal space" for increases of
government expenditure.
In conclusion:
Expansionary fiscal policy can be a promising option to pursue when the
macroeconomy is in a "deep crisis", if the government prior to entering the
"deep crisis" had been engaging in countercyclical expenditure (saving up
funds when the economy was in expansion).
233
Wintersemester 2020/21 Unconventional Monetary Policy
A second option for macroeconomic stabilization could be expansionary

unconventional monetary policy (which may be considered to include
any policy option at the disposal of the central bank that aims at
stimulating macroeconomic activity, beyond the normal business cycle
option of lowering the monetary policy rate).
• The U.S. Federal Reserve, for example, started to pursue such

monetary policy since late 2008, specifically through large-scale
purchases of long-term U.S. Treasury bonds and other long-term
securities ("Quantitative Easing"):
234
Balance Sheet Expansion of All U.S. Federal Reserve Banks

(Million U.S. Dollars)
Sources of Data: Federal Reserve Bank of St. Louis (2020) and Board of Governors of the Federal Reserve System (2020)
235
• The objective of this unconventional monetary policy was to compress

the spread between yields on long-term U.S. bonds and the U.S.
monetary policy rate (the Federal Funds Rate), so as to lower the long-
term rates at which U.S. households and firms can borrow.
• If a central bank starts a purchase program for long-term bonds, this will
lead to an increase of the price of these bonds and therefore lower the
rate of return on these bonds.
• To understand this, consider a generic coupon bond, that involves
-- annual payments (coupon payments), plus
-- a final payment at the maturity date (the final payment is equal to
the initial loan amount granted by the holder of the bond, and is
often called the principal/face value of the bond).
236
• The price of a coupon bond is given by the present value of all its
payments:
CP CP CP F
PCB    ...   , (122)
1 R (1  R ) 2 (1  R) n (1  R) n
where PCB denotes the price of the bond, CP the (fixed) yearly coupon
payment, F the face value of the bond, and R the nominal interest rate
(yield to maturity).
• The yield to maturity of a coupon bond thus equates the present value
of all of the bond's future payments to the bond's price.
• Clearly, as PCB rises, R falls.
237
• Furthermore, no-arbitrage arguments suggest that

-- when the maturity premium on long-term government bonds falls, then
the maturity premium should fall for all types of issuers of bonds
(including firms as issuers of corporate bonds), and
-- commercial banks should then also want to lower the interest rate they
charge households and firms on long-term loans.
Consider then the effects of an expansionary uncoventional monetary policy

that succeeds in lowering the cost of borrowing for households and firms
through lowering the exogenous component of the domestic risk premium, r RP:
238
r
Extended TR
Extended TR '
IS r0RP
A
r
B
r'
0
Y Y Y' Y
239
• Expansionary unconventional monetary policy that succeeds in reducing the

exogenous component of the risk premium will be most effective as long as
output remains below its zero lower bound level, YZLB, as then the
endogenous component of the risk premium falls as output is increasing
(reflecting lower loan risk as the economy is beginning to recover),
enhancing the "normal business cycle" crowding in effects.
• Expansionary unconventional monetary policy may cause problems for

financial market stability, though:
-- If expansionary unconventional monetary policy brings the spectrum of
(nominal) interest rates to low levels, then
-- incentives to save in the form of interest bearing assets may disappear, in
turn
-- causing stock and real estate price booms that are likely to burst, and
thus
-- setting off further financial market turmoil.
240
• Turning to the European case, the European Central Bank (ECB), as

we had seen before, faced the zero lower bound issue notably later
than the U.S. Federal Reserve, in the fall of 2014.
• The ECB decided to pursue expansionary unconventional monetary
policy measures only in early 2015 (when faced with Euro Area
unemployment at persistently high levels following the European
sovereign debt crisis that had started in 2011).
• The ECB in early 2015 launched its large-scale "Public Sector
Purchase Programme", and thus at that time started to engage in
Quantitative Easing.
• The bond purchases under this program are allocated across
countries according to the ECB's capital key.
• As ECB purchases of sovereign debt were ruled out by the Maastricht
Treaty, the purchases are subject to certain further restrictions, such
as no purchases occurring in the primary market.
241
Balance Sheet Expansion of Eurosystem Central Banks

(Million Euro)
242
• Since the cost of borrowing in the Euro Area was already rather low in
early 2015, however, there was relatively limited scope to stimulate
output through further reductions of the cost of borrowing.
• A number of observers argue that the ECB has been aiming at a
depreciation of the Euro (by creating the expectation that future
monetary policy rates in the Euro Area would remain low, specifically
vis-a-vis those in the U.S.).
Consider then the effects of an expansionary unconventional monetary

policy that (slightly) lowers the exogenous component of the domestic
risk premium, and leads to a depreciation of the current value of the
domestic currency through affecting future expectations. From the
exchange rate function (25),
   0   r  (r  r * ) ,
this exchange rate effect can be modelled as an increase of 0 .
243
r
IS '
IS Extended TR
0 Extended TR '
A
r
r0RP
B
r'
0 Y
Y Y Y' YZLB
244
• Expansionary unconventional monetary policy in this case stimulates

output through
-- the exchange rate channel (and resultant Keynesian multiplier effects),
-- (slightly) reducing the exogenous component of the risk premium, and
-- the decrease of the endogenous component of the risk premium (once
more reflecting lower loan risk as the economy is beginning to
recover).
• The trade balance gain of the domestic economy is mirrored in a trade

balance loss of the foreign economies (an example of a "beggar-thy-
neighbor" policy), though, and thus the foreign monetary authorities may
not accept (for long) that their currencies are subject to appreciation.
245
Also:
When the macroeconomy is in a "deep crisis" and (short- and long-term)
interest rates are very low, one may want to aim at policies addressing
the fundamental sources of weak aggregate demand, whether these
may involve, say,
-- low levels of investment as firms do not expect long-run growth, or
-- consumption weakening because of demographic developments.
246

BMAK Short-Run Models

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Goethe University Frankfurt

III. The Macroeconomy in the Short Run

III. The Macroeconomy in the Short Run

1990q1 2000q1 2010q1 2020q1

The graphs highlight that there is a pattern of sustained cyclical fluctuations in

This pattern is called business cycles. A business cycle consists of two

Graph of a Stylized Business Cycle

Understanding and forecasting business cycle regularities is high on the

So-called Burns-Mitchell diagrams inform us about the typical output

In terms of algebraic representation, constructing the Burns-Mitchell diagram

Let us illustrate these steps graphically with an example involving a sample

Peak for t=−3

Burns-Mitchell Diagrams for Germany and the U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Illustrating the conceptual issues involved in constructing these diagrams for

In terms of algebraic representation, constructing the Burns-Mitchell diagrams for

(grand average of Xi,s across all M ∙ 21 periods considered),

X s  X   100%, if series is measured in logarithms,

Burns-Mitchell Diagrams for Germany and the U.S.

Real Consumption, Germany Real Consumption, U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Burns-Mitchell Diagrams for Germany and the U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Burns-Mitchell Diagrams for Germany and the U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Burns-Mitchell Diagrams for Germany and the U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Burns-Mitchell Diagrams for Germany and the U.S.

Inflation, Germany Inflation, U.S.

Source of Data: Federal Reserve Bank of St. Louis (2020)

Key Business Cycle Regularities Revealed

• average output loss from peak to trough: about 1% to 2%;

• consumption and investment are pro-cyclical, with investment notably

Strategy to Develop Models of Business Cycles

From the Burns-Mitchell diagrams, we have learned that business cycles

Developing a model of business cycles will require us to consider the decision

These impulses will then be propagated through mechanisms such as feedback

2. The Real Sector: Aggregate Demand and the IS-Curve

Using the same notation as in our discussion of the macroeconomic accounts,

C  C( Y T , r , other factors ) , (1)

with C /  Y  T   0 (but less than one), and C / r  0 (but small in

For the quantitative analysis of business cycles, we will require a specific

with the parameters C0 , Cy , and Cr . Considering linear functional forms

How can the aggregate consumption functions in Equations (1) to (3) be

Ccurrent  1  r   Wbeginning of current period  Ycurrent  Tcurrent   

Solving the lifetime budget constraint (7) for C future , we obtain

Cfuture  1 r    PVR  Ccurrent  . (8)

u '  Ccurrent  1 r (10)

As an example, consider the instantaneous utility function

The ratio between current and future consumption is independent of current

How then do households adjust consumption to changes in their available

From Equation (10), the household will want to

Let us ask next how households adjust consumption to changes in the

• For debtors the overall effect of an increase in the interest rate on

• In the macroeconomy, that features both creditors and debtors, the

• The empirical evidence suggests that following an increase in the

To summarize: We have provided a theoretical rationale for the consumption

with C /  Y  T   0 (but less than one), and C / r  0 (but small in

Recall once more that "investment" in the macroeconomic accounts

Thus I / r  0 , with this effect in absolute value being empirically rather

with the parameters I0 and Ir .

To keep notation as simple as possible, we also assume that the prices of

The firm then aims to