BMAK Lectures III Part3

Goethe University Frankfurt III.
The Macroeconomy in the Short Run

Macroeconomics 1 (BMAK) 4. Short-Run Macroeconomic Outcomes: The IS-TR Model
Wintersemester 2022/23
Prof. Michael Binder, Ph.D.
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.
134
Goethe University Frankfurt III. The Macroeconomy in the Short Run
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 * )  ,
135
which together yielded the IS-curve in Equation (51):

A Cr  I r  TB   r
Y    r,
1  (C y  TBim  G y ) 1  (C y  TBim  G y )
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 * .
136
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.
137
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.
138
Wintersemester 2022/23 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
139
 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.
140
 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),
141
‐ 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.
142
Wintersemester 2022/23 Quantitative Analysis
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). Substituting from the TR-curve, (75),
 Y Y 
r r 0
MP
 y     r0
RP
,
 Y 
into the IS-curve, (51),
A  (Cr  I r  TB   r )  r
Y  ,
1  (C y  TBim  G y )
we obtain
 MP  y 
A  (Cr  I r  TB   r )   r0   Y   y  r0RP 
 Y  ,
Y  (76)
1  (C y  TBim  G y )
which is one equation in one unknown, namely Y , and we can thus solve for Y as
follows: 143
Macroeconomics 1 (BMAK) 5. Short-Run Macroeconomic Effects of Financial Crises and
Wintersemester 2022/23 Pandemics: The Extended IS-TR Model
Prof. Michael Binder, Ph.D. Quantitative Analysis
  Cr  I r  TB   r     y / Y   A   Cr  I r  TB   r    r0MP  r0RP   y 

1   Y 
 1   C y  TBim  G y   1   C y  TBim  G y 
A   Cr  I r  TB   r    r0MP  r0RP   y 

1   C y  TBim  G y 
 Y  .
 Cr  I r  TB   r     y / Y 
1
1   C y  TBim  Gy 

 Y  . (77)
1   C y  TBim  G y    Cr  I r  TB   r     y / Y 
Equation (77) gives us the IS-TR model-implied output in the short-run

macroeconomic outcome.
144
Macroeconomics 1 (BMAK) 5. Short-Run Macroeconomic Effects of Financial Crises and
Wintersemester 2022/23 Pandemics: The Extended IS-TR Model
Prof. Michael Binder, Ph.D. Quantitative Analysis
To solve for r , we can substitute from (77) back into the TR-curve (75),
 Y Y 
r  r0MP   y     r0 ,
RP
 Y 
to obtain
r  r0MP  r0RP   y  , (78)
Y /  y   1   C y  TBim  Gy    Cr  I r  TB   r 
Equation (78) gives us the IS-TR model-implied interest rate in the short-
run macroeconomic outcome.
We are then also in a position to plug back into the consumption, investment,
government expenditure, trade balance and exchange rate functions to obtain
the short-run outcomes for C, I, G, TB and ε .
145
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 Equations (77) and (78), we obtain Y = 15

and r = 0.03.
*
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 * *
A  *
 Y  TBex  Y  0.15 . (79)
Y
146
From Equation (77) we then have that

Y 1
Y   A   A  0.102,
A 1   C y  TBim  G y    Cr  I r  TB   r     y / Y 
(80)
and from Equation (78) that
r 1
r   A   A  0.003.
A Y /  y   1   C y  TBim  Gy    Cr  I r  TB   r 
(81)
An alternative derivation of the output change provides further economic

insight:
147
From the IS-curve, (51),

A  (Cr  I r  TB   r )  r
Y  ,
IS  curve
1  (C y  TBim  G y )
we have that
Y Y r Y Y
Y   A    A   A   r ,
 A IS curve r A  A IS curve r
IS  curve 
  IS  curve
 r
(82)
and thus
1 Cr  I r  TB   r
Y   A   r . (83)
Substituting into (83) for ∆A from (79) and for ∆r from (81) then yields ∆Y ≈
0.102 , as in (80); as a novel feature, however, Equation (83) gives us a
useful decomposition of the overall change in output:
148
• Change in output due to Keynesian Multiplier effect:

A (84)
 0.25 .
1  (C y  TBim  G y )
• Change in output due to crowding out of consumption (consumption

channel):
Cr
  r   0.023 . (85)
1  (C y  TBim  G y )
• Change in output due to crowding out of investment (investment

channel):
Ir
  r   0.091. (86)
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 . (87)
1  (C y  TBim  G y )
149
Hands-On Analysis of the IS-TR Model

The interactive tool under bmak.macromodels.eu 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, …
150
… and how the other endogenous variables change:
151
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 short-run outcomes?
152
Noting from the TR-curve (75) that

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 (88)
0,
 Ir
and
 TR1
 0. (89)
 Ir
Changes in the sensitivity of investment to the interest rate, Ir , may therefore

affect business cycle outcomes only through the IS-curve.
153
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. (90)
 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, (91)
 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. 154
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 short-run output and interest rate prevailing under I r  34 , simply re-
place I r in Equations (77) and (78) by I r :
Y 
 
A  Cr  I r  TB   r   r0MP  r0RP   y 
 14.739 (92)
 
1   C y  TBim  G y   Cr  I r  TB   r    y / Y 
and
r  r0MP  r0RP   y 
 
A  Cr  I r  TB   r   r0MP  r0RP   y 
 0.021.

Y /  y   1   C y  TBim  Gy   Cr  I r  TB   r 
(93)
155
Following an increase of foreign output, Y*, again by 15, we now have from
Equation (81) (again with I r replaced by I r ) that
r 1
r   A   A  0.002
A 
Y /  y   1   C y  TBim  Gy   Cr  I r  TB   r
 
(94)
and thus from Equation (83) (once more with I r replaced by I r ) that
1 Cr  I r  TB   r
Y   A   r  0.073 . (95)
Under the increase of the sensitivity of investment to the interest rate

considered in this numerical example, the change in output therefore is
smaller than before, that is, the short-run expansion is weaker.
Decomposing the overall change in output that now occurs:
156
• Change in output due to Keynesian Multiplier effect:

A
 0.25 , (96)
1  (C y  TBim  Gy )
independent of the sensitivity of investment to the interest rate.
• Change in output due to crowding out of consumption (consumption

channel):
Cr (97)
  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.
157
• Change in output due to crowding out of investment (investment

channel):
Ir (98)
  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 . (99)
1  (C y  TBim  Gy )

rate the crowding out effects due to the exchange rate channel are
smaller, as the central bank increases the monetary policy rate by less.
158
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.
159

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Goethe University Frankfurt III.

The Macroeconomy in the Short Run

4. Short-Run Macroeconomic Outcomes: The IS-TR Model

• We are now in a position to consider the determination of short-run

• We will obtain (short-run) output, Y, and the interest rate, r , by

The baseline IS-TR model consists of the specifications of desired aggregate

TB  TB0  TBex  ( Y *  T * )  TBim  (Y  T )  TB   0   r  (r  r * )  ,

which together yielded the IS-curve in Equation (51):

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 * ,

Having obtained the IS- and TR-curves, we can graph both:

The short-run macroeconomic outcome occurs at the intersection of the IS-

Set of adjustments following an increase in foreign income, Y* :

 Starting from the original outcome at Point A, the increase in Y* causes

• At the initially market-clearing interest rate, r, output first rises due to

• As output has increased from Point A to Point B, the interest rate

• As the interest rate increases, the movement from Point B to Point C

‐ firms decrease investment in physical capital, also reducing desired

• The new short-run outcome simultaneously clearing the real and

Quantitative Analysis of the IS-TR Model

  Cr  I r  TB   r     y / Y   A   Cr  I r  TB   r    r0MP  r0RP   y 

A   Cr  I r  TB   r    r0MP  r0RP   y 

A   Cr  I r  TB   r    r0MP  r0RP   y 

Equation (77) gives us the IS-TR model-implied output in the short-run

Suppose A = 9.78, Cy = 0.6, Gy = 0.15, TBim = 0.05, TBex = 0.01,

Using these parameter values in Equations (77) and (78), we obtain Y = 15

From Equation (77) we then have that

An alternative derivation of the output change provides further economic

From the IS-curve, (51),

• Change in output due to Keynesian Multiplier effect:

• Change in output due to crowding out of consumption (consumption

• Change in output due to crowding out of investment (investment

• Change in output due to crowding out of the trade balance (exchange

Hands-On Analysis of the IS-TR Model

… and how the other endogenous variables change:

Noting from the TR-curve (75) that

Changes in the sensitivity of investment to the interest rate, Ir , may therefore

Recalling the IS-curve (51), re-written in the form of Equation (52),

Consider a numerical example: Instead of I r  16 , suppose that we have that

Under the increase of the sensitivity of investment to the interest rate

• Change in output due to Keynesian Multiplier effect:

independent of the sensitivity of investment to the interest rate.

• Change in output due to crowding out of consumption (consumption

reflecting that under increased sensitivity of investment to the interest

• Change in output due to crowding out of investment (investment

reflecting that under increased sensitivity of investment to the interest

• Change in output due to crowding out of the trade balance (exchange

reflecting that under increased sensitivity of investment to the interest

The reason as to why in our numerical example the short-run expansion

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