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Appendix
Appendix
to 1
22
to
Chapter
Chapter
The Effects of
Macroeconomic Shocks
on Asset Prices
B y explicitly including the MP and IS curves in the aggregate demand and supply
analysis, we can analyze the response of asset prices, in particular real interest
rates and stock prices, to the macroeconomic shocks we discussed in the chapter.
We start by using aggregate supply and demand analysis along with the MP and IS
curves to explain the impact of demand and supply shocks on real interest rates, infla-
tion, and aggregate output. Then, using a standard formula for valuation of stocks, we
use our results to determine the impact of these shocks on stock prices.
Figure 1
Response to an (a) MP Curve
Autonomous Real
MP1
Monetary Easing Interest
The Fed’s decision to Rate, r
MP2
lower interest rates
at any given inflation 1 3
rate shifts the mon- r1
etary policy curve in
panel (a) from MP1 r2
2
to MP2 and shifts the
aggregate demand
curve in panel (c)
to the right to AD2,
because the lower Step 1. Autonomous monetary
real interest rate at easing temporarily reduces
any given inflation p1 p2 p3
real interest rates . . .
rate leads to higher Inflation Rate, p
investment spending
and net exports. The
economy moves to (b) IS Curve
point 2 in all three Real
panels, with a higher Interest
rate of inflation at π2 Rate, r
and higher output at
Step 2. which temporarily
Y2, and as can be seen raises aggregate output
from the IS curve in 1, 3
r1 in the IS diagram . . .
panel (b), a lower
2
real interest rate at r2. r2
Because Y2 is greater
than Y P, the short-
run aggregate supply
curve will now shift
upward until it
reaches AS3, and the IS
economy will move Y1 Y2
to point 3, where ag-
gregate output is now Aggregate Output, Y
back at potential and
inflation has risen to (c) AD/AS Diagram
π3. The real interest Step 4. but permanently AS3
rate is back at r1 Inflation raises inflation. LRAS
because output is Rate, p
back at Y1 = Y P. AS1
3
p3 2 Step 3. and temporarily
p2 raises output in the
1 AD/AS diagram . . .
p1
AD2
AD1
Y = Y1 Y2
P
Aggregate Output, Y
W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-3
The conclusion from this exercise is that an autonomous monetary policy easing
reduces real interest rates and raises aggregate output temporarily but not perma-
nently. On the other hand, the inflation rate does rise permanently.
This result illustrates the point that monetary policy authorities can affect real inter-
est rates in the short run, but they do not control real interest rates in the long run.
Indeed, as we see in panel (b), the long-run real interest rate is determined by the IS
curve when output is at Y P.
Spending Shocks
Spending shocks can be caused by changes in fiscal policy (changes in taxes or govern-
ment purchases) or by autonomous changes in consumption expenditure, investment
spending, or net exports. Let’s see what happens when there is a positive spending
shock, either because government purchases increase or because business optimism
leads to an increase in investment. Because monetary policy is unchanged, the MP
curve in panel (a) of Figure 2 does not shift. The IS and AD curves in panels (b) and
(c), however, shift to the right, as we learned in Chapters 20 and 21, because increased
spending causes equilibrium output to increase at any given inflation and real interest
rate. The economy moves to point 2 in panel (c), with output and inflation higher at Y2
and π2, respectively. Because inflation is higher, we see from panels (a) and (b) that the
real interest rate has risen to r2. Then, as we saw in the previous example, the aggregate
supply curve shifts up to AS3, and the economy moves to point 3. Output returns to
potential, but notice that because inflation rises to π3, the real interest rate rises even
further to r3 in panels (a) and (b).
We can conclude that positive spending shocks lead to higher real interest rates
in both the short and long runs. Positive spending shocks lead to higher output in the
short run but not in the long run, and lead to higher inflation in both the short run
and the long run.
Figure 2
Response to a (a) MP Curve
Positive Spending Real
MP
Shock Interest
A positive spending Rate, r
Step 5. Real interest rate
shock shifts the IS increases.
and AD curves to the
3
right, to IS2 in panel r3
(b) and to AD2 in 2
r2
panel (c). The 1
r1
economy moves
Step 4. Short-run and
to point 2, with long-run inflation increase.
output and inflation
higher at Y2 and π2,
respectively. Because
inflation is higher, we
see from panels (a) p1 p2 p3
and (b) that the real
Inflation Rate, p
interest rate in the
short run has risen
to r2. Because Y2 is (b) IS Curve
greater than Y P, the Real
short-run aggregate Interest
supply curve then Rate, r IS2
shifts up to AS3, and
the economy moves IS1
to point 3. Output 3
returns to potential, r3 2
but because inflation r2
rises to π3, the real r1
interest rate rises 1
even further to r3. Step 1. Positive
spending shock
shifts IS to right.
Y1 Y2
Aggregate Output, Y
3
p3 2
p2 1 Step 2. and
p1
shifts AD to right.
AD2
AD1
YP = Y1 Y2
Aggregate Output, Y
W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-5
Figure 3
Response to a (a) MP Curve
Temporary Real
MP
Negative Supply Interest
Step 3. increasing real
Shock Rate, r
interest rates in the short run . . .
The temporary
negative supply shock 2
leads to an upward r2
shift in the aggregate
r1
supply curve to AS2 1
in panel (c). When
the economy moves
to point 2, where
output has fallen
to Y2 and inflation
has risen to π2, the
p1 p2
interest rate rises to
r2 at point 2 on both Inflation Rate, p
the MP and IS curves
in panels (a) and (b).
Because Y2 is less (b) IS Curve
than Y P, in the long Real
run, the aggregate Interest
supply curve will Rate, r
shift back down to
AS1 and the economy Step 4. and decreasing
will return to point 2
r2 output in the short run.
1, where inflation,
1
output, and the real r1
interest rate will
return to their initial
levels.
IS
Y2 Y1
Aggregate Output, Y
2
p2 1 Step 1. A temporary
p1 negative supply shock
shifts AS upward . . .
AD1
Y2 YP = Y1
Aggregate Output, Y
W-6 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices
P0 = a
∞ Dt
s t (1)
t = 1 11 + r 2
where
P0 = the current price of the stock, where the zero subscript refers to time
period zero—that is, the present
Dt = the dividend paid at time t
k e = the required return on investments in equity
Future dividends should be positively related to overall economic activity and thus to
aggregate output, while the required rate of return on stocks that we use to discount
the future dividends should move positively with the real interest rate. Armed with
these facts, we can now determine how demand and supply shocks affect stock prices.
Spending Shocks
In Figure 2, we saw that a positive spending shock leads to both higher output
and higher real interest rates in the short run, and to higher real interest rates in
the long run. Here, the effects on stock prices are unclear. The higher output value
would increase the numerator in Equation 1 and would therefore raise stock prices,
whereas the higher real interest rate values would increase the denominator and
thereby cause stock prices to fall. The effect of a positive spending shock on stock
prices is ambiguous.
W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices W-7
IS
Y2 Y1
Aggregate Output, Y
2
p2 Step 1. A permanent
1
negative supply shock
p1 shifts LRAS leftward
and AS upward . . .
AD1
Y P2 Y P1
Aggregate Output, Y
W-8 W E B A p p e n d i x 1 t o C h a p t e r 2 2 The Effects of Macroeconomic Shocks on Asset Prices