Scribd
Upload
156 views27 pages

Unit 1 - IS-LM-PC

The document discusses the IS-LM-PC model and its key components. It explains the relationship between the IS curve, LM curve, aggregate demand, inflation, expected inflation, and the output gap. It also discusses how monetary and fiscal policy can be used to influence these variables and achieve medium-run equilibrium with potential output and the natural rate of unemployment. Supply and demand shocks are compared and their effects on potential output, the natural rate of interest, and inflation are explained.

Uploaded by

Gunjan Choudhary
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
156 views27 pages

Unit 1 - IS-LM-PC

The document discusses the IS-LM-PC model and its key components. It explains the relationship between the IS curve, LM curve, aggregate demand, inflation, expected inflation, and the output gap. It also discusses how monetary and fiscal policy can be used to influence these variables and achieve medium-run equilibrium with potential output and the natural rate of unemployment. Supply and demand shocks are compared and their effects on potential output, the natural rate of interest, and inflation are explained.

Uploaded by

Gunjan Choudhary
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 27

THE IS-LM-PC MODEL

REVISING THE IS-LM MODEL

• Assume a closed economy,Y=C(Y-T) + I(i) +G.


• I = a – bi
• C = cY – eT.
• 1. Derive an expression for the IS curve.

• 2. What condition needs to be satisfied for the IS curve to be downward sloping?


• 1. If G increases, the IS curve will:
• i. Become steeper ii. Become flatter iii. Shifts to the right. iv. Shifts to the left.
• 2. If taxes increase, the IS curve will:
• i. Become steeper ii. Become flatter iii. Shifts to the right. iv. Shifts to the left.
• 3. Between two points on the IS curve, which of the following is true?
• i. Government spending is higher on the lower point than the upper one.
• ii. Consumption is greater on the lower point than the higher one.
• iii. Investment is higher on the lower point than the higher one.
THE IS-LM MODEL
The IS curve: Y = C(Y) + I(r+x) + G – T(t).

The LM curve: fixed at the rate of interest targeted by the Central


Bank.

What does an inward shift of the IS curve imply?

How can policy:

i. Increase income at a constant interest rate.

ii. Increase income keeping keeping C,G and T constant.


THE LABOUR MARKET
Price-setting equation: W/P = (1/1+m)

Wage setting equation: W/P = F(u,z).

Intersection of both gives natural rate of unemployment,


where wages asked by workers equals wages companies
are willing to give.
WHEN UNEMPLOYMENT BENEFITS
INCREASE WHEN MARKUPS INCREASE
DERIVING THE PHILIPS CURVE

• From wage-setting equation: W = 𝑃! (1 – αu + z).


• From price-setting equation: P = (1+m)W.
• Thus: P = (1+m). 𝑃! (1 – αu + z).
• This can be written as: π = π! + (m + z) – αu.
• What factors increase inflation?
• What is the nature of the trade-off here?
THE NATURAL RATE OF UNEMPLOYMENT

• At the natural rate, the actual price level equals the expected price level (by definition).
• So P = 𝑃! and hence π = π! .
• Thus, at natural rate of unemployment, u = 𝑢" .
• So 0 = (m + z) – α 𝑢" .
• Solve for 𝑢" .
• Rewrite original inflation equation.
THE PHILIPS CURVE

• Relation between inflation and expected inflation depends on gap between


unemployment and natural rate of unemployment.
• π - π! = -α(u - 𝑢" ).
• Assume: Output = Employment. If Employment = N and labour force = L,
we know u = (L-N)/L, => N = L(1-u).
• If Y=N,Y - 𝑌" = -L(u - 𝑢" ).
• Therefore π - π! = (α/L)(Y - 𝑌" )
• (Negative relation between output growth and unemployment rate called
Okun’s Law).
• We assume inflation expectations “anchored”, i.e. π! = π
,.
• Expected inflation fixed, doesn’t change. Thus: π - π
, = (α/L)(Y - 𝑌" ).
• The gap between inflation and inflation expectations depends on the
“output gap”, i.e. the gap between actual output and potential output.
• When Y = 𝑌" , inflation equals expected inflation.
As output increases, inflation
increases (why?)

As output reduces, inflation reduces


(why?)

At potential output, is inflation 0?


THE MEDIUM RUN
If real rate at r, output at Y, inflation rises above target. Real
danger of expectations becoming unanchored.

Central Bank raises interest rate to 𝑟! . Output falls back


to 𝑌! , inflation falls back to expected inflation,
unemployment at natural rate of unemployment.

Nominal interest rate i = π


& + 𝑟! .

Medium-run, all variables growing at rate of money supply.


Real variables independent of monetary policy.
REAL INTEREST RATE

• At medium-run equilibrium, (MRE) real interest rate equals the natural rate of interest, i.e
that real rate of interest where output is an natural level.
• I = 𝑟" + π
'.
• Money demand M/P = Y.f(i).
• At medium-run equilibrium, M/P = 𝑌" . f(𝑟" + π
'). RHS is constant in MRE (why?)
• So M grows at same rate as P. R.o.g of money supply 𝑔# = π
' (How?)
• This is called money neutrality. ONLY in MRE, money supply affects only nominal interest
rate and inflation.
CONDITIONS FOR MEDIUM-RUN EQUILIBRIUM

• 1. Y = 𝑌"
• 2. u = 𝑢"
• 3. π = π! = π
, = 𝑔#
• 4. i = 𝑟" + 𝑔#
THE “NATURAL” RATE OF INTEREST

• Simple definition: natural rate of interest that real rate that achieves
potential output.
• The Central Bank changes the nominal rate of interest, hoping to hit the
natural rate of interest.: r = i – π.
• That is why so important to keep inflation expectations anchored, because
then CB only has to deal with one variable, i.e. nominal interest rates.
• Natural rate of interest can change, depending on shifts in IS and PC (not
because of movements along IS and PC. Important).
IMAGINE AN ECONOMY AT MRE.

• 1. If 𝑟" = π
' = 2%, then what is the nominal rate of interest? At what rate is money supply
growing?
• 2. Assume 𝑟" =2%, and the nominal interest rate is three times the natural rate. What is
the rate of inflation in the economy?
• 3. Imagine an economy where u = 𝑢" = 4%. The natural rate of interest is equal to the
natural rate of unemployment. If the nominal rate of interest is 7%, at what rate must
money supply grow if this must be a MRE?
IMPACT OF INFLATION EXPECTATIONS

• If expectations “anchored”, then if Y > 𝑌" , current rate of inflation fixed.


• If (Y - 𝑌" ) = 2%, and π! = π
, = 2%, then π = 4%. (Assume α/L=1).
• But imagine π! = π234. Then expectations unanchored. Even if (Y - 𝑌" )
fixed, i.e. output fixed at a level above potential, inflation will continue to
increase. (What is the logical story for expectations becoming
unanchored?)
• Period 1: (Y - 𝑌" ) = 2%, π! = π
, = 2%, π = 4%.
• Period 2, (Y - 𝑌" ) = 2%, π! = 4%, π = 6%.
PROBLEMS

• 1. Difficult to know exactly what potential output is.


• 2. Difficult to exactly forecast changes in natural rate of unemployment.
• 3. Economy takes time to respond. Raise interest rates, nothing might happen. But does
that mean more rate hikes needed, or need to give economy some more time to adjust?
• 4. Problem of the zero lower bound. What happens when interest rates can’t be reduced?
• 5. Keynesian crisis: what happens when agents don’t want to invest even if interest rates
reduce?
ZERO LOWER BOUND
AND DEBT
DEFLATION
If interest rate can’t go below r, no way for Central
Bank to bring economy back to potential. Inflation at
A is negative. Deflation occurs.

If expectations unanchored, inflation can reduce


further. If that happens, real rate rises, output
further falls (how?)

Leftward movement on both IS and PC. Monetary


policy ineffective at “liquidity trap”.
FISCAL
CONSOLIDATION
Tax increase, IS shifts leftwards (why?)
Short run, deflation, output falls.
Medium run, come back to potential, but at lower
interest rate, higher investment, lower consumption.
Short run pain can be avoided if fiscal and monetary
policies work together.
Is this beneficial?
This is logic of austerity.
A SUPPLY SHOCK
Assume a rise in the price of oil, or a key input in
production.
Firms may initially absorb costs by reducing profits,
maintaining prices. But then, if price increase, permanent,
will increase markups.
The natural rate of unemployment increases; with higher
markups, real wage they can offer is lower.
Unemployment has to be higher to force workers to
accept it.
SUPPLY SHOCK AND
IS-LM-PC
PC shifts up because of supply shock (what does
this mean?)

Maintaining economy at AA’ leads to increase in


inflation. If high inflation continues, expectations
can become de-anchored.

If inflation has to be tackled, rates must rise,


unemployment increases.
DEMAND SHOCK
Economy at medium run equilibrium A. Potential output,
natural rate of interest given by r. Inflation=expectations.

Now IS curve shifts outwards from IS1 to IS2. Maybe C or G


rises, or T reduces. Economy moves from A to B.

Output rises to Y, inflation>expectations at old rate of interest


r. To reduce inflation, must raise interest rates to bring
economy back to Yn. New position at C, natural rate of interest
is now r`.
COMPARISON OF DEMAND AND SUPPLY SHOCK

DEMAND SHOCK SUPPLY SHOCK


POTENTIAL OUTPUT AND NATURAL RATE IN
DEMAND AND SUPPLY SHOCK

DEMAND SHOCK SUPPLY SHOCK


• Potential output does not change. • Potential output decreases.
• Natural rate of interest increases. • Natural rate of interest increases.
• In short-run, can keep output above • In short-run, even if output doesn’t
potential, but inflation increases. change, inflation increases (since
potential has reduced).
• (All above when economy is at medium-
run equilibrium to begin with. But what if
economy stuck at zero lower bound
below potential?)
IMAGINE AN ECONOMY:

• Period 1: Y=Rs 1000, π = π


$ = 2%. (Assume α/L=1). Is this a medium run
equilibrium? Why?
• Period 2: Output rises to Rs 1020. What happens to inflation? What should
government do? How would you characterize what has happened?
• Period 3: Output falls to Rs 990. What happens to inflation? What should
government do?
• Period 3. Output=Rs 1000, π$ = 2%. π rises to 4%. How would you
characterize this shock? What should government do?
•

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy