IS-LM-PC

Question 1

IS-LM-PC model theory

Answer 1

The IS-LM model describes the economy in the short run, with the goods and financial markets being in equilibrium. We now extend the IS-LM model with the insights from chapters 5 and 6 (Labour Market & Inflation), so that it describes the economy in the medium run.
What we want to explain:
* How do production, unemployment rate and inflation evolve in both the short
and the medium run?
* How do opportunities of state interventions in the medium run differ from those in the short run?

Question 2

Elements of the IS-LM-PC model

Answer 2

IS Y LM lo mismo, ahora lm es r en vez de i
para la PC CURVE tenemos q cambiar la mítica Philips curve para relate el change of inflation con production/output/Y y nos da otra Philips curve describela en la mente y
–> if output Y is above potential Yn, the output gap is positive and inflationary pressure arises (inflation is higher than expected)

Question 3

How is the economy in the medium-run

Answer 3

In the medium run, the inflation rate is equal to the expected inflation
The economy converges to potential output Yn
The real interest rate rn in medium-run equilibrium is called the natural rate, the neutral rate, or the Wicksellian rate of interest.
As in the IS-LM model (short run), we can now analyze how the economy reacts to shocks as well as to economic policy measures.
With IS-LM-PC we can now also look at the effects on the labour market and inflation. - + medium-run perspective

Question 4

Discussion of monetary and fiscal policy with IS-LM-PC

Answer 4

Dilo en alto o en your mind*

Question 5

crowding out effect

Answer 5

:

Short-Run Effects
1. Increase in Government Spending (G): This shifts the IS curve up.
2. Higher Output (Y) and Income: Due to increased demand.

Medium-Run Effects
1. Inflationary Pressure: Output (Y) exceeds the natural level (Yn), causing inflation.
2. Central Bank Response: The central bank raises interest rates (i) to combat inflation.
3. Return to Natural Output (Yn): Higher interest rates reduce private investment (I), leading to a decrease in Y back to its natural level (Yn).

Crowding Out (Medium Run)
- Complete Crowding Out: In the medium run, the increase in G is fully offset by a decrease in I due to higher interest rates, resulting in no net change in aggregate demand.
- Change in Output Composition: The total output (Y) remains at its natural level (Yn), but with more government spending (G) and less private investment (I).

So, crowding out occurs as a medium-run effect when the central bank adjusts interest rates to control inflation, leading to reduced private investment.

Summary of crowdind out effect mechanism.
Increase in G → Boosts demand and shifts IS curve right.
Higher Y and Inflation → Central bank raises interest rates to control inflation.
Higher Interest Rates → Reduces private investment (I).
Crowding Out → The increase in G is fully offset by the decrease in I, resulting in no net change in aggregate demand.
Therefore, in the medium run, the economy returns to its natural level of output (Yn) with a different composition: more government spending and less private investment. This is why the increase in G offsets I due to the rise in interest rates driven by inflation control measures.