IS-LM-PC model 1

Question 1

deriving the Phillips curve, assumption and equation

Answer 1

-assumption: expected inflation is the same as inflation before
-equation: pit-pit-1=(m+z)-alpha uz
-alpha uz= change in unemployment rate (it is negative)

Question 2

natural rate of unemployment and inflation and deriving the equation to show relationship

Answer 2

-by definition the natural rate of unemployment is when price level= expected price level
-deriving:
1) assume pit=pit-1=0
2) 0=m+z-alpha Un
3) Un=(m+z)/alpha

1)pit-pit-1=-alpha ut+(m+z)x alpha/alpha
2)pit-pit-1=-alpha ut+ (alpha(m+z))/(alpha)
3)since (m+z)/alpha= Un, pit-pit-1=-alpha ut+alpha(Un)
4)pit-pit-1=-alpha (Ut-Un)

Question 3

Phillips curve and output (PC relation, unemployment, production function, combining)

Answer 3

-PC relation: pit-pit-1=-alpha(Ut-Un)
-unemployment: U/L
-consider labour as the only cost of production, therefore: Y=N
-combining: pit-pit-1=alpha/L(Y-Yn)

Question 4

both Phillips curve graphs, explanation and relation between each variable and inflation

Answer 4

-first graph: pit-pit-1 on y axis, Unemployment rate on x axis. downward sloping Phillips curve, crossing x axis at 0 (at natural rate of unemployment.
-second graph: same y, output on x, upward sloping graph, crossing x at 0 (at natural rate of output)

explanation:
-at high output, there is low unemployment

relation
-output lower than natural rate of output (and thus unemployment is higher than natural rate: inflation is lower than expected inflation
-output higher than natural rate of output (and thus unemployment is lower than the natural rate): inflation is higher than expected inflation

Question 5

introducing IS-LM-PC (relationships and first graph and explanation)

Answer 5

relationships:
-IS: Y=c0+c1(Y-T)+b0+b1Y-b2i+G
-LM: r=ř
-PC:pit-pit-1=alpha/L(Y-Yn)

first graph: set up IS-LM (r), then PC (pit-pit-1) then wage curve (W/P)

1) Y<Yn (negative output gap and IS has shifted right
2)worker bargaining power is relatively low
3)there is decelerating inflation
4)government decides to decrease taxes, ride in consumption, rise in output, followed by multiplied rise in consumption and investment and then output
5)however, cut taxes too much, Y>Yn (positive output gap)
6) worker bargaining power is relatively high
7) there is now accelerating inflation (pit-pit-1>0)

Question 6

demand shocks in the IS-LM-PC (examples and example graph)

Answer 6

-examples of demand shocks: rise in government spending, fall in taxes, fall in risk premium

graph: set up IS-LM-PC graph as normal

1) start at equilibrium (LS=LM, WS=PS, pit-pit-1=0)
2)rise in government spending, rise in output, rise in consumption and investment, multiplied rise in output
3)shift IS to the right
4) positive output gap (Y>Yn)
5) worker bargaining power is relatively high (workers can demand higher wages, firms pass on these higher costs of production in the form of higher prices leading to demand-pull inflation)
6) there is now accelerating inflation (pit-pit-1>0)

Question 7

IS-LM-PC model, how governments increase interest rates to counteract a positive output gap

Answer 7

graph: set up IS-LM-PC model how you originally would (with IS shifted right)

1)there is a positive output gap in the economy (Y>Yn)
2) central bank raises the base rate (LM shifts up).
3)rise in i.r., fall in consumption and investment, fall in output, fall in consumption and investment, fall in output
4)Y is now equal to Yn
5) worker bargaining power is same as firm power
6) inflation stops accelerating
7)inflation graph: inflation on y-axis, time on x-axis. start at 5%, straight line, until demand-shock, then go up until interest rates rise and inflation stays at that rate

Question 8

business cycles (and issues with raising interest rates)

Answer 8

-issues with raising interest rates: will take time for economy to adjust (time for investment decisions and demand to fall). central bank may also be unsure about exact level of YN

business cycle:
-loopy graph (like a-level), expected output line of best fit
-peak, trough, expansion (recovery), contraction (recession)

Question 9

supply shocks in IS-LM-PC and stagflation in 70s (description, rise in oil prices, graph and how firms can counteract)
-how can government react (and issues)

Answer 9

-description of stagflation in the 70s:
1) workers and firms lost faith inflation would remain at some anchored level (now target is 2% in UK)
2) perhaps key driver was President Nixon’s decision to rapidly try and boost growth without triggering inflation ahead of 72 election
-rise in oil prices:
1) oil affects both demand and potential output in the economy, 2x over last 40 years by 5-fold (70s and 2000s)
-graph: set up IS-LM-PC model as normal
1) start at equilibrium (IS=LM, WS=PS, pit-pit-1=0)
2) oil price shock, rise in the markup, PS shifts down
3) new natural rate of output dictates this
a)rise in oil price, increase transport costs etc.
b) there is a fall in potential output
4)the Phillips curve now shifts left, as has to cross at Yn
5)Y>Yn2 (on IS-LM model)
6)worker bargaining power is relatively high and there is accelerating inflation in the economy
7)inflation graph, inflation over time, does stabilise eventually
how gov can react: increase interest rates (shift up LM) however, general output has fallen