IS-LM-PC model II Flashcards
anchored expectations 1 (in equilibrium and disequilibrium)
-resembles UK situation- independent central bank and trust its ability to resolve target of 2%
-in equilibrium: workers ask for 2% increase, wages go up and firms increase prices by 2%
-in disequilibrium: workers and firms will not diverge far from 2% wage/price increase
anchored expectations (difference from last model, explanation, how output affects anchored expectations and inflation)
1) last model: p^et=pit-1, this model pi^t=pi with line (anchored inflation)
2)if we form inflation expectations in an anchored manner, we would expect inflation for next year to be same as CB target rate. trust CB to successfully set interest rates and use other monetary policy tools to ease inflation
3)Yt=Yn: Pit=pi hat
Yt>Yn, Pit>pi hat
Yt<Yn, Pit<Pi hat
demand shocks in IS-LM-PC model (with anchored expectations)
1)start at equilibrium (IS=LM, PC crosses at 0, WS=PS, inflation at anchored level)
2) rise in government spending, rise in output, rise in consumption and investment, multiplied rise in output (IS shifts right)
3) now worker bargaining power is relatively high
4) firms respond by increasing prices (demand-pull inflation, Yt>Yn)
5) difference to last week, do not allow inflation to run away from target
6) c.b. increases r, Yt=Yn, Pi=Pi hat
supply shocks (with anchored expectations)
1) set up equilibrium (WS=PS IS=LM, PC crosses at 0 where Yn is)
2) rise in mark up , fall n 1/(1+m), fall in PS
3) Y>Yn2 (new equilibrium), inflation>anchored inflation
4) policy response: rise in r, Y=Yn2
oil price shocks revisited (with anchored expectations)
why were 2000s so different from oil price shocks
1) worker bargaining power was low in US since 70s
2) globalisation and foreign competition in 2000s decrease w.b.p even further
3) inflation expectations now considered anchored, therefore deviates from target but does not accelerate
4) contribution of industry/manufacturing to GDP and employment fell
5) energy usage more effective- but we have emitted a lot more carbon into atmosphere so still bad
1930s Great depression (problems with policy responses and statistics from great depression)
1)if output falls, central bank can decrease base rate until output is back to potential but things can go wrong:
-reason is due to zero lower bound and debt spirals
-problem may occur if negative demand shock is so large that output falls to such an extent that real i.r. is negative
2) interest rates fell, no bailouts, no fiscal stimulus
-UK rgdp fell by 30%, 29-33, CPI fell by 30%, by 33, just over half of banks existed from 29
zero lower bound and debt spirals
1) assume inflation expectations are adaptive and Y=Yn
2)large rise in x, rise in i.r., r n becomes negative
3)if nominal i.r. becomes 0, it cannot fall further, inflation may continue to decelerate resulting in deflationary spiral
4)leads to deflation and real interest rates rise
stock market crash through IS-LM-PC (1930s) (what happened and reaction)
1) we start in equilibrium where IS=LM, PS=WS, PC crosses axis at Yn
2)rise in x, fall in Investment, fall in output, multiplied fall in consumption and investment, fall in output (fall in IS)
3) worker bargaining power relatively low and decelerating inflation
reaction
1)rise in taxes, fall in c, fall in y, fall in c and i, fall in y
2)even faster deceleration of inflation
3) now have deflation (workers expecting prices to fall so will delay)
4) fall in r: Y<Yn r=i-pi^e, =0–pit-1
policy response to 1930s (description)
-options: deficit spending, allow firms to collude, increase min wages
-aim of response: decrease r and stim output
-cpi rose,
policy response to 1930s (graph)
1) start where we left off (Y<Yn)
2)fiscal stim does not solve
2) by allowing monopoly power and increase TU power can help
3)potential output falls, due to rise in g, actual output is higher
