IS-LM-PC (topic 8) Flashcards
Focus: short run = demand determines output medium run = policy makes output return to potential
In the short run: demand determines output, but what happens in the medium run?
medium run = policy makes output return to potential
What is the labor market equilibrium condition, i.e., the relation between inflation and unemployment?
PC: π - π^e = -α (u - u_n)
If unemployment is lower than its natural rate = inflation is higher than expected (and vice versa).
How can the PC be expressed as a relation of output and unemployment?
Okun’s law: actual relation between output and unemployment,
π - π^e = (α / L) (Y - Y_n )
What happens to inflation when there is a positive output gap?
Inflation will be above target.
Y > Yn => pi > pi bar
Y < Yn => pi < pi bar
Y = Yn => pi = pi bar
Explain the IS-LM-PC equilibrium graphically.
2 separate graphs.
IS-LM: Y-axis - real interest rate r X-axis - output IS - downward sloping curve LM - horizontal line
PC:
Y-axis - inflation - target inflation, pi - pi bar
X-axis - output
PC - upward sloping curve (positive relation between natural level output and inflation)
Yn - horizontal line (natural level of output)
Equilibrium:
IS-LM = At the interest rate, the level of output is at Y.
PC = at the same level of output is pi = pi bar, i.e., Y = Yn.
Why will there be seen reactions in policies in the medium run?
Over time there will be reactions in policy because:
The central bank is mandated to keep inflation close to target.
If there is no reaction, expectations will be de-anchored (i.e., wage setters can start to expect inflation to be the same as the past year and the PC will become a relation between the change in inflation and the output gap. If the output gap remains positive, inflation will start to increase).
- The central bank will react to a positive output gap by increasing r and thereby reduce inflation (contractionary monetary policy).
Explain the graphical effects of contractionary monetary policy.
Economy above natural level of output (positive output gap) => contractionary monetary policy => increase in policy rate => increase in borrowing rate => I, demand, and output decreases => movement along the IS upwards and downwards on the PC => economy comes back to natural level (inflation = target)
What are the 3 different interest rates?
r = r_n: demand for goods = potential output; natural rate of interest; neutral rate of interest.
r_n + x: the real borrowing rate.
i = r + π^e: nominal rate = the real rate + expected inflation.
In the medium run: real rate = neutral rate and inflation = target inflation: i = r_n + π-bar
What does this relation show:
M / P = Y_n L_n (r_n + π -bar)?
output = potential output; nominal interest rate as i = r_n + π-bar
Right hand side = real demand for money is constant in steady state.
Left hand side (money supply) = must be constant as it implies that P must be growing at the same rate as nominal money (M).
Explain this relation:
π = g_M
the rate of money growth.
Explain this relation:
i = r_n + g_M
Rewrite of nominal interest rate: the real interest rate + nominal rate of money growth.
as we know inflation = target inflation in medium run equilibrium
How can you determine if we are in medium run?
Medium run =
Output is equal to potential output 𝑌 = 𝑌𝑛.
The unemployment rate is equal to the natural rate 𝑢 = 𝑢𝑛.
The real policy interest rate is equal to the natural rate of interest 𝑟𝑛 where aggregate demand equals 𝑌𝑛.
The expected rate of inflation π^e is equal to the actual rate of inflation π.
Explain how deflation traps occur.
Example:
Y is smaller than potential output (i.e., negative output gap implying that inflation is lower than target)
If the output gap is large and inflation therefore is much lower than target (and even negative), this means that there is deflation in the economy.
The central bank should decrease the real rate (maybe it needs to be negative if the economy is sufficiently depressed, but this can be hindered by the zero lower bound) until output has increased back to the natural level.
When people see deflation, their expectations are likely to be de-anchored and the deflation will increase.
Deflation spiral/trap = larger deflation => higher real interest rate => lower output => etc.
