ISLM and PC combined

Question 1

how do the IS,LM and PC curves relate ?

Answer 1

as the LM line shifts upwards we move down the pc curve

Question 2

to get to a point where prices stop rising or i rate = 0, where PC crosses X axis there must be a policy adjustment used to restrict income, how does this effect is lm pc model ?

Answer 2

this moves LM up to LM’and reduces Y back down to Yn, the inflation rate is now 0 this is medium run equilibrium

but in the time is takes to work, the inflation level has risen, so the government must again adjust MP to raise LM’ to LM” and lower the inflation rate so that the inflation level comes back down

must enter a recession - very bad !!

Question 3

why couldn’t the government employ this policy adjustment immediately ?

Answer 3

• its difficult to know Y* exactly

- takes time to take effect

Question 4

when we look at the older version of the Phillips Curve how does the ISLMPC model change ?

Answer 4

we now no longer look at the change in the inflation rate but actual change in inflation level.

so a + output gap no longer generates a higher level of inflation rate but actual inflation and to lower inflation we need only raise the LM line and Y stays at Yn

there is no need for a ressecion.

Question 5

what is the problem with adjusting the interest rate when it has a zero lower bound ?

Answer 5

to decrease r to rn ( where y = yn )

if the econ is depressed it could require a negative rn but it has a zero lower bound

Question 6

what is a deflation spiral ?

Answer 6

where deflation leads to a higher R but a higher R leads to more deflation

its a trap

Question 7

what are the effects of an increase in the price of oil on the ISLMPC model ?

Answer 7

so far we have only considered effects on IS curve but have left Yn and Pc unchanged. BUT: some shocks effect demand, Yn and cause definite fluctuations in activity. while output is produced using a number of different things, till now we have only acknowledged labour we must look at what effect an increase in the price of oil has on prices set by firms and the relationship between output and unemployment

increase in the price of oil - an increase in the markup - decreases the PS relation - increases Un - decreases the natural level of employment - decreases the natural level of output.

in SR prices are rising as costs of prod increase through oil and labour. but whilst the natural level of output has shifted down the actual level of output hasn’t fallen yet so actual output is bigger than the potential and therefore the output gap is positive

in the MR/LR the government decrease the policy rate and decrease spending and inflation rate Y has decreased to yn and the output gap closes

Question 8

what should we consider about the analysis of the effects of an increase in the price of oil ?

Answer 8

• IS curve doesn’t shift ?
• formation of inflation expectations ?
• what about the evolution of inflation ? economy may go through large recession with only a partial recovery

Question 9

how does consideration of the short run vs medium run effect the policy that the government may chose ?

Answer 9

in the SR you might be reluctant to carry out fiscal consolidation

if worried about the MR / LR you could see consolidation as helping investment and thus capital accumulation , increasing output.

Question 10

what is a propagation mechanism ?

Answer 10

every shock has dynamic effects on output and its components. these dynamic effects are called propagation mechanisms of the shock.