Lent - Lecture 6 - Policy Analysis in IS-MP

Question 1

Explain the differences regarding “crowding out” in the IS-MP model and the classical model

Answer 1

• in the Classical model:
• Y is fixed ⇒ C(Y - T) is fixed ⇒ S(private) = (Y - T) - C
• S(public) = T - G, which decreases when G increases
• S = S(public) + S(private), which decreases, hence I(r) decreases
• in the IS-MP model:
• higher G induces Y to rise, so CB chooses to raise r
• this causes I to contract
• in IS-MP, there is nothing inevitable about reduced investment

Question 2

Rewrite the policy rule that the central bank follows, but incorporate the ZLB into this

Answer 2

R = max{r̅ + mπ(π - π(t)) + mY(Y - Y̅), r(LB)}

Question 3

From the Fisher equation, what does r(LB) equal?

Answer 3

r(LB) = -π(e)

Question 4

Explain graphically why, in liquidity traps, a fiscal contraction should have more severe effects on Y

Answer 4

• the MP curve is horizontal and then becomes upwards sloping, it is horizontal due the ZLB
• in a liquidity trap, a fiscal contraction (inward shift of IS) causes a large decrease in Y, and no change in r - as we are at the horizontal section of the MP curve

Question 5

What could cause a reduction in r̅?

Answer 5

• secular decrease in investment opportunities
• decrease in long-run government spending

Question 6

What does a reduction in r̅ do to the MP and IS curves?

Answer 6

• in a short-run model, a reduction in r̅ corresponds to a downward shift in IS (r̅ is the interest rate that implements Y = Y̅)
• a reduction in r̅ causes a downward shift in the MP curve (consider what happens with ZLB)

Question 7

Why should the central bank be worries if the neutral real rate falls to low?

Answer 7

• as it undermines the ability to ensure Y = Y̅ even in the absence of IS shocks
• this is the main idea behind the ‘secular stagnation’ hypothesis

Question 8

What are the two possible policy responses for a low neutral rate, r̅?

Answer 8

• raise components of planned expenditure (try and cause a permanent/LR increase in IS)
• raise the inflation target (cause π(e) to increase, r(LB) = -π(e))