Short to medium run IS-LM-PC model Flashcards
Where is the short run equilibrium?
Where IS intercepts LM curve.
What is a positive output gap and how will the government react?
Where actual output exceeds potential output so CB increases real interest rate to decrease inflationary effects and output back to its natural level.
What does the IS-LM-PC model illustrate?
IS-LM intersection point is short run equilibrium. It shows a lower real interest rate = higher output due to downward sloping IS curve and a higher output = higher inflation due to upward sloping PC curve.
How is the AD curve derived?
Derived by showing the effect of a rise in price to the SR equilibrium where IS=LM. Rise in price decreases M/P (real money stock) which shifts LM up and decreases output so the AD curve is downward sloping as a higher price leads to lower output.
What shifts the AD curve?
Money supply, government spending, taxation, unexpected demand side shocks such as rise in consumer confidence.
What is the AS formula and how is it derived?
P=PeF(u,z)(1+m) derived from price setting and wage setting.
What shape is the medium run AS curve and why?
Vertical as in the medium run y=Yn, P=Pe, U=Un
What shape is the SRAS curve and why?
Upward sloping as with producing more output a higher price is charged as employment is higher so nominal wage increases which is passed on via higher prices
What shifts the AS curve?
Changes in expected price, mark up costs and catch all variables.
Explain the effect of expansionary monetary policy in the short run.
Expansionary monetary policy = increase money supply. This shifts AD right increasing output beyond the natural rate to a new equilibrium. As there is a positive output gap price begins to rise above the expected price. This rise in price decreases M/P so LM rises and shifts up decreasing the output given the higher interest rate. As expected price rises from wage spiralling, AS shifts left until the price = expected price at natural level of output. Output returns to initial medium run equilibrium but with higher inflation.
Explain the effects of monetary expansion on the LM curve/ interest rate in the SR.
Monetary expansion = increase money supply which increases M/P so LM falls and interest rate falls. This shifts LM down but is partially offset by the rise in price. Overtime LM returns to original position as the price rises to meet the expected price level and interest rate reverts back to what it was before.
What is money neutrality?
Concept that monetary expansion can only be used to mitigate and not prevent output adjustments and that the increase in nominal money has no impact on the real interest rate as the rise in M is offset by rise in price.
What is the medium run real interest rate called?
Natural, neutral or Wicksellian rate of interest
Explain the effect of a contractionary fiscal policy?
A fall in G or rise in T may cause AD to fall shifting it left whereby a new equilibrium is created where actual output is less than the natural rate. Price is lower than the expected price so overtime the expected price falls causing AS to fall and shift downwards until it reaches the natural level of output and output is returned the the initial level with lower price.
What effect does contractionary fiscal policy have on IS-LM/interest rate?
A rise in T or fall in G shifts the IS curve left. Following a fall in price this increases M/P so LM falls creating a new equilibrium. Overtime as expected price falls and P continues to fall, LM falls further until the natural level of output is acheived. So the interest rate falls.
