Term 2: Week 1 - Closed Economy Model and the TEM

Question 1

IS curve

Answer 1

• Represents demand side of the three equation model
• The ‘I’ stands for investment
• The ‘S’ stands for saving

Question 2

Deriving the IS Curve

Answer 2

• The c0, represents constant consumption which is not impacted by taxes or other macro events.
• c1 is the marginal propensity to consume
• 1-t is the tax rate - and is therefore my disposable income
• therefore c1(1-t) is the proportion of disposable income that i spend.
• a0 is constant
• a1 represts interest sensitive invesment. it is the interest sensitivity of investment.

Question 3

properties of the IS curve

Answer 3

Question 4

Central bank’s preferences

Answer 4

Given by loss function
- L = (yt-ye)^2 + β(πt - πe)^2
- Where β reflects relative inflation aversion of the central bank.
- β <1 = unemployment averse
- β>1 = inflation averse
- β = 0 - neutral

Question 5

MR Curve

Answer 5

• Central banks best response
• MR shows the preferred and combination, for any Phillips curve faced by the central bank.
• Phillips curve, loss is minimized at the tangency point between the Phillips curve and the loss circles

Question 6

Transmission mechanism

Answer 6

• the complex path from the policy rate to the final target. Noting the transmission mechanism, the CB must set their instrument, the nominal interest rate, to achieve the real interest rate that they forecast will generate their preferred output gap

Question 6

Transmission mechanism

Answer 6

• the complex path from the policy rate to the final target. Noting the transmission mechanism, the CB must set their instrument, the nominal interest rate, to achieve the real interest rate that they forecast will generate their preferred output gap