Topic 1 - Matteo

Question 1

why can we not continue to use the IS-LM model?

Answer 1

the IS model is in flow terms whereas the LM curve is in stock terms
the IS curve depends on the real interest rate whereas the LM depends on the nominal interest rate
the two are related by the fisher equation but they cannot be considered identical and depend on what the expected rate of inflation is
since 1990s central banks have not tried to control the stock of money in circulation as the IS-LM model implies but instead relied on setting interest rate periodically and letting quantity of money adjust.
central banks have been increasingly explicit inflation targeteres whereby they adjust the interest rate to achieve desired inflation. this is highlighted by the taylor rule which means the LM curev could be represtented by a horizontal line but there would need to be a way to represent inflation aswell

Question 2

what is the three equation model?

Answer 2

it has three equations or schedules :
1- an IS curve in real interest rate and output space
2- a phillips curve in inlfation and output space
3- a monetary rule describing the central banks optimal choices over inflation and output

Question 3

what is the relationship between output demanded and the current level of the real interest rate>

Answer 3

Output demanded is negatively affected by the current level of the real interest rate

Question 4

what is the equation of the IS curve and what do the variables mean?

Answer 4

It has the equation y= A – ar where A captures all exogenous factors like consumer and investor confidence and government expenditure assuming a closed economy for simplicity

Question 5

what is the equation of the is curve in deviations from the equillibrium form and what are the variables?

Answer 5

It can sometimes be states in deviations from equillibrium form: ( y – ye) = -a(r – rs ) where y is output, ye is the equillibrium output, r is the interest rate and rs is the stabilising rate

Question 6

why is there a negative relationship between the real interest rate and output?

Answer 6

The negative relationship with the real interest rate can be justified in different ways, one of which is the sensitivity of investment as proposed by keynes and allegedly captured by the IS curve

Question 7

what type of phillips curve is used in the 3 equation model>

Answer 7

The phillips curve used is a version of the expectations augemented phillips curve used by friedman in inflation and output space and is equivalent to the SAS curve

Question 8

what is the equation for the expectations augemented phillips curve?

Answer 8

inflation= expected inflation + q( y – ye ) where expected inflation is equal to the last periods inflation.

Question 9

why is the expected inflation equal to the last periods inflation in the expectations augmented phillips curve?

Answer 9

there was an empiracle fit to do so before 2007 and it represents the firms and households trying to compensate for actual past inflation in bargaining for wages and setting prices

Question 10

what is the replacement for the LM curve in the three equation model>

Answer 10

the monetary rule is the replacement for the LM curve

Question 11

what is the purpose of the monetary rule?

Answer 11

it states what the central bank will do given its objectives and is arrived at by an explicit optimazation of a loss function

Question 12

what is the equation for the monetary rule?

Answer 12

target inflation = [-1/(ab)] x [y – ye] where y is output and ye is equillibrium output

Question 13

what does the final equation for the monetary rule represent>

Answer 13

it represents the locus points of tangency between all possible indifference curves describing their loss function and each indifference curves describing the loss function and every possible IAPC. that is why each point on it represents the optimal choice given the existing constraint

Question 14

what does the 3 equation model overall show?

Answer 14

The two quadrants are meant to represent the interactions between the three curves/equations. The central bank chooses where it wants to be in the lower quadrant on the MR, given the current state of the economy on the IAPC, which then determines the interest rate that affects the IS in the top quadrant. In the case of overall initial equilibrium, output is ye; inflation is at target (pT) and the interest rate is at its stabilizing rate (rS). If there is a disturbance, the central bank will choose a level to output in the lower quadrant. In order to achieve that level it will then set an interest rate which will affect the level of demand on the IS curve, which in turn will dictate the level of inflation according to the IAPC

Question 15

what is the 3 eqautions model schematic decision process?

Answer 15

Choose an interest rate

Output demanded is determined

Actual inflation is determined

If actual inflation is the target inflation then end the process, else repeat entire process

Question 16

what occurs on the 3 equation model when there is a negative permanent demand shock?

Answer 16

If the autonomous component of demand A is reduced permanently due to a permanent shock to consumer confidence then the IS curve will shift to the left. At the current rate of interest, the output will be reduced for both quadrants resulting in lower inflation rate. The central bank will then attempt to predict the next periods phillips curve which will incorporate the reduced inflation of this period and it chooses its best option. The IAPC2 will be to the right which means the new loss function minimization point will be the intersection between MR and IAPC2. At this point, the output will be increased as the interest rate has been reduced on the new IS curve which increases the demand, as output is above equillibrium level the inflation will increase shifting the IAPC curve upwards. This process will repeat itself with smaller upward adjustments until equillibrium is restored but the equillibrium interest rate will remain permanently lower

Question 17

what occurs on the 3 equation model when there is a positive temporary inflation shock?

Answer 17

A temporary inflation shock moves the IAPC curve upwards resulting in higher inflation then the target. Faced with this new IAPC curve, the central bank will choose it s best option which is a retraction up the MR curve to minimise its loss function given IAPC2. This implies achieving a reduced output which can be achieved by raising the interest rate thereby reducing the demand. As the output is now below the equillibrium level, the inflation rate will be somewhat reduced. In the following period, the reduced inflation will now become prevailing expected inflation. This will shift the IAPC curve downwards. This new phillips curve will cause the central bank to choose its new best option which is to locate at the point which minimisest the loss function of IAPC3. This reduces the inflation even more due to the output still being lower then the equillibrium level resulting in the process repeating itself until back at the original equillibrium level

Question 18

what occurs on the 3 equation model when there is a temporary demand shock?

Answer 18

A temporary demand shock would mean the IS curve moves one period but then returns to its previous postion the following period. This implies that the equillibrium will be restored to the original level of interest rate

Question 19

what occurs on the 3 equation model when the demand shock is postive>

Answer 19

The demand shock can be positive which will demand that the central bank raise the interest rate

Question 20

what occurs on the 3 equation model when there is a permanent supply shock?

Answer 20

The supply shock can be permanent which will change ye and therefore all IAPC and the MR will shift as they both depend on the equillibrium level of output. They will shift to the right in the case of a postive shock, requiring a lower interest rate in the adjustment process. They will shift to the left in the case of a negative shock requiring a higher interest rate in the adjustment process

Question 21

why is the three equation model useful?

Answer 21

It sucessfully captures most polivy questions during the great moderation

It is a pedagogoically simple and intutive representation of modern macroeconomic models known as dynamic stochastic general equillibrium as used by many central banks and treasury departments

It is a much more realistic representation of the macroeconomy then the IS-LM model

It is susceptible to extensions and qualifications whilst the basic problems can be analysed with the simpler diagrams

Question 22

why is the three equation model wrong

Answer 22

It is wrong because it leaves open a number of questions only some of which can be answered without radical changes or further questions remaining unanswered. Some of these questions are:

What are the deeper justification for the IS and IAPC

Why is the central bank forward looking whilst households and firms are not

Why is the central bank not trying to expand output beyond its current equillibrium level

Do banks play a role at all

How can financial instability arise as it unquestionably did

What if the economy is an open one

Is fiscal policy irrelevant