Question

The IS-LM-PC model connects the goods market, the financial market and the labor market.

a. Present a graph (hand-drawn graphs must be scanned and uploaded in pdfformat) of the model and explain the graph in words (e.g. slopes of the curves, what they depict, how are the three markets connected, etc.).

b. Using the IS-LM-PC model graph show the effect of an increase in the price of oil on equilibrium output, price and interest rate both in the short run and the long run. Also explain in words.

Answer 1

Let: = current inflation; = expected inflation; yt=current outpu; yt*=natural level of output; r*= natural real interest rate; i= nominal interest rate; = desired inflation rate; e= external shock

The upward sloping curve is Philips curve, represented by following equation: = + b(yt − yt* ) +e

So, it depicts a positive relationship between current inflation and output. this is because when price is high, firm expand production. So, output rises.

IS curve: yt= yt*-a(it--r*)+e

There is negative relationship between current output and real interest rate.

MP rule: it= +r*+c(-)+e

Central bank chose an i to attain a desired level of

We can combine Is and MP curves. Replacing it in IS curve with MP cuve, we get:

yt = yt* − a (c − 1) ( -) + e. Hence we see a negative relation between yt and , as long as c>1, that is, Central bank reponse to high inflation. High inflation leads to high nominal rates, and therefore high real rates. High real rates mean borrowing is costly, so output will fall.

Relation between 2 curves: for a , Central Bank sets i. Suppose there is increase in output due to demand shock. This will increase inflation due to Philips curve rule. As increases, i will also increase (MP rule). which in turn increase real interest rate. So, output falls due to high rates, according to IS rule.

b) Increase in price of oil means there is a supply shock. Inflation will increase for a given level of output, so philips curve shifts upwards.

There is a price shock. Inflation will increase, firms will cut off production and output falls in short run (PC rule). In Long run, the expected inflation has increase which will increase i (MP rule). As i increases, output will furtehr fall (IS rule)