Question

Question. (World limit: 450 words) Suppose a change in regulations has permanently decreased the profit margins for the monopolistically competitive firms.

(a) Draw the impulse response functions of the economy following the shock.

(b) Draw the IS=PC=MR diagrams for this scenario. Make sure you explain every step of the adjustment towards the equilibrium.

Answer 1

the IS-MP-PC Model As this is the second module in a two-module sequence, following Intermediate Macroeconomics, I am assuming that everyone in this class has seen the IS-LM and AS-AD models. In the first part of this course, we are going to revisit some of the ideas from those models and expand on them in a number of ways: • Rather than the traditional LM curve, we will describe monetary policy in a way that is more consistent with how it is now implemented, i.e. we will assume the central bank follows a rule that dictates how it sets nominal interest rates. We will focus on how the properties of the monetary policy rule influence the behaviour of the economy. • We will have a more careful treatment of the roles played by real interest rates. • We will focus more on the role of the public’s inflation expectations. • We will model the zero lower bound on interest rates and discuss its implications for policy. Our model is going to have three elements to it: • A Phillips Curve describing how inflation depends on output. • An IS Curve describing how output depends upon interest rates. • AMonetary Policy Rule describing how the central bank sets interest rates depending on inflation and/or output. Putting these three elements together, I will call it the IS-MP-PC model (i.e. The IncomeSpending/Monetary Policy/Phillips Curve mode