9. The IS-LM-PC model

Question 1

The IS-LM-PC model

Answer 1

Potential output (Yn) - the natural level of output when the unemployment rate is equal to the natural rate Un,
Y-Yn = - L (U-Un )
Output gap (Y-Yn) - the difference between output and potential output
If U=Un => Y=Yn => output gap =0
If U>Un => Y output gap < 0
If U Y>Yn => output gap >0

Replacing U-Un in π-π^e = -α(U-Un) => π-π^e=(α/L)(Y-Y_n) which means that:
If output gap=0 => inflation = 0
If output gap<0 => inflation ↓
If output gap>0 => inflation ↑