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ECO2102 Macroeconomics > ECO2102 The IS-PC-MR (3) > Flashcards

ECO2102 The IS-PC-MR (3) Flashcards

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1
Q

Who calculates CPI?

A

The Office of National Statistics (ONS)

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2
Q

What value does the base period price level have in the CPI?

A

100

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3
Q

What is the widespread inflation target?

A

2%

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4
Q

What is the Friedman rule?

A

A level of optimal inflation where inflation and interest rates cancel out to create a nominal rate of 0
i=r+π=0
i - nominal interest rate
r - equilibrium real interest rate
π - inflation

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5
Q

Why do governments target positive inflation?

A

Negative inflation increases the debt burden
If inflation is negative people may postpone spending

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6
Q

Draw AS and AD shocks on the IS WS/PS and PC graphs

A

check word

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7
Q

What is the effect of Shocks without stabilizers in place?

A

Inflationary spiral and disinflation then deflation

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8
Q

What are policies that can be used to stabilize inflation from AD shocks?

A

Policies to shift IS such as changes in government spending

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9
Q

What are policies that an be used to stabilize inflation from AS shocks?

A

policies that change equilibrium output:
Change in unemployment benefits
changing the power of trade unions

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10
Q

Why is monetary policy used in preference to fiscal policy for stabilization?

A

There are shorter implementation lags
Its less politicized because it doesn’t involve the use of taxpayers money

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11
Q

What is the monetary rule (MR)?

A

It captures the optimising behaviour of the central bank

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12
Q

What constraint does the central bank face when trying to hit inflation and output targets?

A

If the central bank wants to increase output, it has to create inflation
If the central bank wants to reduce inflation it has to create a recession

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13
Q

What is the central bank loss function?

A

L=(yt-ye)^2+β(πt-π^T)^2
L=loss
π^T- Inflation target
β- exogenous parameter, quantifies the importance of the inflation target relative to the output target

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14
Q

What does the central bank lost function represent?

A

The loss of the central bank as a function of deviations from two targets.

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15
Q

Why are terms in the central bank loss function squared?

A

Deviations above or below target are equally penalized, hence squares give the same result
The loss is also exponential- bigger deviations are penalized more heavily

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16
Q

What are the indifference curves for central banks?

A

An indifference curve is a combination of π and y that incurs the same loss for the central bank

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17
Q

Where on indifference curves do the central banks try to situate the economy?

A

Central banks set policies to situate the economy on a circle as small as possible, ideally the target (centre)

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18
Q

What does averse mean?
(inflation averse and unemployment averse)

A

It means being concerned about keeping inflation low / unemployment low
Basically what are the central banks priorities?

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19
Q

What do inflation averse indifference curves look like + what is the value of β?

A

Inflation averse - β>1
The curves are squished from the top and bottom

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20
Q

What do unemployment averse indifference curves look like + what is the value of β?

A

Unemployment averse - β<1
The curves are squished from the sides

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21
Q

How do you algebraically derive the MR equation? (first step)

A

Sub in the PC constraint : πt=πt^E+𝝰(yt-ye)
Into the CB loss function: L=(yt-ye)^2+β(πt-π^T)^2
To get: L=(yt-ye)^2+β(πt^E+𝝰(yt-ye)-π^T)^2

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22
Q

What is the second step of algebraically deriving the MR equation?

A

To minimize loss differentiate with respect to yt, and set equal to zero:
2(yt-ye)+2β( πt- π^T)𝝰 = 0
Also change the PC part back to πt
Then get the output gap on one side and divide by two:
yt-ye=-β𝝰( πt- π^T)

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23
Q

What is the MR equation?

A

yt-ye=-β𝝰( πt- π^T)

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24
Q

Why cant the two choice variables (inflation and output) be chosen independently by the central bank?

A

Central banks control interest rates- this determines demand- demand determines output - output determines inflation

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25
What does the MR equation represent?
The trade-off between the two targets e.g. if inflation increases above the target the central bank allows output to fall below target to minimise its loss
26
What decides the extent of the MR trade-off?
The extent of the trade depends on the slope of the PC (𝝰) and the weight placed on inflation(β).
27
Draw the graph of MR
check word
28
How is MR represented on a graph and how do we do this?
Its represented with πt on the vertical axis so we rearrange the equation: πt- π^T=(-1/β𝝰)(yt-ye)
29
What effect do β and 𝝰 have on the MR curve?
The higher they are the flatter the MR is
30
What is the main effect of the Central Bank changing the nominal interest rate?
The bank changes the nominal rate to achieve a desired real interest rate: The real rate affects investment decisions and therefore the level of AD
31
What are constraints to changing interest rates?
The PC acts as a constraint There are also lags in the reaction of investors to changes in the interest rate (r)
32
How are lags in the reaction of investors to changes in the interest-rate modelled?
We assume there is a one-year lag We model this through the IS function: yt=A-ar(t-1) Central bank must forecast what will happen a year ahead to set the right interest rate
33
What models are each part of the IS-PC-MR curve derived from?
IS - Keynesian Cross PC- WS and PS MR- Loss function (L) and PC
34
What are the 3 equations in the IS-PC-MR model?
Check Word
35
What do β, 𝝰, A and a represent in the equations in the IS-PC-MR model?
β - relative weight of inflation target compares to output target for central bank 𝝰 - slope of PC A and a - exogenous parameters based on consumption and investment functions
36
Give a summary of the IS-PC-MR model ( graphs + equations)
check word
37
How do we analyse shocks with the IS-PC-MR?
Start out at equilibrium (MRE) Model what happens immediately after ( how does output, inflation and interest rates react) Model how the economy adjusts to the shock to reach MRE ( most of this is driven by the central bank) Track what happens to our main endogenous variables (output, inflation and interest rates) using impulse response functions
38
What is a key thing to remember about inflation shocks?
It is temporary so dosn't affect MRE
39
What is an inflation shock?
It is a supply shock that raises inflation such as: Oil and Gas price increases Natural disasters increase the price of agricultural products Temporary action by trade unions
40
How do we model an inflation shock?
Introduce shock term (u) into the PS and PC equations: PS: πt=(changeW/W)t+u PC: πt=πt^E+𝝰(yt-ye)+u
41
How do you interpret the shock term u ?
u=0 when there are no inflation shocks u<0 temporarily when there is a negative inflation shock u>0 temporarily when there is a positive inflation shock
42
Draw the graphs for a positive inflation shock and show the impulse response functions
check word
43
List the chain of effects of a positive inflation shock
High inflation temporarily Central bank reduces output by increasing interest rates(r) This creates a negative output gap and slows down growth of wages Inflation goes back to target and output to equilibrium
44
What are Supply side shocks?
They are shocks to the WS or PS They are permanent shocks and change the equilibrium level of employment and output.
45
What are some examples of Supply side shocks?
Changes in trade union power, unemployment benefits, working conditions Changes in the level of competition on the goods market, changes in productivity
46
What is the effect of a supply shock with no stabilisation (money wage decrease)?
Money wage growth falls Prices follow wages so inflation falls With no stabilisation wage growth and inflation continue to fall
47
How would the central bank stop supply shocks?
The central bank stops inflation (say ever-falling). To do this they reduce the real interest rate This would stimulate demand
48
Explain what happens with the IS-PC-MR model when there is a supply shock (lower productivity)?
The PC curve shifts outwards creating a new y equilibrium on the old MR curve, a new MR curve is created shifted out It then shifts back until the PC on the new curve is on the new y equilibrium point
49
Explain how the central bank reacts to a supply shock (lower productivity)?
Inflation falls below the target for a number of years Central bank must reduce the interest rate to stimulate economic activity The central bank needs to aggressively lower interest rates and overshoot the output target which is necessary to reverse the decrease in inflation.
50
What are some examples of demand shocks (positive)?
Export Boom House market boom that increases household wealth and stimulates consumption.
51
What do demand side shocks do to the IS-PC-MR?
it affects the IS function yt=A-ar(t-1) mainly A - autonomous consumption
52
What do demand/supply shocks do to the IS-PC-MR?
Demand shocks (increase)- shift the IS outwards Supply shocks (increase) - shift the WS outwards
53
What is a potential problem with deep negative demand shocks?
They might require interest rates so low that they cant be achieved by the central bank.
54
What is a deep negative demand shock?
A shock that takes the economy interest rates so low that they cannot be reduced further.
55
Why isn't it possible for central banks to reduce interest rates to any level required?
Central bank cant set nominal interest rates below zero this is called the Zero Lower Bound (ZLB)
56
What is the central bank interest rate on?
It controls the interest rate on reserves that commerical banks keep with the central bank.
57
How do we model the Zero Lower Bound?
rt+π(t+1)^E ≥0 so min rt=-π(t+1)^E
58
Draw the effect of a deep permanent fall in A
check word
59
What are the Alternative policies when conventional monetary policy is insufficient to escape the deflation trap?
Fiscal policy (boost IS through point G) Quantitative easing (QE)
60
What are potential problems with alternative policies to monetary policy when escaping a deflation trap?
Fiscal Policy may lead to debt problems
61
Give examples of Inflation shocks, Supply shocks and Demand shocks.
Inflation shocks-energy costs, temporary weather events Supply shocks - climate change, changes in labour market laws Demand shocks - gov spending, autonomous consumption or investment

ECO2102 Macroeconomics (7 decks)

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