Lecture 7: The IS-LM-PC Model

Question 1

What is different from the Short-run to the medium-run?

Answer 1

In the short run, the demand determines output.
In the medium run, with the help of policy, output returns to potential

Question 2

What is Okun’s Law?

Answer 2

Okun’s Law says that when the economy grows faster, unemployment goes down and when the economy slows down, unemployment goes up.

It shows the link between economic growth and jobs.

Question 3

What does the Philip’s curve show?

Answer 3

It shows the relationship between inflation and unemployment.

Question 4

What does the Philip’s curve show about the relationship between inflation and unemployment?

Answer 4

When unemployment is low, companies compete for workers, pushing wages up, which can lead to higher inflation.

When unemployment is high, people are competing for jobs, so wage growth slows down, leading to lower inflation.

So in the short-run, there’s a trade-off:
Lower unemployment = Higher inflation
Higher unemployment = Lower inflation

Question 5

What is the relationship between inflation and unemployment in the long-run?

Answer 5

Over the long-run, the relationship in the short-run may break down - inflation can stay high even if unemployment is high, especially if people expect inflation to continue.

Question 6

What does a left-shift of the IS-Curve mean?

Answer 6

It means that something (other than interest rates) is causing the economy to slow down.

Question 7

What does the IS-LM-PC model add to the basic IS-LM model?

Answer 7

It adds the Phillips Curve (PC) to integrate labor market and inflation dynamics, providing a medium-run perspective.

Question 8

What key questions does the IS-LM-PC model help answer?

Answer 8

It explains how production, unemployment, and inflation evolve in both the short and medium run, and how state interventions differ over time.

Question 9

What is the output gap?

Answer 9

The difference between actual output (Y) and potential output (Yn).

Question 10

What does a positive output gap indicate?

Answer 10

That the economy is overheating, causing inflation to rise.

Question 11

What is the medium-run equilibrium point called in IS-LM-PC?

Answer 11

Point A0, where Y = Yn, unemployment = natural rate, and inflation = expected inflation.

Question 12

What is the natural (or Wicksellian) rate of interest?

Answer 12

The real interest rate in the medium-run equilibrium where inflation is stable.

Question 13

What happens in the short run after an expansionary monetary policy (i ↓)?

Answer 13

LM curve shifts down, r ↓, investment ↑, output ↑, unemployment ↓.

Question 14

What are the medium-run effects of expansionary monetary policy (if inflation expectations don’t change)?

Answer 14

Output > potential (Y > Yn), u < natural rate, inflation rises, and a wage-price spiral begins.

Question 15

What happens if inflation expectations rise in the medium run?

Answer 15

The PC curve shifts up, inflation rises further, requiring contractionary policy to stabilize.

Question 16

What is the Zero Lower Bound (ZLB)?

Answer 16

A situation where interest rates can’t go below zero, limiting the central bank’s ability to stimulate the economy.

Question 17

Why does ZLB matter in IS-LM-PC?

Answer 17

If interest rates hit ZLB, monetary policy may be ineffective, making it hard to return r + x to prior levels.

Question 18

What are the consequences of persistent inflation above the target?

Answer 18

The central bank may need to enforce a recession (Y < Yn) to bring inflation and expectations down.

Question 19

What does the Taylor Rule propose?

Answer 19

A rule-based approach where the interest rate is adjusted in response to inflation and output deviations from target.

Question 20

What is the short-run effect of expansionary fiscal policy (G ↑)?

Answer 20

IS curve shifts up, Y ↑, income ↑.

Question 21

What are the medium-run effects of fiscal expansion?

Answer 21

Y > Yn → inflation ↑ → CB raises i → Y returns to Yn.

Question 22

What is the crowding-out effect in this context?

Answer 22

Increased G crowds out private investment (I) because Yn doesn’t change, only the composition of demand changes.

It’s when increased government spending (G) leads to a reduction in private sector spending, especially investment (I).

Question 23

Why does crowding out occur?

Answer 23

Because increased G raises aggregate demand, which pushes up interest rates (i) — making borrowing more expensive for private investors

Question 24

What happens in the short run when government spending increases (G ↑)?

Answer 24

The IS curve shifts right, leading to higher output (Y) and lower unemployment. Private investment might increase too.

Question 25

Why is there little or no crowding out in the short run?

Answer 25

Because the central bank may not immediately raise interest rates, and there's unused capacity in the economy (Y < Yn).

Question 26

What triggers crowding out in the medium run?

Answer 26

When Y > Yn, inflation rises → central bank raises interest rates to cool the economy → private investment falls.

Question 27

What does "full crowding out" mean in the IS-LM-PC model?

Answer 27

It means the increase in G is fully offset by a decrease in I, so total output (Yn) stays the same — only the composition of output changes.

Question 28

Does expansionary fiscal policy increase potential output (Yn)?

Answer 28

No. Fiscal policy increases demand, not the productive capacity of the economy — so Yn stays the same.

Question 29

What is the final result of expansionary fiscal policy in the medium run (if G ↑ permanently)?

Answer 29

C + I + G = Yn still holds, but now G is higher and I is lower — the economy's size doesn’t change, only who’s spending does.

Question 30

What's the difference between a "shift" of a curve and "movement along" a curve?

Answer 30

A shift means the entire curve moves due to an external factor. A movement along the curve means a change due to a variable already in the curve’s equation.

Question 31

What causes a shift of the IS curve?

Answer 31

Changes in fiscal policy (G or T), consumer confidence, or investment behavior — anything that affects demand at each interest rate.

Question 32

What does a rightward shift of the IS curve mean?

Answer 32

Higher demand/output (Y) at every interest rate. E.g., G↑ or T↓ increases spending.

Question 33

What does a movement along the IS curve represent?

Answer 33

A change in output (Y) in response to a change in interest rate (r).

Question 34

What causes a shift of the LM curve?

Answer 34

Changes in the money supply or money demand (e.g., via central bank policy).

Question 35

What does a downward shift of the LM curve mean?

Answer 35

Lower interest rates for a given level of output — usually due to an increase in money supply (expansionary monetary policy).

Question 36

What does a movement along the LM curve represent?

Answer 36

A change in interest rates (r) as a response to a change in output (Y) (due to changing demand for money).

Question 37

What causes a movement along the PC curve?

Answer 37

A change in output/unemployment that affects inflation, assuming expected inflation is constant.

Question 38

What causes a shift of the PC curve?

Answer 38

A change in expected inflation — if people expect higher inflation, the entire curve shifts up.

Question 39

What does an upward shift of the PC curve mean?

Answer 39

At every output level, inflation is higher due to increased inflation expectations.

Question 40

What happens when the central bank lowers interest rates?

Answer 40

LM curve shifts down, causing movement along IS (higher Y), then movement along PC (inflation rises), and eventually PC shifts up (if inflation expectations rise).

Question 41

What happens when the government increases spending (G↑)?

Answer 41

IS shifts right, causing movement along LM (r↑), Y↑, u↓, and movement along PC (pi↑), followed by PC shifting up if inflation expectations rise.