The IS LM PC Model Flashcards
(30 cards)
What determines output in the short-run according to the IS-LM-PC model?
Demand determines output in the short-run.
The model emphasizes the role of demand in influencing output levels.
How does output return to potential in the medium-run?
Output returns to potential with the help of policy.
This transition is facilitated by adjustments in monetary and fiscal policies.
What is the formula for the output gap?
Y - Y* = -L(u - u*)
Here, Y is actual output, Y* is potential output, u is actual unemployment, and u* is natural unemployment.
What does the Phillips Curve (PC) represent?
The relationship between inflation and unemployment.
The formula is π - πe = -β(u - un), where π is actual inflation, πe is expected inflation, and un is the natural rate of unemployment.
How is output defined in the IS curve?
Y = C(Y - T) + I(Y, r) + x + G
This equation includes consumption C, investment I, net exports x, and government spending G.
What happens if unemployment is equal to the natural rate?
Output is equal to potential, and the output gap is zero.
This indicates that the economy is operating at full capacity.
What occurs when output is above potential?
Inflation exceeds target inflation.
This is indicated by the condition Y > Y*, leading to π > πt.
What is the natural rate of interest?
The policy rate corresponding to the structural output level.
It is also referred to as the equilibrium rate of interest or Wicksell’s rate of interest.
What is Okun’s law?
It links output and unemployment, indicating that changes in unemployment are approximately equal to the negative of the growth rate of output.
The formula derived is u - un ≈ -gy, where gy is the growth rate of output.
What can lead to a deflation spiral?
Deflation pushes real interest rates higher, lowers output, and leads to larger deflation.
This phenomenon can create a negative feedback loop in the economy.
What is the Zero Lower Bound (ZLB)?
The situation where the nominal policy rate cannot be lowered below zero.
In cases of deflation, this can hinder economic recovery.
What are the effects of a fiscal consolidation?
It shifts the IS curve to the left, causing a reduction in output and inflation decreases below target.
In the medium-run, the Central Bank lowers the policy rate to restore output to potential.
What happens to investment in the medium-run after a fiscal consolidation?
Investment decreases in the short-run but increases in the medium-run.
This reflects the adjustment of interest rates over time.
What are the implications of an increase in the price of oil?
It leads to lower implied real wages and a higher natural rate of unemployment.
This is due to the increased markup effect on prices.
How did the Great Depression illustrate the deflation spiral?
The economy experienced a deflation trap, with rising real interest rates and falling output.
Monetary policy adjustments during this period were insufficient to counteract the effects of deflation.
What is the Okun coefficient?
It measures the relationship between output growth and changes in the unemployment rate, typically around 0.4.
This coefficient indicates that a 1% increase in output leads to a 0.4% decrease in unemployment.
What led to a sudden drop in oil prices in 2019?
The pandemic and falling prices to $18
This was a significant economic event affecting global oil markets.
What was the oil price in 2022 due to the Ukraine war?
$110
The conflict had a substantial impact on global energy prices.
How does an increase in the price of oil affect the natural rate of unemployment?
Leads to lower implied real wages and higher natural rate of unemployment
This implies a lower employment level.
What is the relationship between markup (m) and the natural rate of unemployment?
↑ m leads to ↓ W/P and ↑ un = ↓ Nn
Higher markup results in lower real wages.
What happens to the natural level of output if the increase in oil prices is permanent?
The natural level of output becomes lower
This reflects long-term economic adjustments.
What are the short-run effects of an increase in the price of oil?
Higher inflation and upward shift of the PC curve
Output remains the same in the short run.
In the short-run, how is inflation affected by an increase in oil prices?
Inflation is higher and above target
This indicates a deviation from expected inflation levels.
What action does the central bank take to manage inflation after an oil price increase?
Increases the interest rate (r)
This is to avoid de-anchoring inflation expectations.
