The IS, MP, and Phillips Curves + Derived Demand and Supply Framework

Question 1

National Income Accounting Identity

Answer 1

Yt = Ct + It + Gt + EXt – IMt

Question 2

Yt = Ct + It + Gt + EXt – IMt

Answer 2

National Income Accounting Identity

Question 3

What are the 3 approaches to measuring GDP?

Answer 3

1. Expenditure Approach - counting all purchases
2. Production Approach (value added) - Net value of goods produced in the economy
3. Income Approach - Income earned in the economy

Expenditure = Production = Income

Question 4

What does the IS curve capture/show?

Answer 4

Captures negative short-run relationship between r and y
– Interest rate increase depresses investment and lower consumption
– In turn, lower investment and consumption decreases output

Question 5

How do you derive the IS curve?

Answer 5

1. Rewrite National Income Accounting Identity to make It the subject:
   It = Yt - Ct - Gt + IMt - EXt
2. Add and subtract tax revenues:
   It = (Yt - Tt - Ct) + (Tt - Gt) + (IMt - EXt)
   Investment = Private Savings + Public Savings + Foreign Savings
3. Each component is assumed to be a proportion of potential output:
   EXt = āexȲt, IMt = āimȲt, Gt = āgȲt,
   Ct = āc - bc[Rt-β]Ȳt
4. If these components are smooth, then GDP volatility must depend on Investment:
   It/Ȳt = āi - bi(Rt - r)
   (Where Rt = Real interest rate and r = MPK)
5. Divide national income accounting identity by Ȳt and substitute component assumptions:
   Yt/Ȳt = āc - bc[Rt-β] + āi - bi(Rt - r) + āg + āex - āim
6. Condense all a components into a single a bar and (Yt/Ȳt) -1 becomes Ỹt:
   Ỹt = ā - bc[Rt-β] - bi(Rt - r)

Question 6

What does the - bc[Rt-β] component of the IS curve represent/show?

Answer 6

Short-run output fluctuations depend negatively on the gap
between real interest rate and discount factor

Question 7

What does the - bi(Rt - r) component of the IS curve represent/show?

Answer 7

Short-run output fluctuations depend negatively on gap between real interest rate and MPK

Question 8

What does the a bar component of the IS curve represent/show?

Answer 8

Captures aggregate demand shocks
Changes in sensitivity of expenditure to potential output

Question 9

Describe the IS curve

Answer 9

A downwards-sloping straight line with gradient -1/b = -1/(bc+bi)

Question 10

If b increases, what happens to the IS curve?

Answer 10

• Higher sensitivity of It or Ct to interest rate
• Gradient decreases in slope by pivoting about the point (0, r)

Question 11

Suppose information technology improvements create an
investment boom. What will happen to the IS curve?

Answer 11

The ai parameter increases so a overall increases. This shifts the level of output higher for any given level of R so the IS curves shifts rightwards

This is true for any shock which affects an a component

Question 12

How do different central banks control interest rates?

Answer 12

The Bank of England sets the ‘Bank Rate’ which is the interest rate on reserve balances
The Federal Reserve sets the ‘Federal Funds Rate’, the interest rate paid on an overnight loan
The European Central Bank sets the main refinancing operations rate which is the rate on weekly ECB loans

Question 13

Fisher Equation

Answer 13

it = Rt + πt
Nominal interest rate = Real interest rate + Inflation rate

Question 14

it = Rt + πt

Answer 14

Fisher Equation

Question 15

Why does the Fisher Equation show how the Central Bank controls R?

Answer 15

Rearranged to Rt = it + πt, and assuming that inflation is sticky (as in acts very slowly), changing nominal interest rates has a direct short-run effect on real interest rates

Question 16

Describe the MP curve

Answer 16

A perfectly horizontal line which intersects the R axis at r (nominal interest rates)

Question 17

What would happen to the IS curve if there was a sharp fall in house prices and how might the central bank respond?

Answer 17

A sharp fall in prices is a negative aggregate demand shock.
The IS curve will shift leftwards, reducing Ỹ.
The central bank will respond by lowering nominal interest rates (the MP curve will shift downwards) so that the IS and MP curves again intersect at Y0

Question 18

What equation do firms (essentially) use to set their prices?

Answer 18

πt = Etπ(t+1) + vỸt
Current Inflation = Expected inflation + Demand conditions

Question 19

πt = Etπ(t+1) + vỸt

Answer 19

The equation which firms essentially use to set their prices

Question 20

Backward-looking Inflationary Expectations Equation

Answer 20

Etπ(t+1) = π(t-1)

Question 21

Etπ(t+1) = π(t-1)

Answer 21

Backward-looking Inflationary Expectations Equation

Question 22

Phillips Curve

Answer 22

πt = π(t-1) + vỸt
( Δπt = vỸt )

Question 23

πt = π(t-1) + vỸt
( Δπt = vỸt )

Answer 23

Phillips Curve

Question 24

What is the NAIRU?

Answer 24

The Non-Accelerating Inflation Rate of Unemployment

Question 25

Okun's Law

Answer 25

ut - ũt = - (v/α)Ỹt Short-run output is greater when cyclical unemployment is low

Question 26

How do Okun's Law and the concept of a NAIRU relate to the Phillips Curve?

Answer 26

Okun's Law can be combined with Phillips Curve to integrate an 'unemployment gap' into the curve πt = π(t-1) - α(ut - ũt)

Question 27

How can temporary shocks be shown on the Phillips Curve?

Answer 27

Shocks are shown as extra components which contribute negatively or positively to the rate of inflation e.g. Oil price shock raises oil prices --> Δπt = vỸt + ot Here the Phillips Curve shifts vertically upwards

Question 28

Generalised Consumption Equation

Answer 28

Ct = (āc - bc[Rt-β])Ȳt + ꭓ(Yt - Ȳt) Where ꭓ ∈ (0,1) Normal consumption plus some multiple (ꭓ) of the output gap

Question 29

Ct = (āc - bc[Rt-β])Ȳt + ꭓ(Yt - Ȳt)

Answer 29

Generalised Consumption Equation

Question 30

IS Curve with Multiplier

Answer 30

Ỹt = (1/(1-ꭓ)){Ỹt = ā - bi(Rt - r) - bc[Rt-β] } Condensed into... Ỹt = â - b̂i(Rt - r) - b̂c[Rt-β] Where â ≡ ā/(1-ꭓ) and similarly for bi and bc

Question 31

IS Curve

Answer 31

Ỹt = ā - bi(Rt - r) - bc[Rt-β]

Question 32

Ỹt = ā - bi(Rt - r) - bc[Rt-β]

Answer 32

IS Curve

Question 33

Ỹt = â - b̂i(Rt - r) - b̂c[Rt-β]

Answer 33

IS Curve with Multiplier

Question 34

How do the two rounds of a shock work with the multiplier?

Answer 34

Positive demand shock 1st round effect - Increase short-run output for a given value of Ct 2nd round effect - Consumption increases because Ct depends on Ỹt (which has increased) Result: Ỹt increases by more than the initial shock

Question 35

What were the trade offs of Volcker's disinflation push in the late 1970s?

Answer 35

- Economy fell into recession - Unemployment increased - Reduced output BUT + Much less costly than expected + Brought inflation under control

Question 36

LM (liquidity money) Curve

Answer 36

Mt/Pt = L(Ỹt,Rt) Real balances depend positively on short-run output and negatively on real interest rate

Question 37

Mt/Pt = L(Ỹt,Rt)

Answer 37

LM (liquidity money) Curve

Question 38

Describe the LM Curve

Answer 38

A straight line which slopes upwards from left to right in Ỹt,Rt space

Question 39

Why have central banks chosen to control it instead of Mt?

Answer 39

Money demand is subject to volatility many shocks and nominal interest rates are easier to control When CB targets *i*t, Mt absorbs money demand shocks which leads to less macroeconomic instability

Question 40

What is the Taylor Principle?

Answer 40

Monetary policy is stabilizing when the nominal interest rate is higher than the increase in inflation it = Φπt where Φ > 1 (nominal interest rule)

Question 41

Combined Fisher and Nominal Interest Rule Equation

Answer 41

Rt = (Φ-1)πt If Φ < 1, monetary policy response is destabilised

Question 42

Rt = (Φ-1)πt

Answer 42

Combined Fisher and Nominal Interest Rule Equation

Question 43

Inflation-Targeting MPR

Answer 43

Rt - r̄ = ψ(πt - π bar) where ψ>0 Coefficient ψ controls CB’s response to inflation deviations If πt > π bar, then set Rt > r̄ (and vice versa)

Question 44

Rt - r̄ = ψ(πt - π bar)

Answer 44

Inflation-Targeting MPR

Question 45

How is the AD curve derived form the IS and Inflation-Targeting MPR curves?

Answer 45

Using the Inflation-Targeting MPR curve, substitute Rt - r̄ into the IS curve Ỹt = ā - b(Rt - r̄) [assuming that r̄ = β] AD: Ỹt = ā - bψ(πt - π bar)

Question 46

Ỹt = ā - bψ(πt - π bar)

Answer 46

AD Curve (derived from IS and MP curves)

Question 47

Taylor Rule Equation

Answer 47

it = ī + (1+ψ)(πt - π bar) + ΦỸt BoE and Fed set bank rate and FFR using this equation

Question 48

it = ī + (1+ψ)(πt - π bar) + ΦỸt

Answer 48

Taylor Rule Equation

Question 49

Dual-Mandate MPR

Answer 49

Rt - r̄ = ψ(πt - π bar) + ΦỸt

Question 50

Rt - r̄ = ψ(πt - π bar) + ΦỸt

Answer 50

Dual-Mandate MPR

Question 51

How is the AD curve derived form the IS and Dual-Mandate MPR curves?

Answer 51

Using the Dual_Mandate MPR curve, substitute Rt - r̄ into the IS curve Ỹt = ā - b(Rt - r̄) [assuming that r̄ = β] AD: Ỹt = ā/(1+bΦ) - (bψ/1+bΦ)(πt - π bar) Ỹt = ǎ - b̂ψ(πt - π bar)

Question 52

Describe the behaviour of the dual-mandate AD curve

Answer 52

If b̂ < b, the dual mandate AD curve has a steeper gradient than the inflation-targeting curve (and vice versa)

Question 53

How is the AS curve constructed in the AS-AD framework?

Answer 53

The Phillips Curve (with a cost-push shock +ot) is representative of the AS curve πt = πt-1 + vỸt + ot

Question 54

Short-run equilibrium is found where the AS and AD curves are equal. What are

Answer 54

Ỹt = â - b̂ψ(πt-1 - π bar + ot) And πt - π bar = vâ + (1 - vb̂ψ)(πt-1 - π bar + ot) Where â ≡ ā/(1+bψv) and b̂ ≡ b/(1+bψv)

Question 55

Adaptive Expectations Equation

Answer 55

Et[πt+1] = πt-1 Motivated by inflation sluggishness

Question 56

Et[πt+1] = πt-1

Answer 56

Adaptive Expectations Equation

Question 57

Rational Expectations Equation

Answer 57

πt = Et[πt+1] + vỸt

Question 58

πt = Et[πt+1] + vỸt

Answer 58

Rational Expectations Equation

Question 59

If the central bank announces a lower inflation target, what will expected inflation be with rational expectations?

Answer 59

Et[πt+1] = π^1 < π^0

Question 60

What are rational expectations and what is beneficial about them?

Answer 60

With rational expectations, the private sector uses all available information to best forecast all variables of interest It's beneficial because you get costless disinflation (without output downturn and higher unemployment)