Topic 5: IS-LM-PC Model 1 Flashcards
(16 cards)
What do individuals base their inflation expectations on according to adaptive expectations?
Past inflation
Specifically, πᵉₜ = πₜ₋₁
What is the Phillips Curve equation?
πₜ - πᵉₜ = -α(uₜ - uₙ)
Where πₜ is current inflation, πᵉₜ is expected inflation, uₜ is current unemployment, uₙ is natural rate of unemployment, and α is sensitivity of inflation to unemployment.
How can the Phillips Curve be rearranged?
πₜ = πₜ₋₁ - α(uₜ - uₙ)
This shows the relationship between current inflation, past inflation, and the unemployment gap.
Using Okun’s Law, how is the Phillips Curve expressed in terms of output?
πₜ - πₜ₋₁ = γ(yₜ - yₙ)
Where γ = αβ, yₜ is actual output, and yₙ is potential (natural) output.
What are the three core equations of the IS-LM-PC model?
- IS Curve: y = a - br
- LM Curve: r = (M/P) - dy
- PC Curve: πₜ - πₜ₋₁ = γ(yₜ - yₙ)
These equations represent the goods market, money market, and inflation dynamics respectively.
What happens during a positive demand shock?
A rightward shift of the IS curve, output rises, central bank raises interest rates, gradual return to equilibrium
Output rises above potential, leading to upward pressure on inflation.
What is stagflation?
High inflation combined with low growth
Often occurs due to supply shocks, such as the 1970s oil crisis.
What is the impact of an oil price increase on the Phillips Curve?
PC curve shifts left, inflation rises even if output falls
This is due to increased production costs leading to higher prices.
What is the natural rate of interest?
The real interest rate that stabilises output at its natural level (yₙ)
If r < r, inflation rises; if r > r, inflation falls.
What does the IS-LM-PC model integrate?
Goods, money, and labour markets
It links the Phillips Curve to unemployment and output gap.
How do demand shocks affect output?
They temporarily push output above or below potential output
This can lead to adjustments in inflation levels.
True or False: Supply shocks can cause stagflation.
True
Events like oil crises exemplify this phenomenon.
Fill in the blank: The equation for the IS Curve is ______.
y = a - br
What is the relationship between inflation and unemployment illustrated by the Phillips Curve?
Inverse relationship
As unemployment decreases, inflation tends to increase.
What does the time-path of inflation and output gap illustrate after a demand shock?
Inflation rises and stabilises over time
This is seen in the gradual return to equilibrium.
What is the key mechanism during a supply shock?
↑ Oil prices → ↑ Production costs → ↑ Prices (Inflation) → ↓ Output
This sequence explains the transmission of shocks to the economy.
