Topic 6: IS-LM-PC Model 2

Question 1

What does the IS Curve represent in the IS–LM–PC model?

Answer 1

Goods market equilibrium (Y = C(Y–T) + I(Y, i) + G)

C is consumption, T is taxes, I is investment, and G is government spending.

Question 2

What does the LM Curve signify in the IS–LM–PC model?

Answer 2

Money market equilibrium (M/P = YL(i))

M is money supply, P is price level, Y is output, and L(i) is liquidity preference.

Question 3

What is the Phillips Curve (PC) in the context of the IS–LM–PC model?

Answer 3

The relationship between inflation (π) and unemployment (u)

It illustrates the trade-off between inflation and unemployment.

Question 4

What occurs during an initial shock of fiscal expansion?

Answer 4

↑ Government spending → ↑ Demand → ↑ Output (Y)

This leads to a rightward shift of the IS curve.

Question 5

How does the central bank react to a demand shock according to the Taylor rule?

Answer 5

i = i^* + a(π - π^) + b(Y - Y^)

i is the interest rate, i^* is the target interest rate, π is inflation, and Y is output.

Question 6

What happens in the short run after a positive output shock?

Answer 6

Output > potential output → inflation increases

The central bank raises nominal interest rates.

Question 7

What is the effect of inflation expectations adjusting in the medium run?

Answer 7

PC shifts upwards: for the same output, inflation is higher

This leads to further increases in nominal and real interest rates.

Question 8

What is the relationship between output and inflation in the medium run after a demand shock?

Answer 8

Output returns to potential, but inflation stabilizes at a higher level

This indicates the lasting impact of initial shocks.

Question 9

What are the policy implications of demand expansion without a policy response?

Answer 9

Persistent inflation, output may overshoot, long-run instability

Lack of intervention can lead to economic volatility.

Question 10

What is the advantage of an active central bank focused on inflation targeting?

Answer 10

Ensures output returns to natural level and avoids self-fulfilling inflation

This highlights the trade-off between output volatility and inflation control.

Question 11

What are some historical case studies relevant to the IS–LM–PC model?

Answer 11

Post-2008 or COVID-19 stimulus scenarios, stagflation (e.g., 1970s oil shocks)

These cases illustrate the practical applications of the model.

Question 12

True or False: Inflation expectations update rapidly.

Answer 12

False

Inflation expectations typically update gradually, whether adaptive or anchored.

Question 13

What is crucial for stable inflation dynamics according to the IS–LM–PC model?

Answer 13

Anchoring expectations

Effective monetary policy relies on managing inflation expectations.

Question 14

Fill in the blank: The IS–LM–PC model integrates output, ______, and inflation.

Answer 14

[key learning term: interest rates]

This integration is essential for understanding macroeconomic dynamics.