Seminar 6 Answers PDF

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Seminar 6: From the Short to the Medium Run: The IS-LM-PC Model Answers Question 1: Consider an economy with output equal to the natural level of output. Now suppose there is an increase in unemployment benefits. Using the model developed in this chapter, show the effects of an increase in unemployment benefits on the labour market (the WS and PS curves), the goods and money markets (the IS and LM curves) and on the Phillips curve. Show what happens to output, inflation and real interest rate on the SR and MR. Answer

Figure 1: Impact on Labour market, IS-LM curves and Phillips curve. As it can be seen in Figure 1 the WS curve moves to the right implying a higher level of the natural level of unemployment. In the MR the level of unemployment is higher. However a different level of the natural level of unemployment implies a lower level of the natural level of employment (N) and natural level of output Yn. Since Yn is lower now, we need a different Phillips curve (PC). PC shifts to the left implying a lower level of Yn. However at A’ inflation is higher than expected and a higher level of r is needed. rn must increase and the LM curve shifts up. In the MR the PC’ implies a lower level of Yn, and the LM’ a higher level of the real interest rate rn. Output is also lower.

Question 2 Consider an economy with output equal to the natural level of output. Now by using the IS-LM-PC model describe the impact of a fiscal consolidation in the SR and MR. More specifically, describe how the 3 curves move in the SR and MR and the impact of the fiscal policy on output, interest rate and inflation in the SR and MR.

A fiscal consolidation (a decrease in G or an increase in T) will have as a result an inward shift of the IS curve and a lower output in the SR. However, at a lower output (and a higher output gap) prices start to fall and the inflation gap becomes negative. For a lower level of output and prices a lower interest rate is needed therefore the real interest rate falls in the MR and the LM curves shifts down. The lower real interest rate will boost Investment and AD. Y will start slowly to increase in the MR going back to it is natural level. The MR equilibrium is given from point A’’ where output has come back to its natural level, the inflation rate is constant (is not changing) and the economy operates at a lower real interest rate.

Question 3 Consider an economy with output equal lower than the natural level of output (Yn) and negative inflation rate (deflation). Now by using the IS-LM-PC model describe the deflation spiral and the dynamics of output, inflation and the real interest rate. Discuss also the constraint of the central bank and monetary policy to help the economy when the nominal interest rate is close to zero. Answer:

Assume that the economy is at Y’ and r=0. However Y’...