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Video Lecture 4.3 IS-LM-PC Model

The IS-LM-PC model allows including inflation when analyzing the effects of economic policy. It expresses the Phillips curve relationship in terms of output and defines the natural rate of output and unemployment. Monetary policy aimed at reducing inflation lowers output in the short run but brings inflation back to target in the medium run. Fiscal consolidation lowers demand and output in the short run but inflation returns to target as output recovers in the medium run.

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András Tímár
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106 views5 pages

Video Lecture 4.3 IS-LM-PC Model

The IS-LM-PC model allows including inflation when analyzing the effects of economic policy. It expresses the Phillips curve relationship in terms of output and defines the natural rate of output and unemployment. Monetary policy aimed at reducing inflation lowers output in the short run but brings inflation back to target in the medium run. Fiscal consolidation lowers demand and output in the short run but inflation returns to target as output recovers in the medium run.

Uploaded by

András Tímár
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.3 Lecture Video: The IS-LM-PC-Model

Literature: Blanchard et al. 2021, Chap 9


The IS-LM-PC-Model is a model for the medium run which allows to
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include inflation when analyzing the effects of policy
 To add a Phillips-Curve into a IS-LM-model, the PC relationship must be
expressed in terms of output (𝜋 𝑌 relationship)
 PC: 𝜋 𝜋 𝛼 𝑢 𝑢
• With 𝑢 ≡ 1 : 𝑁 𝐿 1 𝑢 N: total employment
L: labor Force
U: total unemployment
• Assumption: Simple production function 𝑌 𝑁 𝐿 1 𝑢
• Given the natural rate of unemployment 𝑢 , we can define the natural rate of employment and the
natural rate of output (= potential output):
𝑁 𝐿 1 𝑢 and 𝑌 𝐿 1 𝑢
• The output gap is defined as 𝑌 𝑌 : 𝑌 𝑌 𝐿 1 𝑢 1 𝑢 𝐿 𝑢 𝑢
• This allows to express the difference between natural and actual unemployment in terms of the
output gap: 𝑢 𝑢 𝑌 𝑌 )

 Inserting into the PC equation: 𝜋 𝜋 𝑌 𝑌 𝜋 𝜋


• Assumption: Inflation expectations are anchored PC
at the inflation target 𝜋: 𝜋 𝜋

0 Y
 PC: 𝜋 𝜋 𝑌 𝑌 YN

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The IS-LM-PC-Model 3

 Problem: When inflation is possible, an inconsistency arises in an IS-LM-model


- The real interest rate is 𝑟 𝑖 𝜋
- In the IS-relation, investment demand should depend on the real interest rate - in the LM-relation,
the central bank controls the nominal interest rate
- Assumption: The central bank is able to steer the nominal policy rate in a way as to achieve the
real interest rate it wants (BAG Chap. 6.4)
• IS-relation: 𝑌 𝐶 𝑌 𝑇 𝐼 𝑌, 𝑟 𝐺
• LM-relation: 𝑟 𝑟̅
• PC-relation: 𝜋 𝜋 𝑌 𝑌

• The intersection of the downward-


sloping IS curve with the horizontal LM
curve gives the equilibrium level of
output in the short run
• In the example, the output level is
above the potential output – as a
consequence, the inflation rate is higher
than the target rate
• Policy must react – with inflation above
the target rate, the economy is
overheating – risk that expectations
become de-anchored

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Anti-inflationary monetary policy - from the short to the medium run 4

• To reduce inflation, the central bank increases the real


interest rate –in doing so it also reduces output
• Short-run adjustment: Lower investment demand reduces
production, income and consumption
• Multiplier effects: lower income – lower consumption,
lower investment
graphically: LM shifts, movement along IS
• Medium-run adjustment: The lower output-gap reduces
inflation
 New medium-run equilibrium in A’:
𝑌 𝑌 , 𝑟 𝑟 , 𝜋 𝜋
• The real interest rate which equates demand for goods
with potential output 𝑌 is 𝑟 : Natural rate of interest (or
neutral rate or Wicksellian rate)
• Complications:
1. The central bank does not know where potential output
is exactly – change in inflation provides a noisy signal
about the output gap
2. Time lag of policy: It takes time for the economy to
respond (firms adjust investment decisions,
consumers adjust to lower income,..)
• Conflict: Central banks approache target gradually – but
going too slowly could imply that inflation expectations
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can become de-anchored
Fiscal consolidation in the short and in the medium run 5

• Initial equilibrium: 𝑌 , 𝑟 , 𝜋 𝜋
• Government decides to reduce its budget deficit by increasing
taxes
• Short-run adjustment:
- At the given real rate, consumption is reduced – lower
aggregate demand, lower production, lower income (lower
investment, …)
IS shifts: A →A’
- The short-run effect of fiscal consolidation is a recession
• Medium-run adjustment:
- Output is below natural level, inflation rate is lower than
target rate
- Central bank reduces the real interest rate – higher
investment, higher aggregate demand, more output,
employment and income
LM shifts: movement along IS from A’→A’’
- As output gap becomes smaller, inflation increases
• New equilibrium: 𝑌 , 𝑟 𝑟 , 𝜋 𝜋
- Composition of demand has changed:
- Same income, but higher taxes – lower consumption
- Lower real interest rate – higher investment

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