Learning unit 9

The Phillips Curve, the natural rate of unemployment

and inflation, and the IS-LM-PC model Learningunit9

Contents

9.1 INFLATION, EXPECTED INFLATION AND UNEMPLOYMENT 266

9.2 THE PHILLIPS CURVE AND ITS MUTATIONS 270
9.3 THE PHILLIPS CURVE AND THE NATURAL RATE OF UNEMPLOYMENT 272
9.4 THE IS-LM-PC MODEL 275
9.5 DYNAMICS AND THE MEDIUM-RUN EQUILIBRIUM 278
9.6 THE ZERO LOWER BOUND AND DEBT SPIRALS 281
9.7 FISCAL CONSOLIDATION REVISITED 285

Study instruction
Read
The introductory part of chapters 8 and 9 of the prescribed book to orient yourself.

Study
Prescribed book: chapters 8 and 9
Subsections: 8.1, 8.2 and 8.3; 9.2 and 9.3
Study guide: learning unit 9

Economics in action – optional study material

myUnisa: lesson LU9

Introduction
The relation between unemployment and inflation is called the Phillips curve. An econ-
omist, AW Phillips, drew a diagram in 1958 plotting the rate of inflation against the
rate of unemployment in the United Kingdom (UK) for each year from 1861 to 1957.
The main finding was a clear inverse (or negative) relationship between rate of unem-
ployment and inflation (or the rate of increase in money wages).
When unemployment was low, inflation was high and when unemployment was high,
inflation was low. In other words, there was a short-run trade-off between unemploy-
ment and inflation.

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Two economists from the USA have done the same exercise on US data from 1900 to
1960 and it also appeared that there was a negative relation between inflation and un-
employment. See figure 8.1 in the textbook.
However, this relation broke down in the USA and most Organisation for Economic
Co-operation and Development (OECD) countries during the 1970s where both high
inflation and high unemployment were experienced. The occurrence of simul-
taneously high unemployment, high inflation and stagnant demand became known as
“stagflation”. The relation between unemployment and inflation then reappeared as a
relation between the unemployment rate and the change in the inflation rate. This will
be discussed in more detail in section 9.2.

Learning unit outcomes

In this learning unit, we shall derive the Phillips curve from the model of the labour
market in learning unit 8 (the labour market) and look at the determination of output
in both the short run and medium run.
Once you have worked through this learning unit, you should be able to explain the
following in words and by means of a chain of events, equations and diagrams:
● the relation between inflation, expected inflation, and unemployment
● the Phillips curve
● the Phillips curve and the natural rate of unemployment
● the Phillips curve in terms of output
● the IS-LM-PC model
● the adjustment from the short run to the medium run
● the role of monetary policy in the event of a liquidity trap and the deflation spiral
● the impact of fiscal policy

Contents
9.1 INFLATION, EXPECTED INFLATION AND UNEMPLOYMENT
(Section 8.1 in the prescribed book)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of equations:
● the relation between inflation, expected inflation, and unemployment

PRIOR KNOWLEDGE

Before you attempt this section, make sure you understand the following:

wage-setting relationship learning unit 8

price-setting relationship learning unit 8
the natural rate of unemployment learning unit 8
equilibrium in the labour market learning unit 8

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DO PRIOR KNOWLEDGE ACTIVITY 9.1 BELOW

Choose the correct option in brackets.

Statement
a. An increase in the level of output implies a/an (increase/decrease) in the level
of employment and an/a (decrease/increase) in the unemployment rate.
b. A decrease in the unemployment rate (decreases/increases) the bargaining
position of workers and they are able to negotiate (higher/lower) wages.
c. An increase in the expected price level (increases/decreases) nominal wages.
d. An increase in nominal wages (increases/decreases) the price level.
e. The higher the mark-up, the (lower/higher) the real wage implied by price
setting.
f. The natural rate of unemployment is the rate of unemployment where the real
wage chosen by wage setting is (equal to/higher than/lower than) the real
wage implied by price setting.

Recall from learning unit 8 the equation for wage determination [W = Pe F(u, z)] and
the equation for price determination [P = (1 + m)W] in the labour market. In learning
unit 8, we assumed that the actual price level was equal to the expected price
level (P = Pe) to determine the natural rate of unemployment, but in this learning unit
we explore what will happen without this assumption, in other words P ≠ Pe.
Without this assumption, using the above equations for wage determination and price
determination we can derive the relation between the price level, the expected price
level and the unemployment rate.
You can follow the derivations of the different equations in the textbook but for this
module, it is not prescribed to derive the different equations in mathematical terms.

The relation between the price level, the expected price level and the unemployment
rate
Equation 8.1 in the textbook [P = Pe (1 + m)(1 – αu + z)] gives us the relation between
the price level, the expected price level and the unemployment rate. The parameter α
captures the strength of the effect of unemployment on the wage.
It is important to understand the relationship between the different variables:
● an increase in the expected price level leads to an increase in nominal wages, which
in turns leads to an increase in the price level; Pe��W��P�
● an increase in the mark-up by firms leads to an increase in the price level; m��P�
● an increase in the unemployment rate leads to a decrease in nominal wages, which
in turn leads to lower prices and a decrease in the price level; u��W��P�
● the higher the catchall variable (z) (e.g. more unemployment benefits), the higher
the nominal wage, which in turns leads to an increase in the price level;
z��W��P�
Summary: [P = Pe(1 + m)(1 – αu + z)]
+ + – +

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DO ACTIVITY 9.1 BELOW

1. Use equation 8.1 in the textbook [P = Pe (1 + m) (1 – αu + z)] to indicate

whether the following will lead to an increase or a decrease in the price level:

Statement
Circle the correct option.
a. An increase in expected prices (increases/decreases) the price level (P).
b. A decrease in the mark-up (increases/decreases) the price level (P).
c. An increase in unemployment (increases/decreases) the price level (P).
d. An increase in the bargaining position of workers (increases/decreases)
the price level (P).
e. A decrease in output (increases/decreases) the price level (P).

2. Indicate whether there is a positive or negative relationship between the fol-

lowing variables and the price level:

Statement
Circle the correct option.
a. A (positive/negative) relationship exists between the expected price level
and the price level.
b. A (positive/negative) relationship exists between wages and the price
level.
c. A (positive/negative) relationship exists between the mark-up and the
price level.
d. A (positive/negative) relationship exists between the unemployment rate
and the price level.
e. A (positive/negative) relationship exists between the employment level
and the price level.
f. A (positive/negative) relationship exists between the level of output and
income and the price level.

The relation between inflation, expected inflation and the unemployment rate
The next step is to derive a relation between inflation, expected inflation, and the un-
employment rate given equation 8.1 [P = Pe (1 + m)(1 – αu + z)] that gives us the rela-
tion between the price level, the expected price level and the unemployment rate.
Let π denotes the inflation rate, and πe denotes the expected inflation rate.
Equation (8.1) above can then be rewritten as
π = πe + (m + z) – αu (equation 8.2 in the textbook)
As mentioned above, it is not important to derive equation (8.2) from equation (8.1)
but you must understand each of the effects at work in this equation:
1. An increase in expected inflation, πe, leads to an increase in actual inflation, π;
πe��π�
Why? If the expected price level Pe increases it will lead, one for one, to an increase
in the actual price level, P. The reason for this is when wage setters expect a higher

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price level, they set a higher nominal wage, which leads in turn to an increase in
the price level: Pe��W��P� (remember that P ≠ Pe).
Given last period’s price level, a higher price level this period implies a higher rate
of increase in the price level from last period to this period – that is, higher inflation.
Similarly, given last period’s price level, a higher expected price level this period
implies a higher expected rate of increase in the price level from last period to this
period – that is, higher expected inflation.
Therefore, the fact that an increase in the expected price level leads to an increase
in the actual price level can be restated as: An increase in expected inflation leads
to an increase in inflation.
2. Given expected inflation, πe, an increase in the mark-up m, or an increase in the
factors that affect wage determination – an increase in z – leads to an increase
in actual inflation π
Given πe: m�� π� or z��π�
Why? Given the expected price level Pe, an increase in either m or z increases the
actual price level, P.
The same argument can be used as under number 1 above to restate this proposi-
tion in terms of inflation and expected inflation: Given expected inflation πe,
an increase in either m or z leads to an increase in inflation π.
3. Given expected inflation, πe, a decrease in the unemployment rate, u, leads to
an increase in actual inflation π
Given πe: u��π�
Why? Given the expected price level Pe, a decrease in the unemployment rate u
leads to a higher nominal wage, which leads to a higher actual price level, P. Restat-
ing this in terms of inflation and expected inflation: Given expected inflation, πe, an
increase in the unemployment rate, u, leads to an increase in inflation, π.
Summary: π = πe + (m + z) – αu
+ + + –

DO ACTIVITY 9.2 BELOW

1. Indicate whether the following statements are true or false. Circle the correct
option.

Statement
a. An increase in expected inflation leads to an increase in actual inflation
since an increase in the expected price level leads to an increase in the
actual price. True or false.
b. Actual inflation is not influenced by factors such as the mark-up or institu-
tional factors. True or false.
c. Given expected inflation, πe, an increase in the unemployment rate leads
to a decrease in actual inflation. True or false.

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2. Circle the correct option.

Statement
a. A (positive/negative) relationship exists between expected inflation and
actual inflation.
b. A (positive/negative) relationship exists between the expected price level
and the actual price level.
c. A (positive/negative) relationship exists between the mark-up and actual
inflation.
d. A (positive/negative) relationship exists between the unemployment rate
and actual inflation.

9.2 THE PHILLIPS CURVE AND ITS MUTATIONS

(Section 8.2 in the prescribed book)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of a diagram:
● the Phillips curve: the trade-off between inflation and unemployment
● the modified Phillips curve: the negative relation between the change in inflation
and the unemployment rate
In the introduction, we referred to the link between unemployment and inflation. An
economist, AW Phillips, drew a diagram in 1958 plotting the rate of inflation against
the rate of unemployment in the United Kingdom for each year from 1861 to 1957.
The main finding was a clear inverse (or negative) relationship between the rate
of unemployment and inflation (or the rate of increase in money wages), known as
the Phillips curve.
When unemployment was low, inflation was high (or positive) and when unemploy-
ment was high, inflation was low, even sometimes negative. In other words, there was
a short-run trade-off between unemployment and inflation and policymakers could
use this trade-off in policymaking: If they were to accept a higher inflation rate, they
could achieve lower unemployment as indicated in diagram 9.1 below. For example,
at a low unemployment rate of 2%, the inflation rate was 4% but at a higher unem-
ployment rate of 4%, the inflation rate was only 1%.

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Diagram 9.1: The Phillips curve: trade-off between inflation and unemployment

Two American economists (Samuelson and Solow) did the same exercise for the USA
using data from 1948 to 1969 and they also found that a negative relation exists
between inflation and unemployment.
Later studies by Friedman and Phelps (using USA data from the 1970s) showed that
the apparent trade-off between the inflation rate and the unemployment rate disap-
peared. Compare figure 8.2 with figure 8.3 in the textbook. In figure 8.3, it is clear that
there is no longer a relationship between the unemployment rate and the inflation
rate.
Why did the original Phillips curve disappear in the 1970s? Asked another way, why
did the negative relationship between inflation and unemployment break down?
The reason: Wage setters or workers changed the way they formed their expectations
about inflation because there was a change in the behaviour of inflation.
From the 1970s, the rate of inflation became more persistent. High inflation in one
year became more likely to be followed by high inflation the next year. As a result,
people, when forming expectations, started to take into account the persistence
of inflation. In turn, this change in expectation formation changed the nature of
the relation between unemployment and inflation.
If the inflation rate in the previous year was high, workers and firms will take this high-
er inflation rate into consideration and revise their expectations of what inflation will
be this year and therefore the expected inflation rate will be even higher.
For the period that Phillips and Samuelson and Solow had looked at the relation
between inflation and unemployment, inflation was not persistent. Therefore, the
workers and firms just ignore past inflation and accept that inflation is constant.
However, as inflation became more persistent, workers and firms started changing the
way they formed expectations. They started assuming that if inflation had been high
last year, inflation was likely to be high this year as well and therefore the

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unemployment rate does not affect the inflation rate as such but rather the change in
the inflation rate.
This negative relation between the change in inflation and the unemployment rate is
often called the modified Phillips curve or the expectations augmented Phillips curve
– see figure 8.4 in the textbook. For low unemployment, the change in inflation is posi-
tive and for high unemployment, the change in inflation is negative, in other words,
high unemployment leads to decreasing inflation and low unemployment leads to in-
creasing inflation. For distinction purposes, we will refer to the original Phillips curve
and only the term Phillips curve to indicate the modified Phillips curve or the expecta-
tions augmented Phillips curve.
Note: The different equations in this section of the prescribed textbook are not pre-
scribed for this module.

DO ACTIVITY 9.3 BELOW

Indicate whether the following statements are true or false. Circle the correct
option.

Statement
a. The original Phillips curve shows the relationship between inflation and interest
rates. True or false.
b. The original Phillips curve shows the relationship between inflation and unem-
ployment. True or false.
c. The Phillips curve has a negative slope to indicate that lower rates of unem-
ployment are associated with a higher rate of change in prices. True or false.
d. The Phillips curve has a negative slope to indicate that higher rates of unem-
ployment are associated with a higher rate of change in prices. True or false.

9.3 THE PHILLIPS CURVE AND THE NATURAL RATE OF UNEMPLOYMENT

(Section 8.3 in the prescribed book)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words:
● the relation between the Phillips curve and the natural rate of unemployment
What is the relation between the Phillips curve and the natural rate of unemployment?
It is important to revise section 8.4 of this study guide. Remember that section 8.4 was
based on the assumption that the expected price level is equal to the actual price level
(Pe = P) and under this additional assumption, wage setting and price setting deter-
mine the equilibrium rate of unemployment (also called the natural rate of unemploy-
ment). By definition, the natural rate of unemployment is the unemployment rate at
which the actual price level is equal to the expected price level (un� P = Pe) and can
be influenced by many factors such as all factors that affect wage setting (the catchall
factor z) and the mark-up set by firms (m).

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Equivalently, in this learning unit, we can say that the natural rate of unemployment is
the unemployment rate at which the actual inflation rate is equal to the expected
inflation rate (un�π = πe).
However, if the inflation rate in the previous year is a good prediction of the expected
rate of inflation this year, we can think about the Phillips curve as a relation between
the actual unemployment rate (ut), the natural unemployment rate un, and the change
in the inflation rate (πt – πt-1), where πt is the expected rate of inflation this year and
πt-1 the previous year’s inflation rate.
The change in the inflation rate (πt – πt-1) depends on the difference between the
actual unemployment rate this year (ut) and the natural unemployment rate (un).
When the actual unemployment rate is higher than the natural unemployment rate,
inflation decreases
(ut > un: inflation �);
or
when the actual unemployment rate is lower than the natural unemployment rate, in-
flation increases
(ut < un: inflation �).
Therefore, we can say that the natural rate of unemployment is the rate of unemploy-
ment required to keep the inflation rate constant.
Research in the USA indicates that the Philips curve that best fits the 1970 to 2014 data
is given by
πt – πt-1 = 3% – 0.5ut
Therefore, during this period in the USA the average rate of unemployment required
to keep inflation constant (at 0) is 6% – see the calculation below:
0 = 3% – 0.5u
t
ut = 3%
0.5
ut = 6%

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Summary of concepts, equations and relationships of the above sections

Concepts Equation Relationships
● inflation P = Pe(1 + m)(1 – αu + z) Pe��W��P�
● expected inflation + + – +
u��W��P�
● change in the inflation rate
● unemployment rate m��P�
● natural rate of π = πe + (m + z) – αu
+ + + – z��W�
unemployment
● Phillips curve πe��π�
● Phillips curve and the natural Given πe: m��π�
rate of unemployment
Given πe: z��π�
Given πe: u��π�
un� P = Pe
un� π = πe
πt – πt-1
ut > un: inflation�
ut < un: inflation�

DO ACTIVITY 9.4 BELOW

Indicate whether the following statements are true or false. Circle the correct
option.

Statement
a. The natural rate of unemployment is the unemployment rate at which the
actual inflation rate is equal to the expected inflation rate. True or false.
b. The natural rate of unemployment is the unemployment rate at which the infla-
tion rate remains constant, that is, the change in the inflation rate is zero. True
or false.
c. When the actual unemployment rate exceeds the natural rate of unemploy-
ment, the inflation rate increases. True or false.
d. When the actual unemployment rate is less than the natural rate of unemploy-
ment, the inflation rate increases. True or false.
e. The rate of unemployment that is required to keep the inflation rate constant,
is called the natural rate of unemployment. True or false.
f. The natural rate of unemployment means that there is no unemployment. True
or false.

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9.4 THE IS-LM-PC MODEL

(Only study this section of this study guide, not in the prescribed book)

Section outcomes
In this section, we build a complete model called the IS-LM-PC model. We do this by
integrating our knowledge about the goods market, financial market, labour market,
price setting by firms in an imperfect market and the Phillips curve.
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of diagrams:
● the link between unemployment, employment and output
● the link between the natural rate of unemployment and the natural level of output
● the impact of a negative and positive output gap on the inflation rate
● the adjustment process from a short-run equilibrium to a medium-run equilibrium
● the role of monetary policy in the event of a liquidity trap and the deflation spiral
● the impact of fiscal policy in the IS-LM-PC model in the short run and the medium
run

PRIOR KNOWLEDGE

Since this model builds upon and integrates our knowledge of the previous units,
it is important that you have a good grasp of the following preceding study units.

wage-setting relationship learning unit 8

price-setting relationship learning unit 8
natural rate of unemployment learning unit 8
inflation, expected inflation, and unemployment learning unit 9.1
the Phillips curve learning unit 9.2
the Phillips curve and the natural rate of unemployment learning unit 9.2

Once we have built this model, we deal with a number of issues relating to the short-
run equilibrium position, the adjustment process from the short-run equilibrium posi-
tion to the medium-run equilibrium position and the impact of fiscal policy.

The Phillips curve (PC curve) in terms of output

Before we start building and working with this model, we must rewrite our Phillips
curve in terms of output since it is with the determination of output that we are mostly
concerned with in this module.
This relationship between unemployment, employment and output is central to the
IS-LM-PC model that you will study in this unit. Make sure you understand the relation-
ship between these three variables.

From unemployment to employment to output

In this section, the argument is that if we know what the natural rate of unemploy-
ment is, we can derive the natural level of employment and, from the natural level of

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employment through a production function, we can derive the natural level of output
or the potential output level.
For example, if the labour force is 150 million and the natural rate of unemployment is
5%, then the natural level of employment is 142.5 million.
Nn = L(1 – un) where
● Nn is the natural level of employment
● L is the labour force
● un is the natural rate of unemployment
Nn = L(1 – un)
= 150 (1 – 5%)
= 150 (1 – 0.05)
= 150 (0.95)
= 142.5 million workers

Associated with the natural level of employment (Nn) is the natural level of output Yn
(the level of production when employment is equal to the natural level of employ-
ment). Yn is also called the potential output.
To move from employment to output we need a production function. Assuming that
each employed worker produces one unit (according to our production function), it
follows that the natural level of output (the potential level of output) is
Yn = number of workers employed x output per worker
= 142.5 workers x 1
= 142.5 million units

Note that, as the natural unemployment rate changes, the natural level of employment
and natural level of output (potential output) will also change.
It is clear that for a given labour force, the natural rate of unemployment determines
the level of employment, and that, given the production function, the level of employ-
ment determines the level of output. Thus, associated with the natural rate of unem-
ployment is the potential level of output.
The difference between actual output and potential output is called the output gap.
The following relations between output and unemployment (known as Okun’s law)
are important. Make sure that you understand these relations:
● If the unemployment rate is equal to the natural rate of unemployment, output is
equal to potential output, and the output gap is equal to zero.
(If u = un; Y = Yn � output gap is zero � change in inflation is zero.)
● If the unemployment rate is above the natural rate of unemployment, output is be-
low potential output and the output gap is negative. If the output gap is negative,
inflation decreases.
(If u > un; Y < Yn� output gap is negative � inflation �.)
● If unemployment is below the natural rate of unemployment, output is above po-
tential output and the output gap is positive. If the output gap is positive, inflation
increases.

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(If u < un; Y > Yn� output gap is positive� inflation �.)
In the diagram below this positive relation between output and the change in inflation
is drawn as the upward sloping PC curve.
On the horizontal axis, output (Y) is measured and the change in inflation (πt – πt-1) is
measured on the vertical axis.
Note: In the textbook the change in inflation is also indicated as (π – π)(–1) in the
explanations and in the figures. See for example figure 9.2. In this study guide we will
only use (πt – πt-1) when we refer to the change in inflation.
When output is equal to potential, in other words when the output gap is equal to
zero, the change in inflation is equal to zero. Thus, the Phillips curve crosses the hori-
zontal axis at the point where output is equal to potential.

Diagram 9.2: The Phillips curve in terms of output (positive output gap)

TUTOR ACTIVITY 23
The relationship between the natural rate of unemployment, the natural level of
employment and the natural level of output
Explain briefly in words and use a numerical example to illustrate whether the follow-
ing statement is true or false: “The higher the natural rate of unemployment, the high-
er the natural level of employment and the higher the natural level of output”.

You should be linked to an e-tutor. Your e-tutor will help you with the solu-
tions to this activity. See TL101 for instructions on how to find your e-tutor.

DO ACTIVITY 9.5 BELOW

1. Given the following information, calculate the natural level of output:

– natural rate of unemployment: 10%
– economically active population: 14 million
– production function: each employed worker produces one unit

2. Study the following PC curve and answer the questions:

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2.1 Indicate whether the following statements are true or false:

a. On the vertical axis, the inflation rate is measured.
b. At points to the left of Yn, the output gap is negative.
c. If the output gap is positive, the change in the inflation rate decreases.
d. At point Yn, the inflation rate is zero.

2.2 Choose the correct word in brackets:

a. At point a, the (negative/positive) output gap causes the change in the in-
flation rate to (increase/decrease).
b. At point a, the potential output is (Y/ Yn).
c. At point a, the unemployment rate is (greater than/smaller than/the same
as) the natural rate of unemployment.

9.5 DYNAMICS AND THE MEDIUM-RUN EQUILIBRIUM

(Study section 9.2 in the prescribed book, only the first subsection – not “the
role of expectations revisited”)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of a diagram:
● the adjustment process from a short-run equilibrium position to a medium-run
equilibrium position
In this section, we look at how an economy moves from a short-run equilibrium posi-
tion to a medium-run equilibrium position. In the short run, the equilibrium level of
output and income can deviate from the natural level of output and income. In other
words, a negative or positive output gap may exist. This short-run deviation from the
natural level of output and income may be due to fiscal policy, monetary policy, con-
sumer confidence or investor confidence.
However, a non-constant inflation rate will eventually prompt the central bank into
action, resulting in an adjustment to the medium run where output is equal to the nat-
ural level of output, unemployment is equal to the natural rate of unemployment, in-
flation is constant and the real interest rate is equal to the so-called “natural rate of
interest”.

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In diagram 9.3 below, the short-run equilibrium position is indicated at point a. The
output gap in this case is positive. The real interest rate (the policy rate) chosen by the
central bank is equal to r and associated with this interest rate, and the level of output
is given by Y where the IS curve intersects the LM curve.
Given the way we have drawn the figure, Y is larger than Yn, meaning that output is
above potential. This implies that inflation is increasing. At output level Y, the change
in inflation is positive and there is an upwards pressure on inflation.

Diagram 9.3: The IS-LM-PC model: the short-run equilibrium position

When working through the adjustment process from the short-run equilibrium to a
medium-run equilibrium, note how policymakers use the real interest rate (r) to influ-
ence the level of output and the change in the inflation rate. Also note that the real in-
terest rate associated with the medium-run equilibrium is called the natural rate of
interest.
In this section, it is important to take into account that we are dealing with a change
in the inflation rate. As long as the level of output is greater than the potential level of
output (the output gap is positive), the inflation rate increases. Policymakers will at a
certain point react to this increasing inflation, for example the central bank will
increase the interest rate in order to decrease output back to potential output. If out-
put is equal to potential output and the output gap is equal to zero, there is no pres-
sure on inflation.
The figure 9.4 below illustrates the medium run adjustment process.
The initial equilibrium is at point a (short-run equilibrium). At this point, the output
gap is positive since output (Y) is above potential output (Yn) and inflation increases.
Looking at the top figure, the central bank decided to increase the interest rate in reac-
tion to this high inflation and over time there is an upward movement along the IS
curve from a to a1 and output decreases.

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Looking to the bottom figure, you can see that as output decreases the economy
moves down the PC curve from point a to a1.
At point a1 the policy rate is equal rn (the natural rate of interest), output is equal to Yn
and at this point inflation is by implication constant. This is the medium-run equili-
brium position.

Diagram 9.4: The IS-LM-PC model: medium-run output and inflation

Note that the sub-section “the role of expectations revisited” is not prescribed for this
module.

TUTOR ACTIVITY 24
The IS-LM-PC model
Assume that the short-run equilibrium is at a point where output is higher than poten-
tial output and there is an upward pressure on inflation. Explain some reasons why the
central bank cannot immediately increase the policy interest rate to a point where out-
put equals potential output to achieve stable inflation.

You should be linked to an e-tutor. Your e-tutor will help you with the solu-
tions to this activity. See TL101 for instructions on how to find your e-tutor.

DO ACTIVITY 9.6 BELOW

1. Illustrate by using an IS-LM-PC model where output is at potential.

2. Illustrate by using an IS-LM-PC model a negative output gap in the short run.
Explain the medium run adjustment process.

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3. Study the following IS-LM-PC model and answer the questions:

Choose the correct option in brackets:

a. The natural rate of interest is (2%/3%/4%).
b. An increase in the interest rate from 2% to 3% (decreases/increases) the
output gap.
c. At point c the change in inflation is (higher/lower/the same) than at point
a.
d. At point c, the inflation rate is (higher/lower/the same) than at point a.

9.6 THE ZERO LOWER BOUND AND DEBT SPIRALS

(Study section 9.2 in the prescribed book, only the subheading “The zero
lower bound and debt spirals”)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of a diagram:
● the deflation spiral
● the meaning of quantitative easing (QE)
● the meaning of the inflation targeting framework

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Please read through the following extract from The Economist:

BEFORE the financial crisis life was simple for central bankers. They had a clear mission:
temper booms and busts to maintain low and stable inflation. And they had a seem-
ingly effective means to achieve that: nudge a key short-term interest rate up to dis-
courage borrowing (and thus check inflation), or down to foster looser credit (and thus
spur growth and employment). Deft use of this technique had kept the world hum-
ming along so smoothly in the decades before the crash that economists had declared
a “Great Moderation” in the economic cycle. As it turned out, however, the moderation
was transitory ̶ and the crash that ended it undermined not only the central bankers’
record but also the method they relied on to prop up growth. Monetary policy has
been in a state of upheaval ever since.
The recession that accompanied the credit crunch in the autumn of 2008 delivered a
massive blow to demand. In response central banks in the rich world slashed their
benchmark interest rates. By early 2009 many were close to zero, approaching what
economists call the “zero lower bound”. Even so, growth remained elusive. Pushing
rates below zero, though technically possible, would not have helped. Negative rates
would merely have encouraged depositors to withdraw their money from banks and
hold it as cash, on which the rate of return, at zero, would have been higher. Central
banks in the developed economies faced a frightening collapse in output and soaring
unemployment without recourse to the tool that had been the mainstay of monetary
policy-making for a generation.
The Economist. 2013. Monetary policy after the crash: Controlling interest. [web log].
April 2013, from http://www. economist. com/news/schools-brief/21586527-third-our-
series-articles-financial-crisis-looks-unconventional
After reading the above article it should be clear to you that when the policy interest
rate set by the central bank is close to or at zero per cent, the conventional monetary
policy is no longer effective at stimulating the level of output and income.
A “deflation spiral” is a very serious economic condition that could occur (and did
occur during the Great Depression) when the zero lower bound is reached. A negative
nominal interest rate implies that instead of earning interest on bonds, you pay
interest on bonds rendering the demand for bonds negligible as holding cash (which
pays a zero interest rate) is preferable to holding bonds. Thus, the nominal interest
rate should not be less than zero, constraining monetary authorities by the zero lower
bound. Remember from learning unit 6 that the real interest rate (r) is equal to the
nominal interest rate minus the inflation rate. The central bank targets the nomi-
nal interest rate but the real interest rate is the rate firms consider when demanding
loans. Thus, the central bank must consider inflation expectations when deciding on
the nominal interest rate. If expected inflation is 3% and the desired real interest rate
is 4%, then the nominal policy interest rate should be set at 7% (4% = 7% – 3%). In a
liquidity trap, the nominal interest rate is close to or at zero rendering conventional
monetary policy ineffective in boosting the level of output and income. When the
economy is in a liquidity trap, people become indifferent with regard to money and
bonds, therefore the Md curve becomes horizontal at the zero percent interest rate.
Now consider a scenario where the economy is so depressed that inflation expecta-
tions become negative – that is, deflation. Since the nominal policy interest rate

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should not become negative (the zero lower bound), the real policy interest rate is
constrained by deflation. If expected inflation is –5%, then the lowest the real policy
interest rate can reach is 5% because the nominal policy interest rate cannot be nega-
tive [5% = 0% – (–5%)]. This restriction on the real policy interest rate means that
if expected deflation increases, the effective real interest rate will increase. The higher
real policy interest rate results in lower output and income which increases the output
gap and further results in additional increases in deflation and so on, potentially lead-
ing to a deflation spiral. A deflation spiral in terms of the IS-LM-PC curve is illustrated
below in diagram 9.5 below. At the real interest rate r, the level of output and income
is below the natural level at the initial equilibrium position a. The output gap is nega-
tive and therefore inflation is decreasing. However, assuming that the economy is in a
liquidity trap, the real interest rate needed in order to move output towards the natu-
ral level may be negative, like rn in the diagram. Thus the central bank is constrained
to lower the real interest rate to zero, at which point the level of output and income Y1
is below the natural level. At Y1 the inflation rate is still decreasing and if it becomes
negative, it could trigger a deflation spiral. With a constant nominal interest rate, each
round of a deflation spiral consecutively increases the real interest rate leading to low-
er demand and lower output, represented by arrows in the diagram indicating a move
further away from the natural level of output and income. Fortunately, deflation was
limited after the recent financial crisis thus avoiding a deflation spiral even though the
zero lower bound had been reached. A possible explanation is that inflation expecta-
tions remained anchored, stopping a rapid downward spiral.

Diagram 9.5: The deflation spiral

The focus of this module is on conventional monetary policy; thus, it is sufficient for
you to understand that when the zero lower bound is reached, monetary policy is inef-
fective. It may interest you, however, to know that during the global financial crisis the
US central bank, the Fed, used an unconventional monetary policy known as

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quantitative easing (QE) to try to influence economic activity after it reached the zero
lower bound in December 2008. The Fed bought government bonds as well as risky
assets with newly created central bank reserves in order to provide banks with more
liquidity. The general consensus is that although QE was somewhat successful, it is
more complicated and less efficient than conventional monetary policy. QE was not
implemented in South Africa because the repo rate never approached the zero lower
bound (see diagram 9.7 below).

The success of inflation targeting in South Africa

In South Africa, monetary policy follows an inflation targeting framework. This means
that the achievement and maintenance of price stability are the primary objectives of
monetary policy. Following the global financial crisis, the South African Reserve Bank
(SARB) was given an extended primary objective which is the “achievement and main-
tenance of price and financial stability”. The inflation rate target band is 3% to 6%.
Since the adoption of inflation targeting during 2000, there have been two periods
where the inflation rate exceeded the upper target limit of 6% by a sizable amount
and for a prolonged time (see diagram 9.6 below). The first was during 2002 when sup-
ply-side shocks such as a depreciation of the rand coupled with increases in global
food and oil prices. The second was in the wake of the global financial crisis. Although
South Africa did not experience a domestic financial crisis, it was one of the worst af-
fected emerging economies according to the Financial Stability Board. A sharp depre-
ciation as foreign investment was withdrawn from the country following the crisis
caused inflation to rise. In response to both of these periods of prolonged high infla-
tion, the SARB employed contractionary monetary policy increasing the repo rate to
curb inflation (see diagram 9.7).

Diagram 9.6: South African inflation rate; period 2001/09/07 to 2018/07/11

Source: TradingEconomics.com [Accessed on 2019/03/29]

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Diagram 9.7: South African repo rate; period 2001/09/07 to 2018/07/11

Source: TradingEconomics.com [Accessed on 2019/03/29]

TUTOR ACTIVITY 25
The deflation spiral
Discuss the following statement:
“Adjustment to the medium run is always easy. If output is too low, the central bank
decreases the real interest rate until output reaches the natural level of output and
income”.
You should be linked to an e-tutor. Your e-tutor will help you with the solu-
tions to this activity. See TL 101 for instructions on how to find your e-tutor.

DO ACTIVITY 9.7 BELOW

Is the unconventional monetary policy known as quantitative easing (QE) applica-

ble to South Africa? Explain your answer.

9.7 FISCAL CONSOLIDATION REVISITED

(Section 9.3 in the prescribed book)

Section outcomes
Once you have worked through this section of the learning unit, you should be able to
explain the following in words and by means of a diagram:
● the short-run and medium-run impact of fiscal policy on the economy using the
IS-LM-PC model
In this section, we use our IS-LM-PC model to consider the impact that fiscal policy
have on the economy. We distinguish between the short-run and the medium-run
impact by assuming that the government increases taxes to deal with its budget
deficit.

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This is represented by a leftward shift of the IS curve in our model and a short-run
equilibrium position is reached. It is important that you understand what happens to
variables such as consumption, investment, output and inflation as the economy
moves to the short-run equilibrium position from its initial equilibrium.
We then move from the short-run to the medium-run equilibrium by considering the
impact of a decrease in the policy rate by the central bank. You must once again
understand what happens to the variables in the model as we move from the short-
run to the medium-run equilibrium position.
Looking at both diagrams below, where output is at potential initially, the economy is
at point a. At point a output Y is equal to Yn, the policy rate is equal to rn, and inflation
is stable.
If the government experiences a budget deficit, it can for instance reduce the deficit
by increasing taxes, shifting the IS curve to the left, from IS to IS1. At the given policy
rate rn, output decreases from Yn to Y1, and inflation starts decreasing. In this case,
where the short-run position was at a point where output was at potential, the fiscal
consolidation leads to a recession. As income comes down and taxes increase, con-
sumption decreases on both counts and as output decreases, investment also de-
creases (because a positive relation exists between income and investment). Thus, in
the short run, both consumption and investment decrease.
What happens in the medium run? When output is too low and inflation is decreasing,
the central bank is likely to react and decrease the policy rate (the LM curve shifts
downwards from LM to LM1) and the economy moves down the IS curve form a1 to a2
until output is back to potential. At point a2 output increases back from Y1 to Yn, and
inflation is again stable.
The policy rate needed to maintain output at potential is now lower than before. It de-
creases from rn to rn1. At this new equilibrium point, income (or output) is the same as
it was before fiscal consolidation but taxes are higher and consumption is lower, but
not as low as it was in the short run.
The real interest rate needed to maintain the natural level of output is now lower than
before (it decreases from rn to rn1), meaning that investment spending is even higher
than before the contractionary fiscal policy. In other words, the decrease in consump-
tion is offset by an increase in investment, so demand, by implication, is unchanged.
The medium-run position, when comparing with the short-run position, looks much
better and makes fiscal consolidation look more attractive. Although consolidation
may decrease investment in the short run, it increases investment in the medium run.

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Diagram 9.8: Fiscal consolidation in the short run and the medium run

Note the constraint of the zero lower bound on the ability of the central bank to use
the policy rate to move the economy to a medium-run equilibrium position. For exam-
ple, if the nominal interest rate is zero or very near to zero, for the monetary policy to
decrease the policy rate will be ineffective to offset the negative effects of fiscal con-
solidation on output.

Summary of concepts, equations and relationships of the above sections

Concepts Equation Relationships
● unemployment Nn = L(1 – un) If u = un; Y = Yn � output gap is zero
● employment � change in inflation zero
● output If u > un; Y < Yn � output gap is
● natural rate of negative � inflation �
unemployment
● potential output If u < un; Y > Yn � output gap is
● positive output gap positive � inflation �
● negative output gap
● IS-LM-PC model

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DO ACTIVITY 9.8 BELOW

Study the following diagram of the IS-LM-PC model that represents the impact of
an increase in taxes in the short run and medium run and answer the questions:

1. Point a1 is a (short-run/medium-run) equilibrium position.

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2. Indicate whether the following variables are higher/lower/the same at point

a1 compared to point a.
Variable Higher Lower The same
Taxes
Consumption
Demand for goods
Potential output
Investment
Unemployment
Output
Natural rate of
interest
Policy rate

3. At point a1, the change in inflation is (increasing/decreasing/constant) since

the output gap is (positive/negative).
4. Point a2 is a (short-run/medium-run) equilibrium position.
5. Indicate what happens to the following variables as the economy moves
from point a1 to a2.
Variable Increases Decreases Unchanged
Consumption
Taxes
Policy rate
Investment
Demand for goods
Unemployment
Output

6. As the economy moves from point a1 to a2, inflation (decreases/increases)

but at a (slower/faster) rate.
7. Indicate whether the following variables are higher, lower or the same at
point a2 compared to point a.
Variable Higher Lower The same
Consumption
Investment
Demand for goods
Natural rate of
interest
Potential output
Change in inflation

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TUTOR ACTIVITY 26
The IS-LM-PC model
Assume the following scenario to distinguish between the short-run and the medium-
run impact on the IS-LM-PC model. The government decides to decrease government
spending to deal with its budget deficit. The economy is at a point where output is
lower than potential output and there is a downward pressure on inflation.
Use the IS-LM-PC model to illustrate and to explain what the possible reaction of the
central bank will be to move the economy back to potential output. Refer in your ex-
planation to the impact on the goods market, the financial market, the exchange rate
in the short run and the impact on the financial market and the goods market in the
medium run.
You should be linked to an e-tutor. Your e-tutor will help you with the solu-
tions to this activity. See TL101 for instructions on how to find your e-tutor.

Summary
In this learning unit we have constructed a complete model called the IS-LM-PC model.
We do this by integrating our knowledge about the goods market, financial market, la-
bour market, price setting by firms in an imperfect market and the Phillips curve.
You should be able to explain the Phillips curve, the link between unemployment, em-
ployment and output, the impact of a negative and positive output gap on the infla-
tion rate, the adjustment from a short-run equilibrium to a medium-run equilibrium
position and the impact of fiscal policy on the IS-LM-PC model in the short run and
medium run in words or using a chain of events, and by means of diagrams.
Although the impact of fiscal consolidation can lead to a recession in the short run, it
is important to compare the impact of the medium-run effect on output where the ini-
tial decrease in consumption is offset by the increase in investment.

ANSWERS TO THE ACTIVITIES

ANSWERS TO PRIOR KNOWLEDGE ACTIVITY 9.1

a. An increase in the level of output implies an increase in the level of employ-

ment and a decrease in the unemployment rate.
b. A decrease in the unemployment rate increases the bargaining position of
workers and they are able to negotiate higher wages.
c. An increase in the expected price level increases nominal wages.
d. An increase in nominal wages increases the price level.
e. The higher the mark-up the lower the real wage implied by price setting.
f. The natural rate of unemployment is the rate of unemployment where the real
wage chosen by wage setting is equal to the real wage implied by price
setting.

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ANSWERS TO ACTIVITY 9.1

1. a. An increase in expected prices increases the price level: Pe��W��P�.

b. A decrease in the mark-up decreases the price level: m��P�.
c. An increase in unemployment lowers the price level because nominal
wages decrease, which eventually decreases the price level:
u��W��P�.
d. An increase in the bargaining position of workers increases the price
level since it implies that there was a decrease in the unemployment rate
that leads to an increase in nominal wages, which in turn leads to higher
prices and an increase in the price level: z��W�.
e. A decrease in output decreases the price level: Y��N��u��W��P�.

2. a. A positive relationship exists between the expected price level and the
price level.
b. A positive relationship exists between wages and the price level.
c. A positive relationship exists between the mark-up and the price level.
d. A negative relationship exists between the unemployment rate and the
price level.
e. A positive relationship exists between the employment level and the
price level.
f. A positive relationship exists between the level of output and income
and the price level.

ANSWERS TO ACTIVITY 9.2

1. a. True.
b. False. Actual inflation is influenced by factors such as the mark-up and
institutional factors.
c. True.

2. a. A positive relationship exists between expected inflation and actual

inflation.
b. A positive relationship exists between the expected price level and the
actual price level.
c. A positive relationship exists between the mark-up and actual inflation.
d. A negative relationship exists between the unemployment rate and
actual inflation.

ANSWERS TO ACTIVITY 9.3

a. False. The original Phillips curve shows the relationship between inflation and
unemployment.
b. True.
c. True.
d. False. The Phillips curve has a negative slope to indicate that lower rates of
unemployment are associated with a higher rate of change in prices.

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ANSWERS TO ACTIVITY 9.4

a. True.
b. True.
c. False. When the actual unemployment rate exceeds the natural rate of unem-
ployment, the inflation rate will decrease.
d. True.
e. True.
f. False. The natural rate of unemployment does not mean that there is no unem-
ployment. It is the unemployment rate at which the inflation rate remains
constant.

ANSWERS TO ACTIVITY 9.5

1. 1. The natural rate of unemployment (un): 10%.

The economically active population (labour force): 14 million.
The production function: each employed worker produces one unit (Y = N).

Given the information, the number of unemployed is 10% x 14 million =

1.4 million workers.
The natural level of employment (Nn) is therefore:
economically active population − number of unemployed = natural level of
employment
14 million − 1.4 million = 12.6 million workers.
Given the production function (each employed worker produces one unit),
the natural level of output (Yn) is also 12.6 million units.
The natural level of output Yn is therefore:
Yn = Nn = L (1 – un)
= 14 (1 – 10%)
= 14 (0.9)
= 12.6 million
2.1 a. False. On the vertical axis the change in the inflation rate is measured.
b. True.
c. False. If the output gap is positive, the change in the inflation rate
increases.
d. False. At point Yn the change in the inflation rate is zero.

2.2 a. At point a the positive output gap causes the change in the inflation rate
to increase.
b. At point a the potential output is Yn.
c. At point a the unemployment rate is smaller than the natural rate of un-
employment (if u < un; Y > Yn � output gap positive � inflation �).

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ANSWERS TO ACTIVITY 9.6

1. An IS-LM-PC model showing a where output is at potential.

2. An IS-LM-PC model showing a negative output gap in the short run.

In the diagram above, the initial equilibrium is at point a (short-run equili-

brium). At this point, the output gap is negative since output (Y) is below po-
tential output (Yn) and inflation decreases. Looking at the top figure, the

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central bank decided to decrease the real interest rate in reaction to this high
inflation and over time there is a downward movement along the IS curve
from a to b and output increases.
Given the way we have drawn the figure, Y is lower than Yn, meaning that
output is below potential. This implies that inflation is decreasing. At output
level Y, the change in inflation is negative and there is a downwards pressure
on inflation.
As long as the level of output is lower than the potential level of output (the
output gap is negative), the inflation rate decreases. Policy makers will at a
certain point react to this decreasing inflation, for example the central bank
will decrease the interest rate in order to increase output back to potential
output. If output is equal to potential output and the output gap is equal to
zero, there is no pressure on inflation.
Looking to the bottom figure, you can see that as output increases the econ-
omy moves up the PC curve from point a to b.
At point b the policy rate is equal rn (the natural rate of interest), output is
equal to Yn and at this point inflation is by implication constant. This is the
medium run equilibrium position.
3. a. The natural rate of interest is 4% and indicated by point c. It is the interest
rate associated with the natural rate of employment or natural level of
output.
b. An increase in the interest rate from 2% to 3% decreases the output gap
since the level of output declines.
c. At point c, the change in inflation is lower than at point a. The change in
inflation is 0% at point c and 4% at point a; therefore, the change is infla-
tion is lower at point c compared with point a.
d. At point c, the inflation rate is higher than at point a. It is important to
understand the difference between the change in the inflation rate and
the inflation rate. At point c, the change in inflation is 0% which means
that the inflation rate is constant at this point (it is neither increasing nor
decreasing). However, the inflation rate at point c is higher than at point a.
The initial equilibrium position is at point a where the inflation rate is in-
creasing by 4%, which corresponds to an interest rate of 2%. The central
bank responds to this increasing pressure on the inflation rate by first in-
creasing the policy rate from 2% to 3% and then from 3% to 4% (repre-
sented by an upwards shift of the LM curve firstly from LM to LM1 and
secondly from LM1 to LM2). During this adjustment process output is con-
sistently above potential, and inflation is constantly increasing. Therefore
when the economy finally reaches the natural level of output (at point c),
the inflation rate is higher than it was at point a.

ANSWERS TO ACTIVITY 9.7

No, quantitative easing (QE) is not applicable to South Africa at this stage since the
repo rate never approached the zero lower bound and South Africa did not experi-
ence a deflation spiral during the global financial crisis.

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ANSWERS TO ACTIVITY 9.8

1. Point a1 is a short run equilibrium position.

2. Indicate whether the following variables are higher, lower or the same if one
compares point a1 with point a.
Variable Higher Lower The same
Taxes Taxes are higher
since the
government
increases
taxation.
Consumption Consumption
spending is lower
since taxes are
higher, the level of
output is lower
and disposable in-
come is lower.
Demand for Demand for goods
goods is lower since con-
sumption spend-
ing and
investment are
lower.
Potential output Potential out-
put is the same
at Yn.
Investment Investment is low-
er since the level
of output is lower.
Unemployment Unemployment
is higher since
the level of out-
put is lower.
Output Output is lower
since taxes are
higher and con-
sumption spend-
ing and
investment are
lower.
Natural rate of Natural rate of
interest interest is
unchanged.
Policy rate Policy rate is
unchanged.

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3. At point a1, the change in inflation is decreasing since the output gap is
negative.
4. Point a2 is a medium-run equilibrium position.
5. Indicate what happens to the following variables as the economy moves
from point a1 to a2.
Variable Increases Decreases Unchanged
Consumption As output starts
to increase con-
sumption spend-
ing increases.
Taxes Taxes are the
same (move-
ment down the
IS curve).
Policy rate The policy rate
decreases.
Investment Investment in-
creases since the
interest rate de-
creases and out-
put increases.
Demand for The demand for
goods goods increases
since investment
and consump-
tion increase.
Unemployment Unemployment
decreases since
the level of out-
put increases.
Output Output increases
since the de-
mand for goods
increases.

6. As the economy moves from point a1 to a2, inflation increases but at a slow-
er rate.
7. Indicate whether the following variables are higher, lower or the same at
point a2 compared to point a.

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Variable Higher Lower The same

Consumption Consumption
spending is low-
er since taxation
is higher and dis-
posable income
is lower.
Investment Investment is
higher since the
natural rate of
interest is lower.
Demand for Demand for
goods goods is the
same but con-
sumption is low-
er and
investment
higher.
Natural rate of The natural rate
interest is lower. It de-
creases from rn
to rn1.
Potential output Potential output
is the same at Yn
Change in At both points
inflation the change in in-
flation is zero.

Checklist
The Phillips curve, the natural rate of unemployment and inflation, and the IS-LM-PC
model
Well Satisfactory Must redo
Concepts
I am able to explain the following concepts:
Unemployment rate
Original Phillips curve
Modified Phillips curve
Price level
Expected price level
Natural rate of unemployment
Natural rate of employment

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Well Satisfactory Must redo

Concepts
I am able to explain the following concepts:
Natural rate of output (potential output)
Output gap (positive and negative)
Actual inflation
Expected inflation
Change in the inflation rate
Quantitave easing
Inflation targeting framework

Relations
I am able to explain the following relations
using words, equations and/or a chain of
events:
Unemployment and inflation
Price level, expected price level and unem-
ployment rate
Inflation, expected inflation and the unem-
ployment rate
Natural rate of unemployment, natural rate
of employment and the natural rate of out-
put (potential output)

Diagrams
I am able to present and explain the following
with the aid of a diagram:
The original Phillips curve
The modified Phillips curve
The Phillips curve in terms of output
Effect of a higher output on the change of
inflation
Short-run equilibrium: IS-LM-PC model
(output gap = zero)
Short-run equilibrium: IS-LM-PC model
(output gap = positive)

298
The Phillips Curve, the natural rate of unemployment and inflation, and the IS-LM-PC model Learning unit 9

Well Satisfactory Must redo

Diagrams
I am able to present and explain the following
with the aid of a diagram:
Short-run equilibrium: IS-LM-PC model
(output gap = negative)
Medium-run equilibrium: IS-LM-PC model
Fiscal consolidation in the short run and
medium run:
IS-LM-PC model

Policy
I am able to explain the following:
How fiscal consolidation (taxes increase)
returns to potential output in the medium
run and the interest rate is lower
How fiscal consolidation (government
spending decreases) returns to potential
output in the medium run and the interest
rate is lower

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Summary
Summary: Exogenous vs endogenous variables
An exogenous (autonomous) variable is independent of the endogenous variable –
the variable we are trying to explain – and, while it influences the endogenous varia-
ble, it is not influenced by it. In the models that we are developing, the main endoge-
nous variable is the level of output and income (Y).
Exogenous variable:
● independent of the model
● taken as given
Endogenous variable:
● dependent on the model
● if there is any change to the status quo, the endogenous variables will change to
re-establish equilibrium

Summary of assumptions for this module

Variable Goods Financial IS-LM closed IS-LM open IS-LM-PC
market market economy economy model
Consumption Exogenous Not Exogenous Exogenous Exogenous
spending (C) AND applicable AND AND AND
C = co + cYD endogenous endogenous endogenous endogenous

Exogenous components:
Autonomous consumption (co) is influenced by access to credit, wealth, expectations, etcetera.
Marginal propensity to consume (c) is influenced by access to credit, wealth, expectations,
etcetera.

Endogenous component:
Disposable income (YD): when disposable income increases, a portion is spent according to the
marginal propensity to consume (c) which is itself exogenous (cYD is called induced
consumption).
Investment Exogenous Not Exogenous Exogenous Exogenous
spending (I) only applicable AND AND AND
endogenous endogenous endogenous
Exogenous component:
Investment spending (Ī) is influenced by business confidence, expectations, regulations,
etcetera.

Endogenous component:
Investment spending (I) is positively related to Y and negatively related to the interest rate (i).
Government Exogenous Not Exogenous Exogenous Exogenous
spending and applicable
taxes (G & T)

300
 Summary

Exogenous components:
Government spending (G) and taxes (T) are both controlled by government.
Quantity of Assumed to Endogenous Endogenous Endogenous Endogenous
money (M) be fixed

Endogenous component:
Quantity of money (M): In this particular financial market model, it is assumed that the quantity
of money is determined by the demand for money. In other words, as the money demand
changes so does the quantity of money. An increase in the money demand leads to an increase
in the quantity of money and a decrease in the demand for money leads to a decrease in the
quantity of money.
Money Fixed Exogenous Exogenous Exogenous Exogenous
demand (Md) AND AND AND AND
endogenous endogenous endogenous endogenous

Financial market model:

Exogenous component:
The part of money demand (Md) that is not influenced by the interest rate. This part is positively
related to the level of output and income (Y) and it is influenced by other liquidity preference
considerations such as business confidence, expectations, etcetera. This will shift the Md curve.

Endogenous component:
Money demand (Md) depends on the interest rate. It is negatively related to the interest rate (i).

IS-LM model:
Exogenous component:
Money demand (Md) is influenced by business confidence, expectations, etcetera.

Endogenous components:
Money demand (Md) is positively related to the level of output and income (Y) and negatively
related to the interest rate (i).
Variable Goods Financial IS-LM closed IS-LM open IS-LM-PC
market market economy economy model
Foreign sector None None None Exogenous Exogenous
(X & IM) AND AND
endogenous endogenous

Exogenous component:
Exports (X) are positively related to the level of income and output of our trading partners (Y*).

Endogenous components:
Exports (X) are negatively related to the real exchange rate (ε).
Imports (IM) are positively related to the domestic level of income and output (Y).
Imports (IM) are also negatively related to the real exchange rate (ε).
Note: If prices are assumed to be fixed then the real exchange rate is equal to the nominal ex-
change rate, that is, ε = E.

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SUMMARY

Labour Assumed to Assumed to Assumed to Assumed to Exogenous

market be fixed be fixed be fixed be fixed AND
(W & P) endogenous

Exogenous components:
Nominal wages (W) are positively related to institutional factors (z), for example, labour laws,
minimum wages, etcetera.
Nominal wages (W) are positively related to the expected price level (Pe).
Mark-up by firms (m) is determined by firms.
The expected price level (Pe) is fixed in the short run; however, in the medium run workers ad-
just their expected price upwards if the actual price level turned out to be higher than their ex-
pected price level when wages were bargained for last, and they will adjust their expected price
level downwards if the actual price level turns out to be lower than their expected price level.

Endogenous components:
Nominal wages (W) are negatively related to the unemployment rate (u).
The actual price level (P) is positively related to nominal wages (W) because an increase in
nominal wages will result in an increase in the price of the product (because the mark-up by
firms is exogenous). This will increase the price level.

302
Sources
Blanchard, O & Johnson, DW. 2014. Macroeconomics: Global and Southern African Per-
spectives. First edition. Pearson.
Blanchard, O & Johnson, DW. 2020. Macroeconomics: Global and Southern African Per-
spectives. Second edition. Pearson.
Dornbusch, R, Fischer, S, Mohr, P & Rogers, C. 1991. Macroeconomics. Johannesburg:
Lexicon.
Fourie, F. 1997. How to think and reason in macroeconomics. Cape Town: Juta.
Keynes, JM. 1936. The general theory of employment, interest and money. London:
Macmillan.
Mohr, P & Fourie, L. 2008. Economics for South African students. 4th edition. Pretoria:
Van Schaik.

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