The IS-LM-PC Model

15 important questions on The IS-LM-PC Model

What is the Philips Curve? Give the function.

It represent the relation between unemployment and inflation.
pi-pi tot de macht e = - alpha (U-U n)

Other countries were affected by which two channels?

1. Trade -> consumers & firms cut spending, part fell on imports.
2.  Financial -> U.S banks repatriated funds from other countries getting them into trouble as well.

Give the formula for employment, rather than U.

N= L(1-u) employment = labor force x (1 - unemployment rate)
  • Higher grades + faster learning
  • Never study anything twice
  • 100% sure, 100% understanding
Discover Study Smart

Give a synonymen for natural level of output and give the respectable sign.

Potential output Yn

U.S recession turned into a world recession called?

Euro crisis

What is it called when output is below its potential? What is the further gap mentioned in the book? 1.

Negative output gap, 1. actual unemployment is above its natural level of unemployment.

What happens if output is below its potential? In order words what will happen if the output gap is negative?

Inflation decreases

When we consider the short-run equilibrium in the IS-LM-PC model, what happens over time if there is no change in policy rate?
Nor in any of the variables which affect the position of the IS curve?

When no intervention of the central bank takes place, the inflation will continue to increase. At some point the central has to stop the inflation from increasing and will increase the policy rate . The higher policy rate will make it more expensive for firms to borrow money and hence investments and plans to increase output will be postponed. With this effect, the economy will slow down and in the medium-run output Y will convert to its natural level of output (Yn).

Consider the medium-run in the IS-LM PC model. If an objective of the central bank is to achieve stable inflation and keep output at Yn, why doesn't the cb increase the policy rate right away to which output will perform at Yn?

The reality is that the economy has to be given some time to convert to its natural output level, changing the policy rate and the stagnation of inflation are developments that can take over a year . Therefore this intuition is not visible directly.

When the cb has changed the policy rate r to a higher level and Yn is achieved. What do we further observe?

In the philips curve the downturn from point A to point A' constitutes a higher level of inflation (inflation rate A' > inflation rate A).

What is the confusing part of the philips curve about inflation?
Vraag leraresse

It is that the deviation of output against its natural level, whether positively or negatively is correlated with change in inflation rather than an increase/decrease in inflation?

If Yn is achieved, what should the policy rate r be? In equilibrium?

Rn, the natural rate of interest

What is the relation between output and the interest rate?

If output is too low, the cb should decrease the interest rate to stimulate output. If output is too high (Y > Yn) than cb should increase the interest rate to slow the economy down.

What is the relation between the zero lower bound and deflation?

If output is below its potential and the interest rate needs to be decreased to reach Rn, it might as well be possible that the natural level of interest is at a point below 0 (zero lower bound). Therefore interest becomes negative and this causes deflation. Since the decreasing interest causes the inflation rate to decrease and if the natural rate of interest is < 0 then an pi < 0 constitutes deflation.

And why is deflation a problem for the economy? What term do we use for this problem?

Deflation is a problem for the output since more deflation leads to a higher policy rate and a higher policy reads leads to a lower output level which causes inflation to decrease/causes deflation to increase further. The deflation spiral

The question on the page originate from the summary of the following study material:

  • A unique study and practice tool
  • Never study anything twice again
  • Get the grades you hope for
  • 100% sure, 100% understanding
Remember faster, study better. Scientifically proven.
Trustpilot Logo