978-0133780581 Chapter 9 Lecture Note

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Chapter 9. FROM THE SHORT TO THE MEDIUM RUN: The IS-LM-PC Model

I. MOTIVATING QUESTION

How are output, the unemployment rate, and inflation determined in the short run

and the medium run?

Short run output in the goods and services market is determined by demand. Inflation is impacted by the

unemployment rate when the labor market is in equilibrium. Therefore output, the unemployment rate,

and inflation are determined by simultaneous equilibrium in the goods, financial, and labor markets.

Simultaneous equilibrium in the goods and financial markets is summarized in an aggregate demand

relation and the relationship between unemployment and inflation is modeled using the Phillips curve

(PC). Labor market equilibrium is conditional on the expected price level. In the short run, the expected

price level may not equal the actual price level, and thus the unemployment rate may not equal the natural

rate. Over time, the expected price level will tend to converge to the actual price level, and the

unemployment rate will tend to return to the natural rate.

II. WHY THE ANSWER MATTERS

This chapter integrates the goods, financial, and labor markets in short-run and medium-run equilibrium.

It maintains the assumption that changes in monetary policy are discrete changes in the level of nominal

money. The next two chapters introduce money growth and inflation into the analysis and begin to

discuss the economy in terms of growth rates (except for the unemployment rate) rather than levels of

variables.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The chapter ties the IS-LM model and Phillips curvetogether to analyze the impact of a shock or

policy on the economy.

ii. The chapter introduces the concepts potential output, actual output, and the output gap.

iii. The chapter makes extensive use of dynamic analysis, introduces the term business cycle, and

distinguishes between shocks and propagation mechanisms.

2. Assumptions

The chapter assumes that the expected price level adjusts to differences between the actual and

(previously) expected price levels. If the actual price level is greater (less) than the expected price level,

wage setters are assumed to increase (decrease) their expected price level in the future. This adjustment

mechanism is essential for the dynamic analysis presented in the text.

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IV. SUMMARY OF THE MATERIAL

1. The IS-LM-PC Model

Consider the IS-LM diagram from Chapter 5. In the short-run output is determined by demand and given

by the equation;

Y = C(Y – T) + I(Y, r + x) + G (9.1)

Output depends on the disposable income of consumers (net of taxes), investment spending (which

depends on output and real borrowing rates) and government spending. Real borrowing rates depend on

the central bank rate (r) and an investment premium (x). The IS curve represents these relationships

graphically.

In chapter 8 we derived equation 8.10 (equation 9.2) which shows the relationship between the change in

inflation and unemployment rate. Rewriting the Phillips curve in terms of output (instead of employment)

yields equation 9.4;

π – π (-1) = (α/L)(Y – Yn)(9.4)

This equation allows us to see what happens when actual output deviates from potential output, or the

output level that occurs at the natural rate of unemployment. The difference between potential output and

actual output is dubbed the output gap. When the output gap is positive (actual is greater than potential)

inflation will occur. When the output gap is negative, inflation falls.

2. Dynamics and the Medium Run Equilibrium

Figure 9-1 plots the IS-LM and the PC curves.Recall that the policy rate (r) is chosen by the central bank.

At this interest rate output is given by Y as shown in the top half of Figure 9.1. The bottom part of Figure

9.1 shows us the change in inflation associated with this interest rate and output combination. These

graphs show the short-run equilibrium. When the central bank increases interest rates as show in Figure

9-2 you see that output falls and inflation falls accordingly. Conversely, a negative output gap can be

countered by lowering the policy rate to increase output.

See Figure 9-2 – Medium-Run Output and Inflation

The change in output reduces pressure on inflation so this interest rate (rn) is called the natural rate of

interest. It may also be called the neutral rate of interest or the Wicksellian rate of interest. The

change in output will occur over time as both consumers and businesses adjust spending due to the

change in interest rates.

The central bank adjustment process seems simple in theory but is more complex in reality. For example,

when the economy is zero lower bound the central bank may not be able to lower policy rates to stimulate

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output. Even lowering interest rates to negative levels may not work and could result in continued falling

output and prices, known as a deflation trap or deflation spiral.

3. Fiscal Consolidation Revisited

We can now use this model to determine the impact of changes in fiscal policy. For example, if the

government attempts deficit reduction via higher taxes it reduces consumption and shifts the IS curve to

the left (See Figure 9-4). This shift results in lower output which, in turn, lowers investment. Output will

now be below the potential level of output. Monetary action may now be needed to increase output back

to the potential level of output. Therefore, monetary and fiscal policy need to work in tandem to keep the

economy at the potential level of output.

4. The Effects of an Increase in the Price of Oil

The text provides evidence that increases in the price of oil are associated with increases in the U.S.

inflation and unemployment rates. In recent years, however, the economy’s response to increases in the

price of oil seems to have been much smaller than in the 1970s that was due to the formation of OPEC. A

box in the text provides econometric evidence to support this observation, and offers two possible

explanations. The first is that worker bargaining power has decreased, so that workers are more willing to

accept wage cuts when the price of oil rises. The second explanation is that expectations of Fed behavior

have changed. In the 1970s, oil price increases led to people to expect an increase in the general price

level. Today, people do not expect the Fed to allow the general price level to increase in response to an

increase in the price of oil.

5. Conclusions

The exercises described in the chapter emphasize the distinction between the short-run and medium-run

effects of shocks to the economy. Such shocks can arise from changes in private behavior or from policy

changes. The dynamic effects of shocks are called propagation mechanisms. Fluctuations in output

(commonly called business cycles) arise from the continual appearance of new shocks, each with its own

propagation mechanism.

V. PEDAGOGY

1. Points of Clarification

i. Central Bank Policy and interest rates. It is worth pointing out that the LM curve is considered

horizontal in this analysis. In other words, interest rates are determined almost solely by the central bank

and are not impacted by market forces. This simplification changes some of the analysis that you may

have presented in earlier versions of the text.

ii. Analysis of Shocks in the IS-LM-PC Model. This is a difficult chapter. Students are likely to

feel overwhelmed, particularly by the dynamics. To help students navigate the analysis of shocks in the

the IS-LM-PCframework, instructors might wish to outline the steps in the analysis.

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a. Unless stated otherwise, assume that the economy begins in medium-run equilibrium. This

implies that output is at its natural level, unemployment is at its natural rate, and the price level

equals the expected price level.

b. Determine whether the shock affects the natural rate of unemployment. If the shock is to a

variable in the IS-LM model, it will not affect the natural rate of unemployment.

c. Determine whether the price level is greater than its expected level or less than its expected

level. If the economy begins in medium-run equilibrium, the expected price level is the initial

price level. Note that inflation expectations have a significant impact on the model’s dynamics.

d. If the price level is greater than its expected level, the central bank will increase interest rates

to combat the change in prices. If the price level is lower than expected the central bank may

lower rates accordingly.

It is also useful to emphasize, as suggested in Chapter 7 of the Instructor’s Manual, that the short-run,

medium-run distinction is an analytical aid to help economists analyze the effects of shocks occurring at

some point in time. In the real world, the economy is always experiencing some short-run shock and

responding to previous shocks. The medium-run equilibrium describes a point to which the economy will

tend to return in the absence of further shocks. The actual path of the economy, however, will depend on

the sequence of shocks it receives.

iii. Price Adjustment and Short-Run Equilibrium. Chapters 3 to 5 discussed

the short run in the context of a fixed price level. The IS-LM model adopts the

assumption that the price level is fixed as a simplification. As this chapter shows,

what is true in the short run is that prices may not adjust fully to restore the natural

level of output, and more generally, that the actual price level may not equal the

expected price level. Going deeper, the fundamental assumption is that nominal

wages do not adjust to actual prices but to expected ones. This assumption makes

sense if wages are set for some period of time, so that wage setters base their

decisions on expected prices over the life of the wage contract. On the other hand,

wages are allowed to adjust immediately to changes in the unemployment rate,

conditional on the expected price level. Clearly, a fully specified model would

need to be careful about the terms and timing of wage adjustment. The IS-LM-PC

framework in the text is a simplification intended to illustrate some basic issues—

in particular slow price adjustment—at a manageable level of complexity.

2. Alternative Sequencing

In Chapter 13, which examines technological change and labor markets, there is a discussion of the

effects of technological change on the IS-LM diagram. Instructors could present that part of Chapter 13 in

the lecture on Chapter 9.

VI. EXTENSIONS

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Instructors may wish to further emphasize the scope for monetary policy to maintain full employment in

the IS-LM-PC framework. For demand shocks, countercyclical monetary policy can be used to restore

the natural rate of unemployment relatively quickly (as compared to waiting for the economy to adjust on

its own). For supply shocks, countercyclical monetary policy moves the economy further away from the

natural rate. For example, consider an adverse supply shock, which increases the natural rate of

unemployment and reduces short-run output. An increase in M would serve to buffer some of the output

fall in the short run, but at the expense of a higher price level in the medium run. A decrease in M,

however, would move the economy to its new natural rate of output more quickly and with a lower

medium-run price level (than would have occurred without the fall in M), but at the expense of an

additional decline in short-run output.

VII. OBSERVATIONS

A horizontal LM curve indicates that money supply and interest rates are both fixed. In previous editions

the LM curve was presented as upward sloping which indicates less central bank control over interest

rates and more market impact. For example, interest rates were affected by other factors, such as the d in

addition to central bank actions.

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