Problem Set 3

Using the IS – MR – PC model

Starting from medium run equilibrium, explain the response of the
economy to a deflationary shock i.e. one that reduces inflation expectations.
Make sure your explanation follows the timeline (available on Moodle). In
addition to describing the paths over time of output, inflation and interest
rates, at each stage describe carefully what happens in the labour market and
the goods market

At the MRE (Medium Run Equilibrium), we assume that y = ye , π = π T 

​

λ
r = r ι ≈ r + π ΔW
s s
T
=π w
 = Constant =
T
(1+μ)(1+t)
 ​

Problem Set 3 1
 Period 1

No interest rate changes, economy at equilibrium at y = ye , r = r1 ,

​ ​

π = πT 

Problem Set 3 2
 Deflationary shock shifts IS curve from IS1 to IS2 . Here it is assumed
​ ​

to be permanent

As such, inflation for first period falls from target π T to πi , hence the ​

deflationary shock.

Output falls from equilibrium ye to y1 due to lower demand due to the
​ ​

deflationary shock. Given p = λ/W , a lower pmeans a lower mark-up

as firms aim to attract greater demand by lowering prices.
Unemployment thus increases.

Central Bank is no more on the MR curve. It forecasts inflationary

expectations and a new set of PC given the new level of inflation at
PC(π e = π1 ). This means it will lower interest rates from r1 to r2 
​ ​ ​

Period 2

Economy is at: y = y2 , π = π2 and r = r2 

​ ​ ​

Assuming the shock is not temporary, IS curve stays at IS2 for now at ​

time period t + 1and all future periods

At y2 > ye , unemployment is lower than in equilibrium and workers

​ ​

have more bargaining power of π2 − πe  ​ ​

Firms will set wages back to W because p = λ/W 

Central Bank will forecast the PC for next period at PC(π e = π2 ), ​

hence raising interest rates to r3  ​

Economy for next period will be at π = π3  ​

This process is repeated for all future periods as the Central Bank tries to
guide the economy back to the initial equilbrium of y = ye , W = W0 and ​ ​

π = π T . Equilibrium interest rates will be lower at r3 < r1 due to the ​ ​

effects of the deflationary shock

How could fiscal policy instead of monetary policy be used to respond to

the shock?

Fiscal policy can respond to the shock in two ways: active and passive

Active fiscal policy involves increase government spending. In fact, if the

deflationary shock arises from ↓ C or ↓ I , then ↑ Gcan restore the goods
market equilibrium back to balance.

Passive fiscal policy is also known as automatic stabilisers. For instance:

Problem Set 3 3
 Unemployment benefits. When C is low due to higher unemployment,
then by default ↑ Gdue to higher unemployment benefits being handed
out to households. This net injection in the circular flow in the economy
will counteract the deflationary shock

Effective fiscal policy means that the shift in IS curve to the left may be
smaller in magnitude or non existent at all.

Policy effectiveness
Describe how monetary and fiscal policy affect output. Please don’t draw
diagrams, just explain in words the mechanism by which changes in policy
transmit themselves to output.

Monetary policy can be conventional (interest rates) or unconventional

(control on monetary supply or credit availability)

By changing interest rates, the central bank affects the cost of borrowing
or the reward for saving, therefore stimulating consumption and thus
incentivising output.

For instance, increasing the bank rate will increase market rates as
banks will have higher costs for overnight borrowing.

Asset prices will depreciate as the economic rent for buying assets
decreases since yields on risk free bonds increase.

Given adaptive/rational expectations, market agents will also

forecast a decrease in inflation and lower their demand accordingly.
This is because now money depreciates at a lower rate and hence
cost of consumption at the current time period increases

Given the above, raising interest rates will lower total demand, and
hence reducing the equilibrium output.

Quantitative easing is the process by which the Central Bank increases

the broad money supply (M2, M3)

By buying financial assets such as government bonds, the Central

Bank decreases the yield on such assets. This is because given
payout/coupon/dividends of yand price p, the yield y/pdecreases
for ↑ p.

By lowering the incentive of investing in assets, the Central Bank

stimulises consumption. Demand is thus stimulated and supply is

Problem Set 3 4
 incentivised, leading to higher output.

Credit availability is how easy it is to obtain credit. The Central Bank can
change the reserve ratio requirement for banks.

A decrease in reserve ratio requirements allows banks to give out

more loans and hence increase the money supply in the economy.
This in turn increases output due to higher demand.

Worth noting is that monetary policy changes output by

stimulating/tightening demand. However, output only increases when
there is spare capacity in the economy. Otherwise, the increase in
demand will induce inflationary pressures. Similarly, output will only
decrease if the economy is at/near capacity. Otherwise, any further
decreases in demand will lead to a decrease in prices and thus
disinflation.

Fiscal policy can affect output by both influencing demand or supply.

Fiscal policy influences demand by changing government spending. In

the goods market equilibrium Y = C + I + G, if ΔC, ΔI = 0then
ΔG = ΔY . This means that changes in government spending will also
result in a respective change in output assuming ceteris paribus and no
multiplier effects.

If there is multiplier effect then effects more pronounced:

ΔY /ΔG > 1for any 0 < MPC < 1
Fiscal policy influences supply by shifting the AS curve. Through policies
aimed at invesments or research, a country can expand their Production
Possibility Frontier by increasing efficiency or developing new forms of
technologies. This increases the ability of an economy to accommodate
its AD.

Give two reasons (based on the material covered in the course) why either
fiscal policy or monetary policy might have no effect on output. Explain your
answer in the context of the model

Monetary Policy might not work due to factors that hamper the Central
Bank’s credibility or transparency

Credibility is important because if noone believes that the Central Bank

will carry forward with their plans, then agents will not adjust their
behaviour accordingly. Credibility can be achieved through both political

Problem Set 3 5
 independence from the government and transparency, such as releasing
key figures for inflation or regular reports to give the public a glimpse in
the decision making process

However, lacks of predibility/transparency will not have an impact on the

effectiveness of monetary policy in the case of adaptive and static
expectations.

In adaptive expectations, PC at tadjusts mechanically given t − 1’s

π . This means that agents will not take into consideration other
factors when making predictions about the economy.

In static expectations, πte = π

​ ˉ . Therefore, agents will expect
inflation at the long run level and medium swings in inflation will not
matter.

In both cases, the IS curve will not shift because the Central Bank's
credibility/stability/transparency will not be taken into account when
making economic decisions.

Another reason why Monetary Policy might not work is the Central Bank
being stuck in a “Liquidity Trap”. This is when the Central Bank cannot lower
interest rates any further.

Interest rates can only go so low before the Central Bank cannot lower
them anymore. In cases like these, demand cannot be stimulated and
borrowing/spending cannot be further encouraged.

Assuming the concept of the ZLB (Zero Lower Bound) to be existent,

then banks offering negative interest will have to change savers to
deposit money in their accounts. Savers therefore will likely hold cash
since this action has a zero nominal interest rates.

The IS curve is not necessarily impacted by the liquidity trap as it

assumes an equilibrium in the goods market. However, if the economy is
in a recession then the IS curve might shift to the left due to lower
investment and consumption.

The PC curve may flatten because it depicts an inverse relationship

between unemployment and inflation. If monetary policy is ineffective,
then demand cannot be boosted, and inflationary pressures cannot be
given to the economy. Combined with high unemployment, the PC curve
may shift to the left or flatten because it takes more employment to
induce inflationary pressures.

Problem Set 3 6
Problem Set 3 7