ECON0016: Macroeconomic Theory and Policy
Term 1, Problem set 3
1. 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 shifts the Phillips curve down. In addition to describing the paths of output, inflation and interest rates, at each stage describe carefully what happens in
(a) The labour market
(b) The goods market
The economy starts at medium run equilibrium, corresponding to the black points on the diagram, output at equilibrium ye, the real interest rate is the stabilising rate rs, expected inflation is πT, nominal wages and prices are growing at the target inflation rate πT.
Period 1
The shock hits, inflation expectations are reduced to a level π1< πT. πT – π1 is a measure of the size of the shock
1. Since output is at equilibrium wage setters want to keep their real wage constant so, given they expect inflation to be π1, bargain to increase their nominal wage by π1
2. Firms immediately set prices as a markup over wages so prices increase by π1
3. The economy moves to the red point, with y=ye, π= π1, r=rs.
4. The central bank is now off its MR curve. Interest rates are assumed only to affect the economy with a one-period lag, so the CB it needs to forecast where the PC will be in the next period. Actual inflation today is π1 so the CB knows expected inflation in the next period will be π1 so forecast5s that the PC will be unchanged at PC1.
5. To get to the intersection of this forecast PC with the MR curve (the green point) in the next period the CB sets interest rates in this period to r1.
Period 2
1. The reduction in interest rates in period 1 increases investment (and will also have an affect on consumption) so moves the economy along the IS0 curve. Aggregate demand and output change to y2
2. Inflation last period was π1 so inflation expectations are unchanged.
3. Output is above equilibrium, so unemployment is lower and workers have more bargaining power. They increase their wages by more than expected inflation to reflect this, a total of π2 >π1. The gap π2 – π1 is a measure of the extra bargaining power workers have as a result of lower unemployment/
4. Firms immediately set prices as a markup over wages so prices increase by π2
5. The economy moves to the green point, with y=y2, π= π2, r=r1.
6. The central bank knows that expected inflation in the next period will equal actual inflation in the current period so forecasts that the PC will shift to PC2.
7. To get to the intersection of this forecast PC with the MR curve (the blue point) in the next period the CB sets interest rates in this period to r2.
Period 3
1. The increase in interest rates in period 2 reduces investment (and will also have an effect on consumption) so moves the economy along the IS0 curve. Aggregate demand and output change to y3
2. Inflation expectations are updated to last period’s inflation π2 and the PC shifts to PC2.
3. Output is still above equilibrium, so unemployment is lower and workers have more bargaining power. They increase their wages by more than expected inflation to reflect this, by a total of π3 >π2 (but note they have less bargaining power than in the previous period so π3 –π2 < π2 – π1
4. Firms immediately set prices as a markup over wages so prices increase by π3
5. The economy moves to the blue point, with y=y3, π= π3, r=r2.
6. And so on….
Imagine monetary policy were passive so interest rates stayed at rs. In this case fiscal policy could be used to shift the IS curve to get exactly the same path of output and inflation. If there is a one-period lag in the effect of fiscal policy on output it would move the IS curve to IS1 in period 1 resulting in output y2 in period 2 then IS2 in period 2 resulting in output y3 in period 3.
2. Policy effectiveness
(a) Describe how monetary and fiscal policy affect output. NB don’t draw any diagrams, just explain in words the mechanism by which changes in policy transmit themselves to output.
· Monetary policy: interest rate changes affect directly investment and consumption. They may also affect asset prices which will further change consumption and investment. In an open economy, there will be effects on the exchange rate which may affect imports and exports. Hence monetary policy affects total aggregate demand and hence, if the goods market clears, output.
· Government spending is a component of aggregate demand so affects AD directly.
· Tax rate changes work by affecting consumption and investment and hence aggregate demand.
(b) 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
· If wages and prices are flexible, the PC will be vertical so changes in aggregate demand have no effect on output
· If households have rational expectations, output can only be moved from equilibrium if the policy change is a surprise to households
· If investment and consumption are completely insensitive to interest rates the IS curve will be vertical and monetary policy cannot change output
· Note that if there are lags in the transmission mechanism of policy, the policy still has an effect on output; it just might not be the desired one as in the example on the “Destabilising policy” slide of lecture 5.