The IS-LM-PC model: Further analysis

EC 235 | Fall 2023

Materials

Required readings:

• Blanchard, ch. 9.

  • Sections 9—2, 9—3, 9—4, 9—5.

Prologue

Prologue

After setting up the IS-LM-PC model, we will analyze a few scenarios from a graphical perspective:

• When the economy is overheating (actual output is larger than potential output);

• The zero lower bound;

• Fiscal consolidation;

• Supply shocks.

Short- and medium-run equilibria

Short- and medium-run equilibria

Suppose, for simplicity, a horizontal LM curve.

Furthermore, the economy is in an expansion, where actual output (Y) is larger than potential (natural) output (Y_n).

What can the monetary authority do to control inflation and return the economy back to its “natural” level?

Short- and medium-run equilibria

The zero lower bound

The zero lower bound

Now suppose that the economy is in a recession.

This implies that actual output is below its potential level.

What can monetary policy do?

The zero lower bound

Fiscal consolidation

Fiscal consolidation

We can now assume a situation where the economy is at its “natural” level, and the government wants to reduce its budget deficit.

What will be the effects in an IS-LM-PC setting?

Fiscal consolidation

Supply shocks

Supply shocks

Lastly, let us study in detail the effects of supply shocks to an economy from this perspective.

Supply shocks