Question 2 - Model IS-LM-PC · Introducció a la Macroeconomia UPF 2019

a) (0.3 points) In 2018, how does equilibrium GDP compare to natural/potential GDP (Y_n)? How does the unemployment rate compare to the natural unemployment rate (u_n)?

Solución: Output is above potential ($Y_{2018} > Y_n$) and unemployment is below the natural rate ($u_{2018} < u_n$).

b) (0.3 points) Graphically illustrate this shock in the IS-LM-PC framework (assuming a horizontal LM). Identify the short-run equilibrium and medium-run adjustment.

Solución: The IS curve shifts right from $IS_0$ to $IS$. Short-run equilibrium moves from $Y_n$ to point $A$ with $Y > Y_n$. On the PC curve, output above potential leads to accelerating inflation ($\pi - \pi_{(-1)} > 0$).

c) (0.3 points) What is the central bank's primary mandate, and how should it react to the higher inflation of 2018? Show this reaction using the IS-LM-PC model. What happens to consumption, investment, and GDP once this monetary response is enacted?

Solución: Primary objective: price stability. Central bank raises the real policy rate from $r$ to $r^*$, shifting LM upward to $LM^*$ until output returns to $Y_n$. Both investment $I$ and interest-sensitive consumption $C$ contract, and GDP returns to its natural level $Y_n$.