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t
=
e
t
+ (y
t
y
t
) +
t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
1
Ination Expectations: This is given by the
e
t
term which represents the
publics ination expectations at time t. We have put a time subscript on
this variable because the publics expectations may change over time. Note
that a 1 point increase in ination expectations raises ination by exactly
one point this is because we are assuming that people bargain over real
wages and higher expected ination translates one-for-one into their wage
bargaining, which in turn is passed into price ination.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 12 / 34
Our Version of the Phillips Curve
Our version of the Phillips curve is as follows:
t
=
e
t
+ (y
t
y
t
) +
t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
2
The Output Gap: This is given by (y
t
y
t
). It is the gap between GDP at
time t, as represented by y
t
and what we will term the natural level of
output, which we term y
t
. This is the level of output at time t that would
be consistent with unemployment equalling its natural rate. We would
expect this natural level of output to gradually increase over time as
productivity levels improve. The coecient (pronounced gamma)
describes exactly how much ination is generated by a 1 percent increase in
the gap between output and its natural rate.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 13 / 34
Our Version of the Phillips Curve
Our version of the Phillips curve is as follows:
t
=
e
t
+ (y
t
y
t
) +
t
Here represents ination and by
t
we mean ination at time t.
The equation states that ination depends on three factors.
3
Inationary Shocks: No model in economics is perfect. So while ination
expectations and the output gap may be key drivers of ination, they wont
capture all the factors that inuence ination at any time. For example,
supply shocks like a temporary increase in the price of imported oil can
drive up ination for a while. To capture these kinds of temporary factors,
we include an inationary shock term,
t
. The superscript indicates
that this is the inationary shock (this will distinguish it from the output
shock that we will also add to the model) and the t subscript indicates that
these shocks change over time.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 14 / 34
The Phillips Curve Graph with
t
= 0
Output
Inflation
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 15 / 34
The Phillips Curve as we move from
t
= 0 to
t
> 0
(An Aggregate Supply Shock)
Output
Inflation
PC (
=0)
PC (
> 0)
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 16 / 34
The Phillips Curve as we move from
e
t
=
1
to
e
t
=
2
Output
Inflation
PC (
)
PC (
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 17 / 34
Part II
The IS-MP Curve
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 18 / 34
Real Interest Rates and the IS Curve
The second element of the model is one that should be familiar to you: An
IS curve relating output to interest rates. The higher interest rates are, the
lower output is.
I want to stress, however, that the IS relationship is between output and
real interest rates, not nominal rates. Real interest rates adjust the
headline (nominal) interest rate by subtracting o ination.
Suppose I told you the interest rate was 10 percent. Is this a high interest
rate? The answer is that it really depends on ination.
Consider the decision to save. If the interest rate if 5% but ination is 2%,
then youll be able to buy 3% more stu next year because you saved and
saving seems like a good idea. In constrast, if the interest rate if 5% but
ination is 8%, then youll be able to buy 3% less stu next year even
though you have saved your money and earned interest.
Similar point applies to rms. If ination is 10%, then a rm can expect
that its prices (and prots) will be increasing by that much over the next
year and a 10% interest rate wont seem so high. But if prices are falling,
then a 10% interest rate on borrowings will seem very high.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 19 / 34
Our Version of the IS Curve
Our version of the IS curve will be the following:
y
t
= y
t
(i
t
t
r
) +
y
t
Expressed in words, this equation states that the gap between output and its
natural rate y
t
y
t
depends on two factors:
1
The Real Interest Rate:
will imply y
t
= y
t
.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 20 / 34
Our Version of the IS Curve
Our version of the IS curve will be the following:
y
t
= y
t
(i
t
t
r
) +
y
t
Expressed in words, this equation states that the gap between output and its
natural rate y
t
y
t
depends on two factors:
2
Aggregate Demand Shocks,
y
t
:
Many other factors beyond the real interest rate inuence aggregate
spending decisions.
These include scal policy, asset prices and consumer and business
sentiment.
t
that moves the Phillips curve up and
down.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 21 / 34
Monetary Policy: The LM Curve Approach
We has described how ination depends on output and how output depends
on interest rates. Can complete the model by describing how interest rates
are determined.
Traditionally, this is where the LM curve is introduced. Links demand for the
real money stock with nominal interest rates and output:
m
t
p
t
= i
t
+y
t
This can be re-arranged to give a positive relationship between output and
interest rates:
y
t
=
1
m
t
p
t
+i
t
(
t
)
The central bank adjusts the nominal interest rate, i
t
, upwards when
ination,
t
, goes up and downwards when ination goes down (we are
assuming that
. In this case,
the real interest rate will be i
t
t
= r
.
Think about why a rule of this form might be a good idea. Suppose the
central bank has a target interest rate of
.
If that can be achieved, then the Phillips curve tells us that, on average,
ination will equal
provided we have y
t
= y
t
. And the IS curve tells us
that, on average, we will have y
t
= y
t
when i
t
t
= r
.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 24 / 34
The Full Model
Thats the model. It consists of three equations.
1
The Phillips curve:
t
=
e
t
+ (y
t
y
t
) +
t
2
The IS curve:
y
t
= y
t
(i
t
t
r
) +
y
t
3
The monetary policy rule:
i
t
= r
(
t
)
I had promised a graphical representation of this model. However, this is a
system of three variables which makes it hard to express on a graph with
two axes.
To make the model easier to analyse using graphs, we are going to reduce it
down to a system with two main variables (ination and output).
We can do this because the monetary policy rule makes interest rates are a
function of ination, so we can substitute this rule into the IS curve to get a
new relationship between output and ination that we will call the IS-MP
curve.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 25 / 34
The IS-MP Curve
If we replace the term i
t
in the IS curve with the formula from the monetary
policy rule, we get
y
t
= y
t
[r
(
t
)] +(
t
+ r
) +
y
t
Now multiply out the terms in this equation to get
y
t
= y
t
r
(
t
) +
t
+r
+
y
t
Canceling terms and re-arranging, this simplies to
y
t
= y
t
(
1) (
t
) +
y
t
This is the IS-MP curve. It combines the information in the IS curve and the
MP curve into one relationship.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 26 / 34
The IS-MP Curve Graph
The IS-MP curve is
y
t
= y
t
(
1) (
t
) +
y
t
How this curve looks in a graph depends especially on the value of
, the
parameter that describes how the central bank reacts to ination.
An extra unit of ination implies a change of (
1) in output. Is this
positive or negative? Well we are assuming that > 0 so this combined
coecient will be negative if
< 1.
Explanation: Increase in ination of x will lead to an increase in nominal
interest rates of
1) x. If
> 1
then an increase in ination leads to higher real interest rates and, via the IS
curve relation, to lower output.
For now, we will assume that
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 28 / 34
The IS-MP Curve as we move from
y
t
= 0 to
y
t
> 0
Output
Inflation
IS-MP (
=0)
IS-MP (
> 0)
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 29 / 34
Part III
Putting the Pieces Together
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 30 / 34
The IS-MP-PC Model Graph
We can now illustrate the full model in a single graph.
The graph features one curve that slopes upwards (the Phillips curve) and
one that slopes downwards (the IS-MP curve provided we assume that
> 1.)
The next gure provides the simplest possible example of the graph. This is
the case where both the temporary shocks,
t
and
y
t
equal zero and the
publics expectation of ination is equal to the central banks ination target.
Note that I have labelled the PC and IS-MP curves to explicitly indicate
what the expected and target rates of ination are and it will be a good idea
for you to do the same when answering questions about this model.
In the next set of notes, we will analyse this model in depth, examining what
happens when various types of events occur and focusing carefully on how
ination expectations change over time.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 31 / 34
Expected Ination Equals the Ination Target
Output
Inflation
PC (
)
IS-MP (
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 32 / 34
A More Complicated Monetary Policy Rule
In a famous 1993 paper, economist John Taylor argued for a monetary
policy rule in which the central bank adjusted interest rates in response to
both ination and the gap between output and an estimated trend.
Within our model structure, we can amend our monetary policy rule to be
more like this Taylor rule as follows:
i
t
= r
(
t
) +
y
(y
t
y
t
)
Substituting this into the IS curve, we get
y
t
= y
t
[r
(
t
) +
y
(y
t
y
t
)] +(
t
+ r
) +
y
t
This can be re-arranged to give
y
t
y
t
=
(
1)
1 +
y
(
t
) +
1
1 +
y
y
t
This shows that broadening the monetary policy rule to incorporate interest
rates responding to the output gap doesnt change the essential form of the
IS-MP curve. As long as
t
=
when y
t
= y
t
and there are no inationary shocks.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 33 / 34
Things to Understand From This Topic
1
The evidence on the Phillips curve.
2
The Phillips curve that features in our model and how to draw it.
3
Why real interest rates are what matters for aggregage demand.
4
The IS curve that features in our model.
5
The monetary policy that features in our model.
6
How to derive the IS-MP curve.
7
What determines the slope of the IS-MP curve.
8
How the IS-MP curve changes when the monetary policy rule takes the form
of a Taylor rule.
Karl Whelan (UCD) Introducing the IS-MP-PC Model January 21, 2013 34 / 34