Question

Consider our medium-run model of the economy: Y =C(Y-T)+I(Y,r+x)+G (IS) r=r (LM) TIt - Ilt-1 = -a(ut – Un) (PC) Suppose the economy starts at a point such that ut = Un and r = rn. Graph the effects of a financial shock that increases the risk premium, x. What happens to output, the interest rate, and inflation in the short-run? What happens in the medium-run? What mechanism causes the transition from the short-run equilibrium to the medium-run equilibrium?

Answer 1

Given data:

Suppose that short-run quarter-to-quarter macroeconomics is best done with predetermined (not necessarily constant) prices and wages, and a little ad hoc dynamics tossed in. Suppose that long-run, decade-to-decade, macroeconomics is best done in the growth-theory manner, with prices and quantities mutually adjusting.

A needed relation is Y - Yn = -L• (u - un);

Where Y = current output (dropping t index)

Yn -= natural level of output at the natural rate of unemployment

L = labour force u = current unemployment rate

π - π (-1) = (α/L) (Y - Yn);

Where π(-1) = π(t-1),

The second wave of runaway interest in growth theory—the endogenous growth literature sparked by Romer and Lucas in the 1980s, following the neoclassical wave of the 1950s and 1960s—appears to be dwindling to a modest flow of normal science

Inflation rate for previous period relative to current rate

π = πt and πt e = πt−1

i.e., that future expected inflation is equal to inflation in the past period.

The IS-LM-PC model tells us that when output is above potential, the real interest rate r rises and the change in inflation rate decreases toward zero.

The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run.

In the long run the general price level, contractual wages, and expectations adjust fully to the state of the economy.

When output is below potential, the change in inflation rate increases toward zero. The Phillips curve thus increases with increasing output, and crosses the horizontal axis

Where Y = Yn,

The value of output which stabilizes inflation. In the medium run, output is equal to potential output. In the left diagrams in equilibrium at point A, Y > Yn, output is above potential, and inflation is increasing.

This is a short-run equilibrium. If r does not change over time, inflation continues to increase.

In the medium run, real policy interest r will be raised in response to inflation and “overheating” of the economy. In the right diagrams, the new medium run equilibrium is shown at A′, at which r′ = rn , where rn = the natural rate of interest. This adjustment is difficult to make precisely by the central bank, because potential output Yn is not well known, the signal is noisy, and there is a lag in economic response, consumer response, demand response, etc.

In the short run both the expansionary monetary and expansionary fiscal policy have the same effects on i,Y and P. In both cases i decreases, Y increases and P increases. In the medium run both fiscal and monetary policy have no effect on the natural level of output but the price level increases in both cases.

Thus to attain a stable inflation over the medium run, the initial boom may in the short run be followed by an overcorrection and a recession. If we assume that inflation will be

constant = (π�), termed a so-called anchored inflation expectation,