Summary
Summary ECON 0016 IS-PC-MR Mechanics UCL
- Course
- Institution
Document explaining adjustment of demand, supply and inflation shocks using the 3 equation model (IS-PC-MR). Includes step-by-step adjustment. Final mark: 75%
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Overviewis pc mismodel
It Demand
consumption
nondurabledurablehousing
a i
y
I
F ws
sum
imperfectlycompetitivelabour
Naru
ng Ps
Psbyfirms
usbyworkersfirms
w adjinline w the
Tat190bang41
y
F1 support
TI Mr
bestresponsetodifferentPc
bestrtogett
, Assumeadaptiveexpectations TL Tet
Timeline when using the IS-PC-MR model
at
Period starts
1. Any interest rate change from the previous period affects output.
I r onlyHasEffectonly onNextPERIOD
2. Shocks happen.
AFTERADisdetermined
3. Expectations of inflation for this period are updated. If there’s an inflationary TCupdated
shock, expected inflation changes to reflect the shock.
ate
4. Nominal wages are set based on expected inflation and the level of
employment. This puts the expected real wage onto the WS curve. AW tomaintainWp
5. Firms set prices as a markup over the nominal wage. This moves the real Te Ap to
wage onto the PS curve and the change in the price level is the rate of inflation. maintain
µ
6. Now the economy is on the IS and PC curves.
7. If inflation and / or output are different from the Central Bank’s (CB’s) targets
(the medium run equilibrium)
ye
I
(a) Since interest rates only affect demand with a one-period lag, the CB itwouldbe
forecasts the position of the PC in the next period by working out what
Ifrencast inflation expectations will be next period.
monpolicy
ti eeoutput it must choose to get on its MR curve in the
(b) This tells it the level of
next period.
REFITse
(c) It then forecasts the IS curve next period by judging whether any shock to
the IS curve is temporary or permanent to work out what level of interest
rates it must set now to achieve this output level.
temp smallA r
(d) The CB sets interest rates.
perm bigA r
Period ends
y
t
, t o
M RE
I shock Ir
Tc
Aprices y ye
positive
outputGap
Er
I unemployment
Tbargainingpower
forecastPc
A nomwage
set r Tc
Aprices
Ez
new
eq
forecastPc
set r
, Analysis
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