Using the IS - MR - PC model

Starting from medium run equilibrium, explain the response of the economy to a deflationary shock i.e. one that reduces inflation expectations. Make sure your explanation follows the timeline.

In addition to describing the paths over time of output, inflation and interest rates, at each stage describe carefully what happens in the labour market and the goods market

How could fiscal policy instead of monetary policy be used to respond to the shock?

2. Policy effectiveness

(a) Describe how monetary and fiscal policy affect output. NB don't draw diagrams, just explain in words the mechanism by which changes in policy transmit themselves to output.

(b) Give two reasons (based on the material covered in the course) why either fiscal policy or monetary policy might have no effect on output. Explain your answer in the context of the model

Discussion points (think about these for the class; don't hand anything in)

(a) What is the mechanism by which the central bank announcing an inflation target translates into an actual inflation rate?

(b) How would your answer to q1 change if households had rational expectations?

(c) What issues might make using fiscal instead of monetary policy in q1 difficult in practice?

(d) How does consumption depend on interest rates? How would this change if the assumption made in the derivation of the PIH that interest rates were constant across time were relaxed?

(e) How would the economy behave if monetary policy was passive (i.e. kept the real interest rate constant at the stabilising rate)? Think of the two examples of shocks covered in lecture 3.

(f) Does policy work in practice? Think of examples from the recent past.