Note 1: The IS-MP-PC Model is a 2-part diagram. The top part contains the IS-MP curves (as in the previous chapter). The bottom part contains the PC curve. In both cases the horizontal axis is given by SRO.

Note 2: Relative to the book (and lecture), there's a small change in notation: "a" refers to AD shocks and "o" refers to inflation shocks. In the book and lecture notes both letters display an over-line, but the Google Classroom's editor does not allow it.

The effects of a reduction in exports in the IS-MP-PC model:

Initial Equilibrium. Consider the IS-MP-PC model. Draw the diagram corresponding to a situation where there are no AD shocks (a=0), the Fed sets the real interest rate equal to the MPK, and there are no inflation shocks either (o=0). Label the initial equilibrium as point A in the diagram, both in the top and bottom parts of the diagram. Which of the statements below is correct?*

A.At the initial equilibrium (point A in the diagram), SRO will be equal to zero and the unemployment rate will be equal to 0%. In addition inflation is equal to 2.5%.

B.At the initial equilibrium (point A in the diagram), SRO will be equal to zero and the unemployment rate will be equal to the natural rate of unemployment. In addition inflation is stable (i.e. equal to the level of the previous period).

C.At the initial equilibrium (point A in the diagram), SRO will be below zero and the unemployment rate will be equal to 0%. In addition inflation will

be 2.5%.

D.At the initial equilibrium (point A in the diagram), SRO will be positive and the unemployment rate will be below to the natural rate of unemployment. In addition inflation is stable (i.e. equal to the level of the previous period).

Shock to exports and new equilibrium. Suppose that Europe enters a severe recession and, as a result, American exports to Europe fall dramatically. The Fed keeps the interest rate unchanged. Think about which curves need to shift in the IS-MP-PC diagram. Update the diagrams and label the new equilibrium as point B (in top and bottom diagram). Which of the statements below is correct?*

A.The reduction in exports (aX falls) is a positive aggregate demand shock (i.e. a<0). As a result, in the IS-MP diagram (top) the IS curve shifts to the right. Because the interest rate is unchanged, SRO now turns positive (point B). In the PC (bottom) diagram, we move up along the curve so that inflation rises above the initial level. In other words, at point B we have an increase in inflation

B.The reduction in exports (aX falls) does not affect the position of the IS curve. We simply move up along the curve. The PC curve shifts to the left, leading to an increase in inflation at point B.

C.The reduction in exports (aX falls) is a negative aggregate demand shock (i.e. a<0). As a result, in the IS-MP diagram (top) the IS curve shifts to the left. Because the interest rate is unchanged, SRO now turns negative (point B). In the PC (bottom) diagram, we move down along the curve so that inflation falls below the initial level. In other words, at point B we have a negative change in inflation.

D.The reduction in exports (aX falls) is a negative aggregate demand shock (i.e. a<0). As a result, in the IS-MP diagram (top) the IS curve shifts to the right. Because the interest rate is unchanged, SRO now turns negative (point B). In the PC (bottom) diagram, we move down along the curve so that inflation falls below the initial level. In other words, at point B we have a negative change in inflation

The Fed saves the day. Suppose the Fed wants to help the U.S. economy go back to full employment (SRO=0) by changing the interest rate. What should the Fed do? Assume the IS curve remains as in the previous question. Update the diagram and label the final equilibrium as point C. Which of the following statements below is correct?*

A.To bring SRO back to zero, the Fed needs to raise the (real) interest rate so that the MP curve cuts the IS curve at SRO=0. As a result, in the IS-MP diagram (top), point C lies vertically above point A. In the PC diagram (bottom), the PC curve does not change. The economy simply climbs up so that point C coincides with point A and we go back to stable inflation.

B.To bring SRO back to zero, the Fed needs to lower the (real) interest rate so that the MP curve cuts the IS curve at SRO=0. As a result, in the IS-MP diagram (top), point C lies vertically below point A. In the PC diagram (bottom), the PC curve does not change. The economy simply climbs up so that point C coincides with point A and we go back to stable inflation.

C.To bring SRO back to zero, the Fed needs to cut taxes so that the MP curve cuts the IS curve at SRO=0. As a result, in the IS-MP diagram (top), point C lies vertically below point A. In the PC diagram (bottom), the PC curve does not change. The economy simply climbs up so that point C coincides with point A and we go back to stable inflation.

D.To bring SRO back to zero, the Fed needs to raise taxes so that the MP curve cuts the IS curve at SRO=0. As a result, in the IS-MP diagram (top), point C lies vertically above point A. In the PC diagram (bottom), the PC curve does not change. The economy simply slides down so that point C coincides with point A and we go back to stable inflation.