Question

Consider the textbook three-equation model: yt =A−art−1 (IS Curve) πt = πt−1 + α(yt − ye) (Phillips Curve) yt − ye = −αβ(πt − π T ) (Monetary Policy Rule) Use the three equation model to diagrammatically analyze and discuss the following shocks:

a. A temporary negative aggregate demand shock.
b. A permanent negative aggregate demand shock.
c. A permanent positive aggregate supply shock.

Answer 1

To analyze the effects of different shocks on the three-equation model, we consider a temporary negative aggregate demand shock, a permanent negative aggregate demand shock, and a permanent positive aggregate supply shock. Each shock has specific effects on nominal GDP, inflation, and the output gap, which cause shifts in the IS curve and the Phillips curve.

Step-by-step explanation:

To analyze the effects of different shocks on the three-equation model, let's consider the following scenarios:

1. A temporary negative aggregate demand shock: This would lead to a decrease in nominal GDP (A) and inflation (π), while the output gap (yt - ye) would increase temporarily. As a result, the IS curve would shift downward, the Phillips curve would shift upward, and the monetary policy rule would remain unchanged.
2. A permanent negative aggregate demand shock: In this case, nominal GDP (A) and inflation (π) would both decrease permanently, and the output gap (yt - ye) would also decrease. The IS curve would shift downward, the Phillips curve would shift upward, and the monetary policy rule would remain unchanged.
3. A permanent positive aggregate supply shock: This shock would lead to an increase in real GDP (yt), a decrease in inflation (π), and a decrease in the output gap (yt - ye). The IS curve would shift upward, the Phillips curve would shift downward, and the monetary policy rule would remain unchanged.