Eco 102 week 9 Full Model

Lecture Overview

• Course: ECO102: Principles of Macroeconomics

• Instructor: Tyler Paul, Assistant Professor, Teaching Stream, Department of Economics

• Term: Winter 2025

Learning Objectives

1. Combine IS-MP-PC curves into a full model

2. Introduce more realistic MP curve (Chapter 22.2)

3. Use the model to study the COVID recession

Full Model: Combining IS-MP-Phillips Curves

Components of the Full Model

• IS Curve: Connects real interest rate and output gap

  • Equilibrium occurs where PAE = Y

• Phillips Curve: Relations between output gap and unexpected inflation

  • Formula: π − πe = αY~ + o (includes demand-pull inflation + cost-push shocks)

• MP Curve: Represents the central bank’s policy rate plus risk premium

  • Formula: r = rf + rp

  • Where rf = risk-free rate and rp = risk premium

Goal

• Determine key endogenous macro variables:

  • Output gap (Y~), unexpected inflation (π − πe), and real interest rate (r)

Categories of Macro Shocks

Initial Assumptions

• Model starts in long-run equilibrium ( Y~ = 0)

Types of Shocks

1. Financial Shocks: Changes in borrowing costs (r)

• Typically due to shifts in risk premium (rp) → affects MP curves

2. Spending Shocks: Changes in autonomous spending (C~, I, G, NX)

• Shifts IS for all levels of real interest rate

3. Supply Shocks: Changes to production costs (o~)

• Causes firms to adjust prices → shifts Phillips Curve (PC)

Inflation Expectations Shocks

Dynamics of Expectations

• Inflation expectations are treated as exogenously determined

• Impact of sudden increase in πe is analyzed:

  • PC curve remains unaffected by changes in πe

Key Insights

• Actual inflation (π) is endogenous and corresponds directly to any change in expected inflation

Studying Expectations Shocks

• Use original Phillips Curve to explore impacts of expectations shocks:

  • Plot π on vertical axis: π = πe + αY~ + o~

  • Observations: When πe declines, actual inflation decreases, while unexpected inflation remains unchanged

Procedure for Analyzing Shocks

1. Identify the Shock

• Determine which curve(s) shift and the extent of the shift

2. Find New Equilibrium

• Assess resulting output gap (Y~) and real interest rate (r)

3. Compute Unexpected Inflation

• Evaluate changes in unexpected inflation based on new output gap

Full-Model Example 1: Tax Policy

• Steps to analyze the shock from a sharp increase in taxes:

  1. Identify shock

  2. Find new equilibrium

  3. Compute unexpected inflation

Clicker Questions

• Identifying Shocks - Consider implications of generative AI on IS-MP/PC models

• Possible impacts include shifts in IS curve indicating productivity impacts

Full-Model Example 2: Productivity Boost

• Generative AI and its implications for labor productivity:

  • Same analytical approach for determining equilibria and unexpected inflation

Working Backwards to Identify Shocks

• Example: If Y~ < 0 and π − πe < 0, analyze causation considering spending constraints

Aggregate Consumption Shock of COVID-19

• Decline in consumer spending shifts IS curve left and affects the economy's dynamics

Lowering Potential Output Due to COVID

• Factors affecting potential output include worker willingness and employment levels leading to reduced productivity

Government Spending Strategies During COVID

• Massive government spending measures resulted in inflated household incomes and affected aggregate spending positively despite high unemployment rates

Inflation Dynamics During COVID-19

• The fluctuations in inflation reflected demand-pull and cost-push conditions, indicating multifaceted influences on the economy post-pandemic

Next Week

• Topic: Monetary Policy (chapter 22)

• Midterm: March 13th, with additional details to be provided

• Homework Due: Sunday, March 16 at 11:59 PM