Three-Equation Model, IS - PC - MR

MACROECONOMICS: THE
THREE-EQUATION MODEL: IS –
PC - MR
THE PHILLIPS CURVES
 Three Basic Phillips Curves (PC):
 Expectations-Augmented Phillips Curve (EAPC);
 π = πe + α(y – ȳ)
 Inertia Augmented Phillips Curve (IAPC);
 πt = πt-1 + α(yt – ye)
 Lucas ‘Surprise’ Supply function;
 y = ȳ + β(π – πe)
 The difference between the EAPC and IAPC is that, as we assume
adaptive expectations (see appendix), πe is a function of πt-1 and πt-2 etc.
Hence, the IAPC gives a weighting of ‘1’ to πt-1 and 0 to all the other
past inflation values.
 The difference between EAPC/IAPC and the Lucas function, is the
direction of causation (in the former, the output gap drives inflation, in
the latter, the inflation gap drives the output).
 In addition, the equilibrium output is different in the EAPC/Lucas from
the IAPC because the IAPC assumes an imperfectly competitive.
THE PHILLIPS CURVES
 Phillips curve analysis can show Inflation
how costly disinflation policies are. LRPC
 We start at A, and want inflation
down to 2.
 Pursue a disinflationary policy,
which moves us down SRPC(4) to SRPC (4)
B.
 Inflation is now at 3, thus the SRPC SRPC (3)
shifts to SRPC (3) and move from B
to C. A
4
 Continue disinflationary policy, SRPC (2)
moving down SRPC(3) to D. 3 B C
 Inflation is at 2, so SRPC shifts to
SRPC (2) and we arrive at Z. E D Z
2
 Note that we have to induce
unemployment (go below Ye) in
order to lower inflation.
 Could have just gone from A to E,
but has a massive cost.
Ye Y
RATIONAL EXPECTATIONS
 Rational Expectations means that there’s a perfect market for
information, such that everyone has access to (and utilises)
knowledge about EVERYTHING already known at the time.
 Hence, the only deviation from what is expected to happen is
through random shocks (mu and xi).
 Hence, we can adapt the Lucas model under rational expectations: If
πe = π, then y = ye + ξ
 One can justify the Lucas function: If each firm can ONLY observe
the price of it’s own goods, and sees the price of it’s good rise, it can
attribute this to either:
 A general rise in prices (which he can’t verify), OR a rise in demand
for his good.
 We assume he already has formed expectations of inflation. Thus, if
the price rise is BEYOND his expectations, he will increase output
as he has (mistakenly) attributed it to a rise in the demand for his
good. This describes the Lucas function.
THE MONETARY RULE
 Here is a graphical interpretation of the LRPC
MR, a mathematical derivation will
follow in the monetary policy slides.
 In order to understand what point along
the SRPC the Government/Central Bank
will choose, we have to model them with
PREFERENCES. SRPC (4)
 These preferences can be modelled as a
preference function which are shown by
the ovals.
A
 Both Ovals have a centre of Z; this is the 4
bliss point, where the Government wants SRPC (2)
to be. B
3
 However, one Government puts a higher
weight on the potential costs of
disinflation than the other, so one will go E Z
to B and the other E, from point A.
2
Ye Y
THE MONETARY RULE
 It is possible to plot the locus Inflation
of all the points of tangency LRPC
between the SRPC (the
constraints) and the preference
functions (the objective).
 The resulting locus is the SRPC (4)
MONETARY RULE.
 MR 1 is the MR for a
Government which has a 4
weight to the consideration of SRPC (2)
the costs involved with
disinflationary policy. MR2,
however, is a ‘cold’ turkey 2 MR2
approach, which just wants to
cut inflation.
MR1
Ye Y
r
THE IS-PC-MR MODEL

c
 We can now combine the three elements r’ d
to see how the central bank can change r’’ a
interest rates to cope with certain shocks. rs
We shall first consider an inflationary
shock.
 Assume we are initially at position A, IS
which corresponds to position a on the IS
curve. Y
 We experience a positive inflation shock, π SRPC’
thus being driven to point B. We want to
go back to A. SRPC’’
 What the Government can do is increase B SRPC
interest rates from the stabilising
interest rate (rs) to r’ (a movement along
the IS curve from a  c). C
 This will move us from B to C. D
 We then lower the interest rate A
incrementally, as the SRPC shifts, so that
we move along the MR locus until we go
to A.
MR
Ye Y
r
THE IS-PC-MR MODEL

 In the case of a temporary demand r’
shock (for 1 period duration). c b
 Initially at ‘a’ (A), a positive demand rs a
shock shifts the IS curve out to IS’ and at
rs, we arrive at position b (B).
IS IS’
 The inflation at rate B defines the new
SRPC (SRPC’) and therefore the Y
optimum point for that period (C).
 The IS curve has shifted back and thus π SRPC’
we wish to be at point c with interest rate
r’.
 We then, as before, adjust the interest rate
SRPC
until we arrive back at our initial position B
at the stabilising rate of interest.
 For a PERMANENT SHOCK, we C
would have a higher value of rs – where
IS’ meets Ye. To get to it, we go through A
the same method as above.
MR
Ye Y
THE IS-PC-MR MODEL: MATHS
 The IS curve equation can be simplified to Y = A – ar,
where A is the sum of the exogenous constants
(including exogenous demand, investment, Gov
expenditure). We will also note that at the stabilising rate
of interest (rs ), output is at it’s equilibrium level (Ye ).
Hence Ye = A – ars
 Thus, Y – Ye = -a(r – re ): IS curve in output gap form.
 This isn’t needed to calculate the MR, BUT is important.
 To calculate the MR, we need to minimise th
Government’s loss function vis-a-vis the SRPC.
THE MR DERIVATION
 Government has a loss function of the form:
 V = (y – ye)2 + β(πt – πT)2
 This states that the bliss point is at equilibrium output at

a TARGET level of inflation. Any deviation from this
point will cause a loss of utility.
 It is important to note here that the value of the
parameter β determines the shape of the preference
curves as it describes the weighting attached to the
Government’s consideration of inflation.
 We are going to use the IAPC: πt = πt-1 + α(y – ye) as our
constraint.
THE MR DERIVATION
 Substitute constraint into the objective function:
 L = (y – ye)2 + β[πt-1 + α(y – ye) – πT]2
 Differentiate with respect to output:

 δL/δy = 2(y – ye) + 2αβ[πt-1 + α(y – ye) – πT] = 0
 2(y – ye) + 2αβ[πt – πT] = 0

 Thus, we can describe the MR as:
 (πt – πT) = - 1/αβ . (y – ye)
 Hence the gradient of the MR depends on both the

weighting given to inflation and alpha.
APPENDIX: ADAPTIVE EXPECTATIONS
 πe = πet-1 + a(πt-1 – πet-1): Adaptive expectations
 This suggests that expectations are formed due to the
expected inflation of the previous period plus the error
term multiplied by some weighting.
 If past forecasting mistakes are fully corrected so that
a=1:
 πe = πt-1

Three-Equation Model, IS - PC - MR

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MACROECONOMICS: THE

THE IS-PC-MR MODEL

THE IS-PC-MR MODEL

 This states that the bliss point is at equilibrium output at

 Differentiate with respect to output:

 2(y – ye) + 2αβ[πt – πT] = 0

 Hence the gradient of the MR depends on both the

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