Integrating Inflation into IS-LM to Create a Dynamic Equilibrium Model of the EconomyThe Final Form Model of Price InflationThe Link Between Unemployment and Real OutputThe Full Links Among: Inflation, Unemployment and Real OutputSlide 5The Accelerationist Phillips Curve Adds a Crucial Dynamic Dimension to IS-LMSlide 7Assume the equilibrium is disturbed by a tax cutThe real money supply is reduced, shifting LMThe real money supply is reduced, shifting LM until the IS-LM equilibrium matches the NAIRU equilibrium of the Accel. Phillips CurveSlide 11BRINNER113.pptIntegrating Inflation into IS-LMto Create a Dynamic Equilibrium Model of the EconomyLecture 13BRINNER213.pptThe Final Form Model of Price InflationIf we assume the three key coefficients actually equal 1( if we had perfect measures of the concepts): price inflation affecting wageswage inflation affecting prices)And productivity affecting both wages (positively) and price(negatively), then:(1) RP = RW-RQ+Supply ShocksAND, EARLIER,(2) RW=RP\1+ RQ+ A0-A1*(U-U@VOL)Substituting (2) into (1) yields:RP=RP\1+ RQ+ A0-A1*(U-U@VOL) -RQ+Supply Shocks =RP\1+ A0-A1*(U-U@VOL) +Supply Shocks(Note: Productivity is neutral in this formulation)OR, RP-RP\1 =THE CHANGE IN INFLATION (i.e the acceleration in prices)= A0-A1*(U-U@VOL) +Supply ShocksBRINNER313.pptThe Link Between Unemployment and Real OutputThe cyclical relationship between unemployment and real growth is known as Okun’s Law: –the change in Unemployment Rate=about half the growth rate difference between potential and actual GDP growth–or, the level of the Unemployment Rate=about half the % gap between potential and actual GDPBRINNER413.pptThe Full Links Among:Inflation, Unemployment and Real OutputThe critical relationships are:1. The change in inflation responds (with a negative derivative) to the unemployment rate2. The unemployment rate responds (with a negative derivative) to the GDP level, given GDP@FETherefore,3. The change in inflation responds (with a positive derivative) to the GDP level, given GDP@FEchange in inflationGDP [email protected] Full Links Among:Inflation, Unemployment and Real OutputThe change in inflation responds (with a positive derivative) to the GDP level, given [email protected] favorable external shock, such as a drop in oil prices or imported goods prices, effective reduces the NAIRU (the unemployment rate required to keep inflation unchanged), and thereby raises [email protected] in inflationGDP levelGDP@FEwith NAIRU (1)GDP@FEwith NAIRU (2)BRINNER613.pptThe Accelerationist Phillips Curve Adds a Crucial Dynamic Dimension to IS-LMImagine an initial IS-LM “equilibrium”Any GDP indicated by such an “equilibrium” that is greater than GDP@FE will push unemployment lower than NAIRUThis will increase inflation, raising the price levelHigher prices effectively reduce the real money supply, and probably reduce consumer spending– both IS and LM curves shift leftward–In other words, the initial “IS-LM equilibrium” was only temporary if GDP wasn’t consistent with NAIRUTherefore, the fiscal or monetary “multipliers” analysis and conclusions we reached earlier need to be rethought–These policy changes are temporary stimulants, not permanent influences on GDP–Long-run GDP multipliers are zero unless the stimuli sufficiently boost investment so as to boost the level of GDP consistent with NAIRUBRINNER713.pptThe Accelerationist Phillips Curve Adds a Crucial Dynamic Dimension to IS-LM0rRP1-RP0GDPGDPGDP1=GDPFEr1GDP1=GDPFEIS1LM1A sustainable equilibrium:•IS=LM•GDP=GDPFE•Thus inflation is stable (presumably equal to nominal money supply growth thus the real money supply is constant)BRINNER813.pptAssume the equilibrium is disturbed by a tax cut0rGDPGDPGDP21 > GDPFEr1GDP1=GDPFEIS1LM1The new IS-LM “equilibrium” is not sustainable:•IS=LM but•GDP>GDPFE•Thus inflation is rising (presumably faster than nominal money supply growth thus the real money supply will be reduced)IS2r2RP2 > RP1BRINNER913.pptThe real money supply is reduced, shifting LM0rGDPGDPGDP31 < GDP2r1GDP1=GDPFEIS1LM1This diagrammed, new IS-LM “equilibrium” is still not yet sustainable:•IS=LM with higher “r” and lower “GDP”•But GDP is still >GDPFE•Thus inflation is rising (presumably faster than nominal money supply growth thus the real money supply will be reduced)IS2r2RP2 > RP1LM3r3BRINNER1013.pptThe real money supply is reduced, shifting LM until the IS-LM equilibrium matches the NAIRU equilibrium of the Accel. Phillips Curve0rGDPGDPGDP31 < GDP2r1GDP4=GDPFEIS1LM1This diagrammed, new IS-LM “equilibrium” is once again sustainable:•IS=LM with higher “r” and lower “GDP”•GDP = GDPFE•Thus inflation is stable, matching desired money supply growthIS2r2LM3r3LM4r4BRINNER1113.pptThe real money supply is reduced, shifting LM until the IS-LM equilibrium matches the NAIRU equilibrium of the Accel. Phillips Curve0rGDPGDPGDP31 < GDP2r1GDP4=GDPFEIS1LM1Note: If the IS curve shifts to the left with each increase in the price level, this accelerates the convergence to the equilibrum output and requires less of a shift in the LM curve. Thus, the equilibrium with both IS and LM curves moving in the same direction is achieved at a lower interest rate. (As shown with IS3 and LM3) This may be important for the composition of GDP: it could mean higher investment than otherwise, for
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