The effects of an increase in energy prices in the IS-MP-PC model.

Question A) 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?

1) 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).

2) 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).

3) 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%.

4) 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%.

Question B) Inflation shock and new equilibrium. Suppose that political crises in Venezuela and Iran lead to a sharp and unexpected increase in oil prices. American companies pass on the cost increase to consumers as an increase in prices (i.e. an inflation shock). The Fed keeps the interest rate unchanged. Think about which curves need to shift in the IS-MP-PC diagram. Update the diagram and label the new equilibrium as point B (in top and bottom diagram). Which of the statements below is correct? *

1) The IS curve shifts left when the inflation shock happens. Thus SRO falls. Thus, in the IS-MP diagram point B is to the left of point A. In the PC diagram (bottom), we slide down along the PC curve. As a result, inflation falls relative to the previous period (i.e. point B in the PC diagram lies vertically above point A).

2) The IS curve shifts up when the inflation shock happens. Thus SRO increases. Thus, in the IS-MP diagram point B is to the right of point A. In the PC diagram (bottom), we slide up along the PC curve. As a result, inflation rises relative to the previous period (i.e. point B in the PC diagram lies vertically above point A).

3) Nothing changes in the IS-MP diagram (top) when the inflation shock happens. Since neither the IS nor the MP change, SRO remains at zero. Thus, in the IS-MP diagram point B coincides with point A. In the PC diagram (bottom), the PC curve shifts down because of the inflation shock. As a result, inflation falls relative to the previous period (i.e. point B in the PC diagram lies vertically above point A).

4) Nothing changes in the IS-MP diagram (top) when the inflation shock happens. Since neither the IS nor the MP change, SRO remains at zero. Thus, in the IS-MP diagram point B coincides with point A. In the PC diagram (bottom), the PC curve shifts up because of the inflation shock. As a result, inflation increases relative to the previous period (i.e. point B in the PC diagram lies vertically above point A.

Question C ) The Fed's mission. Suppose the Fed is unhappy with the increase in inflation and wants to remedy the problem and stabilize inflation. What will the Fed do? Assume the inflation shock stays (i.e. the PC 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?

1) To put the brakes on the rising inflation, the Fed will lower the (real) interest rate i.e. shift the MP curve down. As a result, the economy will climb along the IS curve and SRO will become negative. Thus, point C in the IS-MP diagram is to the left of point A=B. In the PC diagram (bottom), the economy slides down along the curve so that point C will be to the left of point B.

2) To put the brakes on the rising inflation, the Fed will cut taxes i.e. shift the MP down up. As a result, the economy will slide down along the IS curve and SRO will become positive. Thus, point C in the IS-MP diagram is to the right of point A=B. In the PC diagram (bottom), the economy climbs up along the curve so that point C will be to the right of point B.

3) To put the brakes on the rising inflation, the Fed will increase the (real) interest rate i.e. shift the MP curve up. As a result, the economy will climb along the IS curve and SRO will become negative. Thus, point C in the IS-MP diagram is to the left of point A=B. In the PC diagram (bottom), the economy slides down along the curve so that point C will be to the left of point B.

4) To put the brakes on the rising inflation, the Fed will raise taxes i.e. shift the MP curve up. As a result, the economy will climb along the IS curve and SRO will become negative. Thus, point C in the IS-MP diagram is to the left of point A=B. In the PC diagram (bottom), the economy slides down along the curve so that point C will be to the left of point B.

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