UMD Microeconomic Theory IS LM PC Model in A Recession Question
Therefore,
full credit will require you to show all steps and work; clearly label any graphs; and fully explain
any answers that ask for an explanation.
You can either type your answers using a word processing software of your choice (but be sure
to still show all steps and work!) or write them by hand and scan them using the camera on your
phone/tablet. In either case, you need to submit the file as a single pdf document.
Question 1: Setting up the IS-LM-PC model in a recession
a. Set up an IS-LM-PC graph for which the economy is below potential output. Assume that
inflationary expectations are adaptive.
b. Assume that output fell below potential output in period t.
i. What happens to inflation in period t? Why?
ii. What happens to inflation in period t+1? Why?
Question 2: Demand shocks, inflation and monetary policy
Assume that the economy starts from the medium-run equilibrium (where Y=Yn) and consider
the following scenarios. In this question, you don’t need to explain and you’re not required to
show a graph. But, when you’re not sure of the answer, don’t guess – instead, use the IS-LM-PC
model to help you.
b. An increase in government spending.
i. What happens to inflation over time if inflationary expectations are anchored?
ii. What does the central bank need to do to return to the medium-run equilibrium?
c. In March 2020 consumer spending dropped sharply as Covid started spreading in the U.S.
i. What happens to inflation over time if inflationary expectations are anchored?
ii. What does the central bank need to do to return to the medium-run equilibrium?
