Question

Graph the effects of oil price increase in the IS-LM-PC model. Explain, in words, whathappens to unemployment and inflation?

Answer 1

The IS-LM-PC Model combines the 3 important markets which are the goods market, the financial markets and the labor markets. In this model, the Phillips curve is revised one which showing a relationship between inflation and output rather than between inflation and unemployment. Thus, any policy which is focused to fall in interest rate that causes the output to rises (IS-LM) leads to positive changes in the inflation rate (IS-LM-PC).

To understand the effects of an oil price shock we divide our analysis to in 2 parts:

Part 1: Wage Determination Model

• The Wage setting relation if given as:

W/P = f( u, z)

Where, W/P = Real Wages which negatively depends upon the unemployment rate and positively on other factors “z” which are unemployment insurance, minimum wage legislation etc. Thus the wage setting curve is a downward sloping curve in relation to unemployment.

• The price setting relation is given by :

P = (1+m)W or W/P = 1/(1+m)

Where W/P is the real wages and “m” is the markup over the production cost. The price setting relation does not depend upon unemployment and thus its curve is horizontally flat.

• In figure 1, we can see the wage setting curve WS intersects the price setting curve at point A with the natural rate of unemployment given by Un.
• Given that wages are fixed, an increase in the prices of oil increase the cost of production. Thus, the firms respond by increasing the prices in order to maintain the same profit levels. This means there is an increase in the markup value from m to m’. This causes the price setting relation to increase and shifts the curve downwards from PS to PS’. With this the natural rate of unemployment increases from Un to Un’, however the real wages decreases from W/P to (W/P)'.

Part 2: IS-LM-PC Model

• In this model, as assumed the revised Phillips curve is a function of inflation and output. The curve is upward sloping, which means it increases with an increase in output and it also crosses the x-axis where actual output is equal to the potential output, i.e. Y = Yn. This is the medium run equilibrium shown by point A, in figure 2(b). In this figure, the output is shown on the X-axis and inflation rate is shown on the Y-axis. The initial Phillips Curve is given by PC that interscts at point A.
• The corresponding point is shows in the Figure 2(a) where the goods and the money market are in equilibrium. Here at A, the initial IS and LM curve intersect to maintain the natural rate of interest “r(n)”.
• From Part 1, as the natural rate of unemployment increase from Un to Un’, the potential output falls from Yn to Yn’. This causes the PC curve to shifts upwards from PC to PC’ in the short-run leading to an increase in prices and thus the inflation rate.
• In response to the above event, the central bank increases the interest rates from r(n) to r(n)’. This can be seen from the upward shift of the horizontal LM curve to LM’. This policy is adopted by the central bank to stabilize inflation. With a rise in interest rate there is further downward pressure on aggregate demand (This can be shown by shifting the IS curve downwards) demand that shifts the IS curve downwards) This causes the output to permanently remain at lower levels like Yn’.

· Thus, an increase in oil prices causes rise in inflation plus permanent lower aggregate output and higher unemployment.