Class 2. The AD-ERU model and the 3-equation model

Discussion points

In this class, you will work through the medium run model and the dynamic 3-

equation open economy model. Make sure that you have been through your answers

to the problem set and that you can answer the following questions. You will be called

on in class to provide answers.

PS2.1

Assume you are modelling a small open economy.

a) What does the ERU curve represent? What would happen to the ERU curve if

unemployment benefits were raised? What would you expect to happen to

inflation? [30]

b) What does the AD curve represent? Derive the AD curve graphically from the

IS curve. Suggest two variables that shift both the IS and the AD curves and

summarize their effect on the medium-run real exchange rate. [30]

c) Suppose there is a rise in the world interest rate. Describe the new MRE. Does

your answer depend on the exchange rate regime? Explain. [40]

1. Why is the ERU curve vertical? What is being assumed about the real wage

wage-setters care about (in their utility function)? Does a rise in

unemployment benefit affect the demand or supply side of the labour market

and how?

2. Why does inflation change – how do you derive the relevant Phillips curve

following the rise in unemployment benefits?

3. What are you holding constant when you derive the AD curve from the IS

diagram? What are you varying?

4. What variables will shift the AD curve? Will they shift the IS curve?

5. For one of the examples you gave in (b), explain in words the difference

between the initial and the new MRE.

6. Explain in words why the AD curve shifts to the left when the world interest

rate is higher. What happens to the MRE?

PS2.2 A positive permanent demand shock – dynamic adjustment

a) Using the simulator:

• Apply shock: Permanent 3% positive demand shock. Give a plausible

explanation of what could cause such a shock.

• Use the impulse response functions to help explain the path of the economy

following the shock (output, inflation, real interest rate, real exchange

rate). In particular, how can you explain the adjustment of the real

exchange rate?

• Save your data and use the button on the bottom left of the main page to

switch to the closed economy version of the simulator

• Apply shock: Permanent 3% positive demand shock

• Print the impulse response functions for the key variables (inflation,

output, interest rates, exchange rates).

b) If you cannot get the simulator to work, sketch the impulse-response functions for

the above exercise.

c) Comment on the differences in the impulse response functions between the open

and closed economy simulations (or in your sketches). Is the change in interest

rate necessary to stabilise the economy larger in the open or closed economy?

Why?

d) The default setting in the simulator uses the same coefficient on the real interest

rate in the open and closed economy (‘sensitivity of expenditure with respect to

real interest rate’). This means that ‘a’ is the same in the equation for the open

and closed economy IS:

1 1

1

Open economy IS equation

Closed economy IS equation

t t t

t t

y A ar bq

y A ar

− −

−

= − +

= −

Sketch each of these IS curves. Now, explain in words why we would not expect

the coefficient on the real interest rate to be the same in the open and closed

economy IS curves. Would you expect the IS curve to be flatter or steeper in the

open economy?

e) [Extension for the keen: Use the simulator to experiment with the

sensitivity of output to the real interest rate in the open economy and

check what happens to the CB’s choice of interest to respond to the shock.

Hint: choose a much lower sensitivity to see the results in the graphs; you

can also enlarge the vertical scale to get a better view. ]

7. If the coefficient on the interest rate in the IS curve is the same in the closed

and open economy, why does the central bank raise the interest rate by less in

the open economy? How is the result in the impulse response function

produced by the simulator reflected in the 3-equation model diagram? Why is

there no difference in the paths of inflation and output between the closed and

open economies? Match the simulator result to the diagrams and to your

verbal explanation.

8. Why is investment less sensitive to the interest rate in the open economy?

How does this affect the slope of the IS curve?

9. Who tried the last part of the question – what results did you get from the

simulator?

Is the simulator useful in helping you to understand the model? In helping you to

understand macroeconomic policy-making in the world? Justify your answer.

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