Lecture Notes: IS-LM-PC Model and Current Events

Current Events Discussion

• Silicon Valley Bank Collapse
  • Silicon Valley Bank, 16th largest in the US, was shut down by the FDIC.
  • The bank's closure followed a significant decline in stock value.
  • Influenced by a bank run, primarily from its tech sector clients.
  • The run was exacerbated by social media spreads after SVB announced issuing new equity.
  • Key Factors:
    • Rapid growth followed by net outflows due to tech sector struggles.
    • Bank invested heavily in long-term treasury bonds before interest rate hikes in 2022.
  • Regulatory Aspect:
    • Deposits under $250,000 are FDIC insured; 95% of SVB deposits exceeded this.
    • The bank was lightly regulated, partially due to the 2018 adjustment of the Dodd-Frank bill.
  • Government and Market Reaction:
    • Government guaranteed all deposits, not just those under $250,000.
    • FED provided credit lines to banks to avoid asset sales.
    • Market volatility remained high, indicating ongoing stress.

IS-LM-PC Model Introduction

• Purpose: To integrate previously discussed models (IS-LM with the Phillips Curve) to analyze short and medium run economic scenarios.

Short Run Analysis

• IS-LM Model Basics:

  • Equilibrium in the goods market is determined by the IS curve.
  • LM curve is simplified to focus on real interest rates set by the FED.
  • Output is determined by the intersection of IS and real interest rate.

• Phillips Curve:

  • Inflation is influenced by the output gap (difference between actual output and potential output).
  • Short run inflationary pressures arise when output exceeds potential output.

Medium Run Adjustments

• Natural Rate of Interest:
  • Defined as the real interest rate where output equals potential output.
  • The FED adjusts real interest rates to align with this natural rate.
  • Inflationary pressures indicate a real interest rate too low; FED raises rates to adjust.

Inflation Expectations

• Unanchored vs. Anchored Expectations:
  • Unanchored expectations mean current inflation affects future expectations, leading possibly to persistent inflation.
  • Anchored expectations allow for moderate policy adjustments without severe recessions.
  • Central banks aim to maintain credibility to keep expectations anchored.

Monetary Policy Implications

• Short vs. Medium Run:

  • Short run: Monetary policy dictates output and inflation direction.
  • Medium run: Real variables (natural rate of output and interest rate) dominate.
  • Long run neutrality of money implies monetary policy primarily affects nominal variables.

• Central Bank Strategy:

  • Must avoid scenarios where expected inflation becomes unanchored.
  • Should focus on real interest rates to stabilize inflation and output.