Here you should not spend time explaining the model if no explanations are asked. However, you should explain the economic mechanisms in all the sub-questions.

We have the following 4 relationships that make up the product market in the IS-RR-PK model:
(9.1) Y = C + I + G
(9.2) C = zC + c1 (Y –T) –c2 (i -) 0 ˂c1˂1c2˃0
(9.3) I = zI + b1Y –b2 (i -) 0 ˂b1˂1b2˃0
(9.4) T = zT + tY0 ˂t ˂1

We insert (9.2), (9.3) and (9.4) into (9.1) and find the equilibrium value for Y:

(9.5) Y = 1/ 1 − c*1 (1 − ) −*1 (z^C – c*1z^T – c*2 (i -^) + z^I – b^2 (i -^) + G)


a) Give a brief explanation of what the IS curve shows, and why it has a negative slope in a figure where you have nominal interest rate (i) on the vertical axis and GDP (Y) on the horizontal axis.

The above model also has a Phillips curve that explains the relationship between inflation and the GDP gap.

(9.8) = ^ + β ( − ^/ ^) + z β ˃ 0

b) Suppose that i.a. the power price increases, which in this model can be analyzed as Δz> 0.

Draw a figure with the IS curve as in a), and a figure with the PK curve where you have inflation (π) on the vertical axis and GDP (Y) on the horizontal axis. Show what happens in the two figures as a result of the above cost shock (inflation shock).

We now imagine that Norges Bank sets the interest rate following the interest rate rule: (9.10) i = zi+ d1(π–π*) + d*2(−^/^) d*1˃0 d*2˃0

c) Now draw the IS and RR curve in the same figure and a separate figure with the PK curve, and show the effects on GDP (Y), inflation (π) and the nominal interest rate (i) of the cost shock mentioned above.