Macroeconomics Second Midterm PDF

Macroeconomics Second Midterm Topic 1: Labor Market 1 - A Tour of a Labor Market: ○ A given unemployment rate reflects An active labor market Many separation and hires Many workers entering and exiting unemployment...

Macroeconomics Second Midterm Topic 1: Labor Market 1 - A Tour of a Labor Market: ○ A given unemployment rate reflects An active labor market Many separation and hires Many workers entering and exiting unemployment An slerotic labor market (inactive) Few separations and hires and non active unemployment pool ○ The Current Population Survey (CPS) in the US shows the average monthly flows ○ Separations include quits and payoffs ○ The average duration of unemployment – the length of people time spent unemployed – is 2 months ○ Average flows The flow of workers in and out are large The flows in and out of unemployment are large relative to the number of unemployed There are also large flows in and out of the labor force, much of it directly to and from unemployment ○ Many who are classified as “out of the labor force” are in fact discouraged workers Not actively seeking employment, but will take one if they find it ○ Economists often focus on the employment rate The ratio of employment to the population 2 - Movements in unemployment ○ When unemployment is higher The proportion of unemployed becoming employed within one month is lower A higher proportion of workers become unemployed  ○ When unemp. is high workers are worse of in 2 ways: Employed workers face a higher probability of losing their job Unemployed workers face a lower probability of finding a job, or they can excerpt to remain unemployed for a longer time 3 - Wages Determination ○ Wages are set by collective bargaining A negotiation between unions and firms More than 10% of US wages are set by collective bargaining The higher the skills needed to the job, the more likely there is to be bargaining between employers and individual employees ○ Workers are typically paid a wage exceeding their reservation wage Reservation wage: the wage that would make them indifferent between working or being unemployed ○ Wages Typically depends on labor-market conditions: The lower the unemployment rate, the higher the wages ○ Worker’s bargaining power depends: How costly it is for the firm to find other workers How hard for workers it is to find another job if they were to leave the firm ○ Turnover Rate: Refers to the rate in which employees voluntarily leave a company and are replaced by new hires ○ Layoff Rates: Signify the frequency with which employees are involuntarily separated from their employers ○ Efficiency wage theories: Link the productivity of the efficiency of workers to the wage they are paid Firms may pay a wage above the reservation wage in order to decrease workers turnover and increase productivity Firms that see employee morale and commitment as essential to the quality of workers work will pay more than those whose activities are routine  When unemployment is low, firms that want to avoid an increase in quits and will increase wages to induce workers to stay with the firms ○ Aggregate nominal wage ‘W’ depends on: the expected price level: ‘Pe’ The unemployment rate: ‘u’ Catch-all variable: ‘z’ ○ Both workers and firms care about real wages (W/P), not nominal wages Nominal wages: depends on the expected price level (rather than actual price level) Because when nominal wages are set, the relevant price levels are not yet known ○ Cause and Effect: An increase in unemployment. rate decreases wages Higher unemployment. rate either weakens workers bargaining power or allows firms to pay lower wages and still keep workers willing to work ‘z’ stand for all the factors that affect wages given the expected price level and unemployment rate, for example: unemployment rate insurance: as the payment of unemployment benefits to workers who lose their jobs employment protection: makes it more expensive for firms to lay off workers 4 - Price Determination: ○ Prices set by firms depends on their costs, which in turn depends on the nature of the production function ○ Y → output N → employment A → labor productivity (output per worker) ○ The production function is the relation: Between the inputs used in production The quantity of output produced  The prices of these inputs ○ Assume that A is constant and ‘A = 1’, then: Output = Employment This implies that the cost of producing one more unit of output is the cost of employing one more worker at ‘W’ The marginal cost of production is equal to ‘W’ Now assume firms set their price according to a markup ‘m’ over the cost so that: 5 - The Natural Rate of Unemployment ○ Assume that W depends on the actual price level (P) rather than the expected price level (Pe), equation now becomes: The higher the unemployment rate the lower the real wage chosen by wage setters The wage setting relation The relation between the real wage and the rate of unemployment ○ Price setting decisions determine the real wage paid by firms: ○ Divide both sides of the price determination equation by the nominal wage ○ This showcases the, I |implied real wage or the price-setting relation Real wage = 1/1+ markup ○ The equilibrium unemployment rate ‘Un’ can be derived by eliminating ‘W/P’ between equations:  ‘Un’ depends on ‘z’ and ‘m’ ‘Un’ is also called the natural rate of unemployment or the structural rate of unemployment ○ Wages, Prices and the Natural Rate of Unemployment ○ The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting  5.1 - Movements and Shifts: ○ Shift in the Wage Setting Curve (WS) An increase in unemployment benefits leads to an increase in the natural rate of unemployment (SHIFT RIGHT) A decrease in the unemployment benefits leads to a decrease in the natural rate of unemployment (SHIFT LEFT) ○ Shifts in the Price Setting Curve (PS) An increase in the markups leads to an increase in the natural rate in unemployment A decrease in the markups leads to a decrease in the natural rate of unemployment Interpretations: ○ We have assumed that the price level is equal to the expected price level  ○ In the short run, the price level may well turn out to be different from what is expected when nominal wages are set, so that unemployment is not necessarily equal to the natural rate or output equal to its natural level ○ Because expectations are unlikely to be systematically wrong, in the medium run, it tends to return to its natural level ○ Price level is equal to the expected price level 6 - Wage and Price setting relations versus Labor Supply and Labor Demand: ○ Wage and Price Setting and the Natural Level of Employment ○ Description: The wage setting relationship is now upward sloping: Higher employment implies a higher real wage The price-setting relation is still a horizontal line The equilibrium is given by point A, with “natural” employment ‘Nn’ The price setting relation looks like a flat labor-demand relation Topic 2: AS-AD Model 1 - Aggregate Supply: ○ AS: Captures the implications of equilibrium in the labor market Captures the effects of output on the price level It’s derived from the behavior of wages and prices Equation for wage determination: Equation for price determination Replacing the nominal wage in the second equation above by its expression from the first gives: The second step is to replace the unemployment rate, ‘u’, with its expression in terms of output For a given labor force, the higher the output, the lower the unemployment rate ○ Aggregate Supply relation or AS Relation ○ It’s the relation showing the trade-off between inflation and unemployment ○ AS Relation Properties: First property : An increase in outputs leads to an increase in the price level An increase in output leads to an increase in employment The increase in employment leads to a decrease in the unemployment and unemployment rate The lower the unemployment rate leads to an increase in the nominal wage The increase in the nominal wage leads to an increase in the prices set by firms and therefore to an increase in the price level Second property: An increase in the expected price leads one-for-one, to an increase in the actual price level. This effect works through wages: ○ If wage setters (companies) expect the price level to be higher, they set a higher nominal wage ○ The increase in the nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level ○ Aggregate Supply (AS) Curve: Upwards sloping and goes though the point where: Y=Yn and P= Pe  An increase in output ‘Y’ leads to an increase in the price level The aggregate supply curve goes through point ‘A’ where: Y = Yn → P = Pe When output, Y, is equal to the natural level of output, Yn, the price level, P, turns out to be exactly equal to the expected price level, Pe When output is above the natural level of output, the price level is higher than expected → Conversely, when output is below the natural level of output, the price level is lower than expected ○ Shifts and Movements: An increase in the expected price level PE, shifts the aggregate supply curve up A decrease in the expected price level shifts the AS curve down ○ The Effect of an Increase in the Expected price level on the Aggregate Supply Curve: 2 - Aggregate Demand: ○ Captures the implications of equilibrium in both the goods market and financial markets Captures the effect of the price level on output It is derived from the equilibrium conditions in the goods and financial markets  We will assume that consumption(C) also depends on real wealth ‘WE’ is nominal wealth (the nominal value of all the assets owned by households). The higher the real wealth (WE), the higher will consumption (C) will be ○ Equilibrium Condition in the Goods Market: Note that an increase in ‘P’ will lead to a decrease in output ‘Y’, using ‘IS-LM’ model ○ Relationship between price level and output. An increase in price level will reduce real wealth, consumption, this leading to a reduced output  The negative slope of the AD curve is additionally justified for an open economy, where and increase in ‘P’ leads to reduced net exports ○ AD Curve Movements and Shifts Any other variable other than the price level that shift either the IS or LM curve also shifts the aggregate demand relationship ○ The AD relation can be represented with this equation: ‘W/E’ justifies the negative slope of the AD relation and i, G and T are the monetary and fiscal policy variables. a change in any of them will shift the AD relation 3 - Aggregate Supply and Aggregate Demand merged: ○ AS Relation equation: ○ AD Relation equation:  For a given value of the expected price level, ‘Pe’ (which enter the aggregate supply relation), and for given values of the monetary and fiscal policy variables: i, G and T (which enter the aggregate demand relation), these two relations determine the equilibrium value of output, Y, and the price level, P The maximum quantity that a economy can produce, all else equal is called: potential GDP ○ Equilibrium in the Short Run The aggregate supply curve, AS, is drawn for a given value of ‘Pe’ The position of the curve depends in ‘Pe’ The AS curve goes through point ‘B’: If Y = Yn, and therefore, P = Pe ○ Equilibrium in the Medium Run At point A, output exceeds the natural level of output Hence, the price is higher than the expected price The fact the price level is higher than wage setters expected is likely to lead them to revise upward their expectation, ‘Pe’ ○ Conclusion:  4 - Effects on the AS-AD Model ○ Monetary Expansion: For a given price level, the monetary expansion reduces i (interest rates), leading to an increase in I (investment) and Y (output): shift from AD to AD’ As output is higher than the natural level of output (Yn), the price level is higher than wage setters expected (P>Pe). This causes the aggregate supply to shift up over time (AS´´) The economy moves up along the AD’ curve. It stops moving when the expected price meets again the natural level of output. In A´´→ pe´´= Yn Summary of impacts Short run: (P) and (Y) → INCREASE Medium run: (P) increase again and (Y) remains equal Medium term composition of demand: (C) decreases, (I) increases, (G) remains equal ○ (C) decreases are prices are now higher and people feel less wealthy, (I) increases as  interest rates are low due to the monetary expansion, and (G) remains unchanged ○ Decrease in Budget Deficit For a given price level, the fiscal contractionary policy reduced G or increases T, leading to an decrease in Y: a shift from AD to AD´ As output is lower than the natural level of output, the price level is lower than waggers setters expected. Pe>P. This causes the aggregate supply curve to shift over time The economy moves down along the aggregate demand curve, AD’. The process stops when output has returned to the natural level of output. A´´→ pe´´= Yn Summary of impacts Short term: Price (P) and output (Y) decrease Medium term: (P) decreases again and Output (Y) remains equal Medium term composition of demand ○ Through (G) Gov. Spending: (C) increases, (I) remains unchanged, (G) decreases ○ Through (T) Taxes: (C), (I), (G) remains unchanged ○ Changes in Price of Oil Real Oil Prices in the Economy Large increases in the price of oil have been related with high inflation and recession: stagflation Change of Markups Effect An increase in the markup leads to an increase in the natural rate of unemployment A decrease in the markup leads to a decrease in the natural rate of unemployment An increase in the natural rate of unemployment (scenario above) leads to a decrease in the natural output For the adjustment dynamics, recall the AS relation:  The Dynamic Effect of an Increase in the Price of Oil Summary of impacts: ○ Short term: (P) increases, (Y) decreases ○ Medium term: (P) continues to increase, (Y) decreases again ○ Medium term composition of demand: (C) decreases, (I) decreases, (G) remains I decreases because we have now assumed that I also depends on Y Topic 3: Economy in the Long Run 1 - The Facts of Growth ○ Growth: A steady increase in aggregate output over time ○ Measuring the Standard of Living Growth ties directly with standards of living Output per person, instead of output, is the variable we compare over time across countries We need to correct for variations in exchange rates and systematic differences in prices across countries We use purchasing power (PPP) numbers which adjust the numbers for the purchasing power of different countries The right measure on the production side is output per worker or output per hour worked ○ Construction of Purchasing Power (PPP) Ask professor about the slide examples ○ Easterlin Paradox: Once basic needs are satisfied, higher income per person does not increase happiness, and the level of income  relative to others, rather than the absolute level of income, matters 20.2 Growth in Rich Countries since 1950 The convergence of levels of output can be extended to the set of OECD countries. However, this approach only looks at the club of economic winners. ➔ There has been a large increase in output per person ➔ There has been a convergence of output per person across countries ➔ Countries with lower levels of output per person in 1950 have typically grown faster 2 - Thinking about Growth ○ Aggregate Production Function, F: Y=Output K=Capital N=Labor The function ‘F’ depends on the state of technology Constant return to scale: Decreasing returns to capital: Increases in capital lead to smaller and smaller increase in output  Decreasing return to labor: Increases in labor lead to smaller and smaller increases in output ○ Prod. Function and Returns to scale: Implies a simple relation between output per worker (Y/N), and capital per worker (K/N) Increases in capital per worker: Movements along the production function Improvements in the state of technology: Shifts (up) of the production function Growth comes from capital accumulation (a higher saving rate) and technological progress (the improvement in the state of technology) ○ Output and Capital per Worker: Decreasing returns to capital Increase in capital per worker lead to smaller and smaller increases in output per worker ○ The Effects of an improvement in the State of Technology Improvement in technology shifts the production function up, leading to an increase in output per worker for a given level of capital worker  3 - Openness in Goods and Financial Markets ○ Openness in Goods Markets: The ability of consumers and firms to choose between domestic goods and foreign goods. Even countries most committed to free trade have tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods than can be imported) ○ Openness in the Financial markets The ability of financial investors to choose between domestic assets and foreign assets – until recently, even some rich countries had capital controls – restrictions on foreign assets their domestic residents could hold and the domestic assets foreign could hold ○ Openness in Factor markets: The ability of firms to choose where to locate production and of workers to choose where to work. The American Free Trade Agreement (NAFTA)- Mexico, US, Canada The European-Union ‘s Single Market (1993), is a market in which the free movement of goods, services, capital and persons is assured ○ Openness In Good Markets Volume of trade IS NOT a good measure of openness Tradable goods: Goods that compete with foreign goods in either domestic markets for foreign markets Tradable goods represent 60% of aggregate output in the USA Real exchange rate: The prices of domestic goods relative to foreign goods Nominal exchange rate: The price of domestic currency in terms of foreign currency Nominal appreciation: An increase in the price of the domestic currency in terms of foreign currency Example: An increase in the exchange rate  Nominal depreciation: A decrease in the price of the domestic currency in terms of foreign currency Example: Decrease in the exchange rate Fixed exchange rates: A system in which two or more countries maintain a constant exchange rate between their currencies In fixed exchange rate system, revaluations are increases in the exchange rate, and devaluations are decreases in the exchange rate Real appreciation: An increase in the real exchange rate An increase in the relative price of domestic goods in terms of foreign goods Real depreciation: A decrease in the real exchange rate A decrease in the relative price of domestic goods in terms of foreign goods Bilateral exchange rates: Two countries Multilateral exchange rates: 2+ countries ○ Openness in Financial Markets Foreign exchange: Buying and selling currencies Balance of payments: A set of accounts that summarize a country's transactions with the rest of the world Current account: Transactions above the line record payments to and from the rest of the world Export and imports of goods and services (trade balance) Net income balance between income received from the rest of the world and income paid foreigners Net transfer received - the difference in foreign aid given and received Current account balance: The sum of net payments to and from the rest of the world Current account surplus: Positive net payments from the rest of the world Current account deficit: Negative net payments from the rest of the world Financial Account: Transaction below the line record net foreign holdings of domestic assets  Net capital flows of financial accounts balance: An increase in net foreign indebtness Holdings of domestic assets - the increase in domestic holdings of foreigners assets Financial account surplus: Positive net capital flows Financial account deficit: Negative net capital flows Statistical discrepancy: Difference between current and capital account transactions Example Assume three consecutive transactions: ○ A US firm imports a European car for USD 50,000 EUR to the European firm (assume E = 1) ○ The European firm buys USD 50,000 ○ The European firm buys US bonds for USD 50,000 ^USHFA = Change in US Holdings of Foreign Assets ^FHUSA = Change in Foreign Holdings of US Assets Gross National Product (GNP) Measures the value added by domestic factors of production ○ Here ‘NI’ denotes net income – payments received from the rest of the world less income paid to the rest of the world  Expected Returns Holding 1-Year US Bonds vs. 1-Year UK Bonds. Arbitrage implies that: Which is called the uncovered interest parity relation or the interest parity relation The assumption that financial investors hold only the bonds with the highest expected rate of return ignores transactions costs and risks The previous equation implies that: which gives a good approximation of the interest parity condition Arbitrage by investors implies that the domestic interest rate must be equal to the foreign interest rate minus the expected appreciation rate of the domestic currency The equation above, can also be state as the condition that the domestic interest rate must be equal to the foreign interest rate minus the expected depreciation of the foreign currency  ○ Conclusions of Openness in Goods and Financial Markets: Openness in Goods Markets: Allows people and firms to choose between domestic and foreign goods The choice depends primarily on the real exchange rate Openness in Financial Markets: Allows investors to choose between domestic and foreign assets This choice depends primarily on their relative rates of return, and on the expected rate of appreciation of the domestic currency ○ Consequence of Openness: Saving, Investment and the Investment and the Current Account Balance Income of domestic residents in an open economy Denote the current account by CA, the above equations becomes: Current balance account = saving - investment An increase in investment must be reflected either in an increase in private saving or public saving or in a deterioration of the current account balance. A deterioration in the government budget balance must be reflected in an increase in either private savings, or in a decrease investment, or else in a deterioration if the current account balance A country with high savings rate must have either a high investment rate or a large current account surplus 4 - Consequences for the AD-AS Model ○ AD relation looks like this ○ Consequences The AD curve of an open economy is flatter.The multiplier effect is smaller in an open economy An increase in domestic demand increases output, but reduces NX An increase in foreign demand increase output and NX ○ The effect of a decrease in the budget deficit Medium term composition of demand: If consolidation is done through Government Spending: (C) increases, (I) remains unchanged, (G) decreases, (NX) increases If consolidation is done through Taxes: (C) decreases, (I) and (G) remain unchanged, and (NX) increases NX increase because of the reduction of P ○ The effect of an increase in foreign prices  Medium term composition of demand: (C) decreases, (I) and (G) remain unchanged, and (NX) increase NX increases because of the real depreciation of our currency caused by a higher P*, partially compensated by a higher P ○ The effect of a decrease in the interest rate Medium term composition of demand: (C) decreases, (I) increases, (G) remains unchanged, and (NX) ?? NX increases initially because the lower interest rates depreciates the currency, but the increase in ‘P’ more than compensate ○ The effect of a decrease in the foreign interest rate under a fixed-exchange rate regime Medium term composition of demand: (C) decreases, (I) increases (G) remain unchanged, and (NX) ?? - the increase in P may be compensated by an increase in P* Under a fixed exchange rate regime there is no autonomous monetary policy if ‘i*’ decreases then ‘i’ decreases as well