7- Aggregate demand and the labour market

Question 1

When considering Aggregate Demand, in what 3 main ways does the IS relationship differ from normal?

Answer 1

• We use the real interest rate instead of the nominal
• We assume a relationship between the log of output and the interest rate
• We add a demand shock ε^d

Question 2

How do we denote the equilibrium level of output and interest rates?

Answer 2

Using a star: Y, r

Question 3

What is the log expression for the output gap?

Answer 3

ŷ = log(Y) - log(Y*)

Question 4

How do we denote the log price level (log(P_t))?

Answer 4

With a lowercase p instead: p_t

Question 5

In what 2 main conditions does the Taylor rule state that policymakers raise the interest rate?

Answer 5

• If inflation is too high (π > π^T)

- If output is too high: (ŷ > 0)

Question 6

What are the 3 stages of analysing Aggregate Supply (AS)?

Answer 6

• We analyse the labour market, considering labour supply & demand in competitive and non-competitive labour markets
• We show how flexible wages and prices lead to a vertical AS curve
• We then show how sticky prices lead to an AS curve that slopes up in the short run

Question 7

What happens when the real wage is greater than the equilibrium real wage (w>w*)?

Answer 7

Unemployed workers would be willing to work for a lower real wage than that currently paid, so the real wage falls to w*

Question 8

What happens when the real wage rate is less than the equilibrium real wage (w

Answer 8

Firms would be willing to pay a higher real wage than that currently paid, so the real wage rises to w*

Question 9

What are the 3 criteria points for someone to be classified as unemployed?

Answer 9

• Do not have a job
• Have been actively looking for work in the past 4 weeks
• Are available to start work in the next 2 weeks

Question 10

What is the main feature of a competitive labour market?

Answer 10

All workers who wish to work can get jobs

Question 11

How is involuntary unemployment explained?

Answer 11

In an imperfectly competitive labour market, the wage may be above the competitive wage in which case supply will exceed labour demand. So we can explain involuntary unemployment if the wage is above the competitive wage

Question 12

What are 3 main causes for the wage to be above the competitive rate and thus cause involuntary unemployment?

Answer 12

• There is bargaining over the wage between employers and a trade union
• A legal requirement, for example a minimum wage
• The firm may choose to offer a higher wage, in order to increase effort or to reduce labour turnover

Question 13

Describe the monopoly union model of wage bargaining

Answer 13

Workers set the real wage, firms set employment

Question 14

How does the union maximise its utility in the monopoly union model?

Answer 14

They maximise their utility subject to the labour demand curve by choosing the wage at the point where there is tangency between the labour demand curve and the union indifference curve

Question 15

Where is the inflation target (π^T) on the aggregate demand graph?

Answer 15

The inflation target is where the aggregate demand curve intersects the y-axis

Question 16

What process just gives you the relationship between Labour demand and wages?

Answer 16

Find the MPL by differentiating the production function (dY/dL) and equate it to w