B. Medium Run Flashcards
What can the AD relation be summarised as?
Y=Y(m/p, G, T)
What shifts AD?
Any variable, other than P, that shifts either the IS or LM curve
What does the AD-AS model explain?
The business cycle, inflation and unemployment
When can price expectations be wrong?
They can only be wrong in the SR not the MR
What assumption from the IS-LM model is removed when looking at the AD-AS model?
We remove the assumption that prices are fixed
Conditional on price level expectations, when does an equilibrium in the labour market occur?
When real wage implied by wage setting behaviour equals the real wage implied by price setting behaviour
Labour force
Employed workers and those looking for a job
Participation rate
The ratio between labour force and population of working age
Why are wages dependent on the business cycle?
When there is a boom, firms need more workers to produce more output. They have to offer a higher wage to attract more workers so wages are higher in a boom
Types of bargaining
- individual bargaining
- take it or leave it
- collective bargaining
What does bargaining power depend on?
- how costly would it be for firms to replace the worker
- how difficult would it be for the worker to find another job
- market conditions
Why do employers pay wages greater than the reservation wage?
To incentivise workers to put in effort which will increase productivity and reduce turnover costs
What does nominal wage depend on?
Expected price level P^e
Unemployment rate u
A catchall variable z
Why do workers have to make predictions about expected price levels?
They are told their nominal wage for the next 2-3 years (depending on contract) but dont know their real wage unless they work out price levels
What does work hours supplied depend on?
Expected real wage w/P^e
What variables are included in z?
Unemployment benefits
Min wage
Job protection laws and regulations
What do prices depend on?
Costs which is equal to wage
What does the price setting relation show?
Price setting decisions determine the real wage paid by firms
Natural rate of unemployment
The unemployment rate at which price and wage decisions are consistent
What steps are associated with an increase in output causing an increase in price level?
- ^Y causes ^N
- ^N causes lower u
- Lower u causes ^W
- ^w causes ^P
Neutrality of money
In MR the increase in nominal money is reflected entirely in a proportional increase in price level. The increase in nominal money has no effect on output or interest rate
What are the effects on output and price level of a fall in gov spending in SR and MR?
SR fall in price and output
MR fall in price but output is back to original level
How does a price fall affect the IS LM diagram?
A price level decline increases the real money stock so the LM curve shifts outwards
In the SR what effect does a budget deficit reduction have?
Decreases output and may decrease investment
What effect does a budget deficit reduction have in the MR?
Output returns to Yn with higher investment
In the LR what does output depend on?
Capital stock
How does the multiplier in the AD AS model compare to the K cross model?
It is much smaller than in the Kcross model. K cross multipler is 4. AD AS multiplier is 0.6
What is the multiplier in the MR?
Zero
What happens in the AD AS diagram following a supply shock?
AS shifts to SR equilibrium then shifts further to the MR equilibrium
Example of a supply side shock
Sudden increase in oil prices
