Chapters 7-10 Flashcards
Duration of unemployment
The average length of time people spend unemployed
The average duration of unemployment equals?
The inverse of the or proportion of people leaving unemployment each month
Long term unemployment
Generally considered 12months or more unemployed
Collective bargining
The process of wage determination whereby firms and unions bargin
What are the two determinants of bargaining power?
How costly it would be to replace the worker were they to leave. and How easy it would be for the worker to find their next job. If it is costly to replace the worker and they can find their next job more easily then the worker will have more bargaining power.
The nature of the bargaining power is also determined by what?
The nature of the job. If there is a low skill set required the worker is more easily replaceable.
Labour market conditions. If there is high unemployment the firm will have an easier time finding a replacement
Efficiency wages theories
The idea that if an employer pays more than the worker’s reservation wage then they are going to be more productive and feel good about their job. Also means they are more likely to remain rather than leave
What does the aggregate nominal wage depend upon?
The expected price level Pe, The unemployment rate and a ‘catchall’ variable that stands for all other things which might affect wage setting
Why does the price level effect nominal wages?
Because workers are more concerned with how much goods they can buy with their money. Similarly firms are more concerned with how much the pay relative to the goods they sell.. Both are concerned with W/P
What is the effect of an increase in the unemployment rate?
Wages decrease
What is a factor which would be encompassed in the ‘Catchall’ variable?
Unemployment insurance - payment of benefits to those who lose their jobs
What is the marginal cost of production?
the cost of producing one more unit of output. Which in the simplification of the production function (which is Y=N) is equal to W
What is the equation for the determination of prices?
P = (1+μ)W where μ is the mark up (if there was perfect competition in the goods market μ =0)
What would be the price if the market had perfect competition?
W
What determines μ?
The product market relation. It has a positive relation
What is the wage setting relation and what does it say?
W/P = F(u,z)
it also implies a negative relation between the real wage and the unemployment
What is price setting relation?
Derived from divide the price determination equation by W
Gives ratio of the price level to the real wage implied by the price-setting behaviour. We invert this to get it in terms of the real wage.
What does this equation say? W/P = 1/1+μ
price-setting decisions determine the real wage paid paid by firms. An increase in mark up would mean the firm would increase their prices and subsequently the real wage would decrease
How do graphically illustrate the price and wage setting relations?
Unemployment on the x axis, real wage on the y.
WS is a downward sloping curve
PS is a horizontal line cutting the y axis at 1/1+μ
What is the equilibrium in the labour market?
Requires that the real wage in the wage setting relation be equal to that of the real wage in the price setting relation.
F(u,z)=1/1+μ
What is the natural rate of unemployment?
The level of unemployment where the WS and PS curves intersect
What would an increase in z (i.e. unemployment benefits) cause?
Unemployment becomes less ‘painful’, increases the wages set, real wage increases, the natural rate of unemployment increases. The WS curve shifts upwards
What would an increase in μ cause?
The mark up means that firms increase the prices of their goods and thus the real wage decreases and un increases.
What is the natural level of employment?
Derived from u=U/L it is given by Nn=L(1-un)
What is the natural level of output?
it is the level of production when employment is equal to the natural level of employment.
F(1-Yn/L,z) = 1/1+μ
What is the aggregate supply relation?
Captures the effects of output on the price level and can be written as:
P=Pe(1+μ)F(1-Y/L,z)
What is the first property of the AS relation?
An increase in output leads to an increase in th price level
- increase in output leads to an increase in employment
- increase in emp leads to a decrease in unemp and therefore unemp rate
- lower unemp rate leads to a higher nominal wage
- increase in nominal wage leads to an increase in prices set by the firm
What is the second property of the AS relation?
An increase in the expected price level leads to a one for one increase in the actual price level
What does the AS curve look like and why?
It is upward sloping. Increase in output leads to an increase in the price level
What is the significance of when Y=Yn?
When this is the case P=Pe
What happens when output is above the the natural level of output?
The price level is higher than expected
What happens when there is an increase in the expected price level Pe?
The AS curve shifts upwards. The increase also leads to an increase in wages which in turn leads to an increase in prices so the price level is higher.
What is the aggregate demand relation?
Captures the effect of the price level on output and is derived from the equilibrium conditions in goods and financial markets
How is the AD curve formed?
For given values of G and T . increase in interest rate leads to a decrease in output. Whereby the LM curve intersects the IS curve
What does the aggregate demand relation show?
The negative relation between price level and output
What will cause the AD curve to shift?
Anything other than price level which will cause the IS or LM curve to shift
What will an increase in government spending cause the AD curve to do?
Shift to the right
What is the short run equilibrium for AS and AD?
When the two curves intersect. The AS curve will pass through the value of Pe
What happens in the medium run in terms of AS and AD?
The AS curve will shift and so the economy will return to the equilibrium output
What happens when there is monetary expansion?
In the short run output will exceed natural output. In the medium run the price level then increases bring the markets back into equilibrium. This is explained by an initial decrease in interest rates and the output increasing as the LM curve shifts down but as the price level adjusts the LM curve moves upwards
What is the effect of monetary policy in the short run?
Output increases, Price level increase and interest rates decrease
What is the effect of a decrease in government spending (to decrease the budget deficit)?
Shifts the AD curve leftwards and then over time the AS curve moves along the AD curve to return to natural output.
What are the general effects of decreasing government spending?
Interest rate will decrease, output will initially decrease and price level will decrese
In the medium run what does the budget deficit lead to?
A decrease in interest rate and an increase in investment
Short run effect of monetary expansion
Output: Increase
Interest rate: Decrease
Price level: Increase( small)
Short run effect of Deficit reduction
Output: Decrease
Interest rate: Decrease
Price level: Decrease (small)
Short run effect of increase in oil price
Output: Decrease
Interest rate: Increase
Price level: Increase
Medium run effect of monetary expansion
Output: No Change
Interest rate: No change
Price level: Increase
Medium run effect of deficit reduction
Output: No Change
Interest rate: Decrease
Price level: Decrease
Medium run effect of an increase in oil price
Output: Decrease
Interest rate: Increase
Price level: Increase
Where is the equation for inflation derived from?
The aggregate supply relation
The equation for inflation
π=πe+(μ+z)-αμ
What is the effect on actual inflation when expected inflation increases?
It increases
Given expected inflation, what is the effect of an increase in a variable which affects wage determination?
an increase in inflation
Given expected inflation, what is the effect of an increase in the unemployment rate?
Decrease in inflation
Wage-price spiral
mechanism whereby a higher nominal wage leads to firms increasing their prices and price level increases. Subsequently workers ask for a higher nominal wage etc….. low unemployment leads to a higher nominal wage
Early incarnation of the Phillips curve
π=(μ+z)-αut
Modified Phillips Curve
πt-πt-1=(μ+z)-αut
What is the basic idea of the modified phillips curve?
Unemployment rate affects not the inflation rate but rather the change in the rate of inflation
What is the other relation for thinking about the phillips curve?
πt-πt-1= -α(ut-un)
If ut<un what is the effect on inflation?
πt>πt-1
If ut>un what is the effect on inflation?
πt<πt-1
NAIRU
Non-accelerating inflation rate of unemployment
Wage indexation
Provision that automatically increases wages in line with inflation.
What is the equation for inflation when wage-indexation is incorporated?
πt=[λπt+(1-λ)πe]-α(ut-un)
λ being proportion of contracts that are indexed
What effect does wage indexation have?
Increases the effect of unemployment on inflation. The more contracts that are indexed the greater the effect of unemployment on inflation
What is the relation between output growth and changes in unemployment
Okun’s Law
The Phillips curve relation
The relation between unemployment, inflation and expected inflation
If gyt>gy then…
ut<ut-1
If gyt<gy then…
ut>ut-1
If gyt=gy then….
ut=ut-1
What is Okun’s law?
ut-ut-1= -β(ggt-gy)
the aggregate demand relation (re-written)
gyt=gmt-πt
What does okun’s law imply in the medium run?
As unemployment rate must be constant it implies gy=gm-π
Therefore in the medium run inflation must be equal to the nominal money growth minus nominal output growth
What is the rate of unemployment in the medium run?
The natural rate of unemployment
In the medium run what is the nominal interest rate equal to?
the natural real interest rate plus the rate of money growth. an increase in the money growth therefore leads to an increase in the nominal interest rate.
Fisher effect
In the medium run nominal interest rate increases one-for-one with inflation
What does tighter monetary policy lead to?
Lower output growth and lower inflation.
deflation
decrease in the price level
disinflation
decrease in the rate of inflation
How can disinflation be obtained?
at the cost of higher unemployment.This can be visualised by looking at the phillips relation
Point year of excess inflation
the difference between the actual and and the natural unemployment rates of 1 percentage point per year..
example if un=6% an unemployment rate of 8% for four years in a row corresponds to 8point years of excess unemployment
the sacrifice ratio
the number of point-years of excess unemployment needed to achieve a decrease in inflation of 1%
SR= point year of excess unemployment/decrease in inflation
The Lucas critique
If people believe that inflation is going to be lower in the future then they will lower their expectation accordingly without having to necessarily increase unemployment above the natural level
nominal rigidities
The fact that in modern economies many wages and prices are set in nominal terms for some time and are typically not readjusted when there is a change in policy
