TERM 1: Sudden stops & Unemployment Flashcards by Ella Grant

What is a sudden stop?

A country with a CA<0 relies on lots of capital inflows (so BOP=0). At some point investors may worry about the risk of non-payment = suddenly stop investing. Very fast CA reversal: CA > 0.

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What is a currency union?

Fixed ER system - cannot devalue currency

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Claim about sudden stops and floating ER economies

Sudden stop –> big devaluation in the currency –> RER depreciates (e rises). No unemployment.

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Claim about sudden stops and fixed ER economies

Sudden stop –> very little RER depreciates (e rises). Huge unemployment.

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Why is RER depreciation useful in a crisis?

Allows firms to maintain international competitiveness despite nominal wage rigidity.

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Real wage formula (for this topic)

Real wage = nominal wage / nominal ER

Real wage = Wt/St

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Why are nominal wages downwards rigid?

Workers resist wage cuts even in a crisis due to wage contracts and unions.

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Formula for nominal wage rigidity

Wt >= gamma Wt-1

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In a currency union, can real wage be reduced?

NO - nominal wages fixed, nominal ER fixed = no scope for real wage depreciation to adjust to sudden stop

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Great depression facts about employment and wages

31% fall in employment 1929-1931
But only 0.6% fall in nominal wages
Real wages actually rose 26% 1933 vs 1929

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What allowed some European countries to recover faster following the Great Depression?

The Sterling Bloc (UK, Norway etc) recovered faster as they left the Gold Standard earlier than the Gold Bloc (France, Belgium, Netherlands). Meant less real wage growth = larger increases in production.

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What allowed Argentina to recover following sudden stop in 1998?

In 2002, devalued currency from 1-1 rate against the dollar to 1-3. Real wage depreciation, unemployment fell.

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2 margins to reduce labour costs following a sudden stop

Intensive margin - cut nominal wages of existing workers

2. extensive margin - labour shedding –> unemployment

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The Slackness Condition formula

(h bar - ht)(Wt - gamma Wt-1)

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What is gamma? The nominal wage rigidity measure

Gamma = approx. 1

i.e. nominal wages today have to be at least as high as yesterday - can never decrease = downwards rigid.

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Model 4 specifications

2 periods
small open economy
Free K mobility
2 goods: traded and non-traded

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LOOP holds for which good?

Traded goods only: PtT = St Pt*

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What do we assume about the foreign price level + implications

We normalise P*=1
Therefore LOOP for traded goods means:
PtT = St - price of traded goods in domestic economy = nominal ER

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What is little pt? What else does it measure?

pt = PtN/PtT - relative price of non-tradables in terms of traded goods = also the REAL EXCHANGE RATE (RER)

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Traded vs nontraded goods in terms of production

Traded goods = endowed (PtT Yt)

Non-traded goods = must be produced

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HH preferences

U(C1T, C1N) + U(C2T, C2N)

HH P1 BC in terms of tradables

C1T + p1 C1N + B1* = Y1 + (1+r0)B0*

HH P2 BC in terms of tradables

C2T + p2 C2N = Y2 + (1+r1)B1*

P1 vs P2 in terms of households and bonds

P1: purchase bonds
P2: get returns on bonds

What do we assume about B0*?

That B0*=0 - HH have no initial assets.

PV BC for HH

C1T + p1C1N + (C2T + p2C2N)/(1+r1) = Y1 + Y2/(1+r1)

FOC for period 1

U2(C1T, C1N) / U1(C1T, C1N) = p1 | MRS between period 1 traded & non-traded goods = their relative price

Interpret/explain this FOC

Suppose HH have 1 unit traded goods in P1. Can consume: MU = U1(C1T, C1N) Or sell & buy 1/p1 then consume non-traded good: MU = U2(C1T, C1N)/p1. At the optimum, these MUs are equal hence our FOC.

How do we interpret this FOC?

As the demand function for non-tradables as a fucntion of the relative price/RER for a given level of C1T.

Why is the demand function for non-tradables downwards sloping?

As p1 falls, non-tradables become cheaper relative to tradables = demand rises.

How does a change in C1T affect the demand curve for C1N?

If C1T falls, the demand schedule for non-tradables shifts left = C1N also falls.

How do we interpret a sudden stop for our analysis?

Sudden stop = increase in world IR r1

How does a rise in r1 affect the demand for tradables and thus non-tradables?

We assume rise in r1 --> fall in demand for C1T via income and substitution effects. If C1T falls, demand schedule for tradables shifts left = C1N falls too.

2 assumptions about production side of non-tradables

1. perfectly competitive firms | 2. labour is the only input

Production function for non-tradables and 2 properties

Q1N = F(ht) F' > 0 F''<0 - concave, diminishing MPL

Profit function in non-traded sector in terms of traded goods

Pi = ptF(ht) - (Wt/St)ht | Remember St=PtT by LOOP and Pt*=1

FOC for optimal labour demand

pt F'(ht) = Wt/St - MRPL = MCL in real terms pt = (Wt/St) / F'(ht) relative price = real wage / MPL

How do we also interpret the demand for labour condition? How come?

As the supply curve of non-traded goods. Since QtN is a monotonically increasing function of ht. More hours worked --> more supply of the good.

Why is the supply of non-traded goods upwards sloping?

Higher p = higher relative price of non-traded goods = higher MRPL, but doesn't affect MCL = firms hire more workers = production increases.

How does a change in real wage affect supply curve?

If nominal wage W1 falls or the nominal ER S1 rises i.e. currency depreciation, then supply curve shifts down and to the right.

What do we assume about production?

That it is demand driven: firms pick (ht, pt) so that at that price, households demand all that is supplied. Thus CtN = QtN = F(ht)

Info about labour supply

Workers supply h bar inelastically, but may not be able to sell them all. They take ht<=h bar as given.

Impact of rise in r1 on market for tradables in a frictionless model.

Demand shifts left. In order to keep h=h bar but reduce costs given lower demand, need p1 to fall by reducing W1 or increasing S1 (devalue currency) = supply shifts right = crosses new demand at h bar. Results = no unemployment, large RER depreciation.

2 types of frictions

1. labour market friction Wt>=Wt-1 | 2. Institutional frictions in a currency union: St=S bar

Impact of rise in r1 on market for tradables in a model with friction.

Demand shifts left. Cannot reduce real wage, so only way to cut costs is fire workers, therefore supply contracts. Results = huge unemployment, small RER depreciation.

Name 4 policies to avoid creating unemployment in a sudden stop

1. Devalue currency 2. Labour market reforms to reduce rigidities 3. Monetary authority create inflation (means real wage falls) 4. Impose wage subsidies

What are wage subsidies?

Gov pay a fraction of firms' wage bills to reduce costs without h

New optimal labour hiring FOC with wage subsidies / supply schedule

pt=[(1-tow)(Wt/St)]/F'(ht)

When would the gov increase wage subsidies? What would the effect be?

At FE, no wage subsidies needed. After sudden stop following demand shock, increase tow = supply curve shifts right = crosses new demand at h bar = no unemployment caused.

Formula for the exact wage subsidy needed given demand and supply conditions

(1-tow1) = F'(hbar) x U2(C1T, F(hbar))/U1(C1T, F(hbar)) x S1/W1