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EC201 - MACRO TERM 1 > TERM 1: Sudden stops & Unemployment > Flashcards

TERM 1: Sudden stops & Unemployment Flashcards

1
Q

What is a sudden stop?

A

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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2
Q

What is a currency union?

A

Fixed ER system - cannot devalue currency

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3
Q

Claim about sudden stops and floating ER economies

A

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

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4
Q

Claim about sudden stops and fixed ER economies

A

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

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5
Q

Why is RER depreciation useful in a crisis?

A

Allows firms to maintain international competitiveness despite nominal wage rigidity.

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6
Q

Real wage formula (for this topic)

A

Real wage = nominal wage / nominal ER

Real wage = Wt/St

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7
Q

Why are nominal wages downwards rigid?

A

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

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8
Q

Formula for nominal wage rigidity

A

Wt >= gamma Wt-1

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9
Q

In a currency union, can real wage be reduced?

A

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

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10
Q

Great depression facts about employment and wages

A

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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11
Q

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

A

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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12
Q

What allowed Argentina to recover following sudden stop in 1998?

A

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

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13
Q

2 margins to reduce labour costs following a sudden stop

A
  1. Intensive margin - cut nominal wages of existing workers

2. extensive margin - labour shedding –> unemployment

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14
Q

The Slackness Condition formula

A

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

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15
Q

What is gamma? The nominal wage rigidity measure

A

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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16
Q

Model 4 specifications

A
  1. 2 periods
  2. small open economy
  3. Free K mobility
  4. 2 goods: traded and non-traded
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17
Q

LOOP holds for which good?

A

Traded goods only: PtT = St Pt*

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18
Q

What do we assume about the foreign price level + implications

A

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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19
Q

What is little pt? What else does it measure?

A

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

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20
Q

Traded vs nontraded goods in terms of production

A

Traded goods = endowed (PtT Yt)

Non-traded goods = must be produced

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21
Q

HH preferences

A

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

22
Q

HH P1 BC in terms of tradables

A

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

23
Q

HH P2 BC in terms of tradables

A

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

24
Q

P1 vs P2 in terms of households and bonds

A

P1: purchase bonds
P2: get returns on bonds

25
Q

What do we assume about B0*?

A

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

26
Q

PV BC for HH

A

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

27
Q

FOC for period 1

A

U2(C1T, C1N) / U1(C1T, C1N) = p1

MRS between period 1 traded & non-traded goods = their relative price

28
Q

Interpret/explain this FOC

A

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.

29
Q

How do we interpret this FOC?

A

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

30
Q

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

A

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

31
Q

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

A

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

32
Q

How do we interpret a sudden stop for our analysis?

A

Sudden stop = increase in world IR r1

33
Q

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

A

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.

34
Q

2 assumptions about production side of non-tradables

A
  1. perfectly competitive firms

2. labour is the only input

35
Q

Production function for non-tradables and 2 properties

A

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

36
Q

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

A

Pi = ptF(ht) - (Wt/St)ht

Remember St=PtT by LOOP and Pt*=1

37
Q

FOC for optimal labour demand

A

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

38
Q

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

A

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.

39
Q

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

A

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

40
Q

How does a change in real wage affect supply curve?

A

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

41
Q

What do we assume about production?

A

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)

42
Q

Info about labour supply

A

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

43
Q

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

A

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.

44
Q

2 types of frictions

A
  1. labour market friction Wt>=Wt-1

2. Institutional frictions in a currency union: St=S bar

45
Q

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

A

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.

46
Q

Name 4 policies to avoid creating unemployment in a sudden stop

A
  1. Devalue currency
  2. Labour market reforms to reduce rigidities
  3. Monetary authority create inflation (means real wage falls)
  4. Impose wage subsidies
47
Q

What are wage subsidies?

A

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

48
Q

New optimal labour hiring FOC with wage subsidies / supply schedule

A

pt=[(1-tow)(Wt/St)]/F’(ht)

49
Q

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

A

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.

50
Q

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

A

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

EC201 - MACRO TERM 1 (9 decks)

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