2. YOUR WORK
I am a bit behind. All will be back to normal by next
week
Please return your assignments to me today
3. Q1)
Important that you can tell this story, distinguishing
between SR and LR effects will be crucial from now
on
Might help you to think about what you‟ve been
learning in Micro when answering questions like
this
Once you‟ve got your head round the SRAS/LRAS
story, you are more or less home-free
4. 1) CTD
SRAS shows the average price of goods and
services set by firms as a function of the aggregate
level of output they are producing.
Conventionally drawn with output on the horizontal
axis and avg prices on the vertical.
What defines „short-run‟ in this model? Time?
5. 1)CTD
No, not time. At any given moment, workers have a
particular expected price level, Pe
As long as workers‟ retain that specific expected
price level, the economy is in the short run
There is therefore one SRAS curve for each
possible expected price level
The curve is based on two relationships
First, the wage bargaining equation, which states
that the lower the unemployment rate, the greater
bargaining power workers have
Second, firms price setting behaviour. Firms set
prices by applying a mark-up over costs (wages)
6. 1) CTD
As firms produce more output, they will need to hire
more workers, thus lowering the unemployment
rate.
To entice the work force to supply more
labour, firms will have to offer a higher nominal
wage
Firms will then raise the prices of their
goods, causing an increase in the average price
level in the economy
Of course, this now means that workers‟ expected
prices are incorrect, but we will come back to that in
a moment...
7. 1) LRAS
LRAS shows relationship between P and Y on
assumption that workers‟ expectations are correct
(P=Pe)
There can only be one level of output that meets
this condition, we will call this Yn
If Y > Yn , unemployment is lower than the natural
rate, firms will have to offer higher nominal
wages, but then they will have to raise their prices
If Y < Yn , we get the opposite story
Once price expectations are equal to actual
prices, we will always return to Yn
8. Q2)
If the economy is initially operating below Yn the AD
curve cuts the relevant SRAS curve at a price level
below the expected price level.
With no change in the position of the AD curve
there would be a tendency for Pe to drop (since
P < Pe) and hence for P to drop, causing the
economy to slide down its AD curve eventually
reaching Yn
The economy will eventually return to its natural
level of output all by itself. Why might a policymaker
not be satisfied with this?
9. 2)CTD
This might take too long. If an election is coming in
six months and adjustment will take a year, a
government might decide to do something about it
Not always such a cynical motive. It is also possible
that time is important, as people are out of
work, their productivity is falling. The sooner they
get back to work, the better
So, what can the government do?
10. 2) CTD
If SRAS takes too long to adjust, government can
try and shift AD.
Many ways to do this, increase real money
supply, increase government spending, but in this
example, you are asked to consider impact of a
devaluation
So what will a devaluation do to the AD curve?
What condition must hold to answer this question?
11. YES
The Marshall-Lerner condition must hold.
Mathematical derivation is on Handout 8, but
intuition is important
A weaker £ must (eventually) lead to an increase in
net exports, otherwise the devaluation will have
made things worse
12. 3) YOU MIGHT BE WONDERING...
What is the point of this question?
This example is very abstract, doesn‟t relate to
anything specific
But, modeling variables as functions of their own
lags is important
This SRAS/LRAS/AD model is introducing
dynamics for the first time
Some variables move in the short-term, then return
back to their long term equilibrium
Some variables move a lot in the short-term, then
converge to some new level
This question is about exploring the maths behind
that process
13. 3) CTD
If one of your chosen roots is absolutely greater
than 1 then the Y will move further away from its
new “equilibrium” value – the system is dynamically
unstable.
If the roots are both absolutely less than one then
the Y is dynamically stable but you can still get
some odd patterns.
Here are some examples:
