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# Macro9

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### Macro9

1. 1. INTRO TO MACROECONOMICSExercise 9 Twitter: @RajEconwww.rajchandeteaching@blogspot.comRaj.Chande@bristol.ac.uk
2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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:
14. 14. A0 = 25; R1 = 0.5; R2 = 0.5: Yt = 25 + Yt-1 –0.25Yt-2 Yt = 50 + Yt-1 –0.25Yt-2 Yt 250 200 150 100 50 0 1 3 5 7 9 11 13 15 17 19
15. 15. A0 = 25; R1 = 0.9; R2 = -1.5: Yt = 25 –0.6Yt-1 + 1.35Yt-2 Yt = 50 –0.6Yt-1 + 1.35Yt-2 Yt 800 600 400 200 0 -200 1 3 5 7 9 11 13 15 17 19 -400
16. 16. A0 = 25; R1 = 1.5; R2 = 1.5 Yt = 25 +3Yt-1 –2.25Yt-2 Yt = 50 +3Yt-1 –2.25Yt-2 Yt 50000 40000 30000 20000 10000 0 1 3 5 7 9 11 13 15 17 19