INTRO TO MACROECONOMICSExercise 9 Twitter: @RajEconwww.firstname.lastname@example.orgRaj.Chande@bristol.ac.uk
YOUR WORK I am a bit behind. All will be back to normal by next week Please return your assignments to me today
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
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?
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)
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...
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
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?
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?
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?
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
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
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: