EC 205 Macroeconomics I. Lecture 5

Transcription

1 EC 205 Macroeconomics I Lecture 5

2 Macroeconomics I Chapter 3: The Science of Macroeconomics

3 Outline of model A closed economy, market-clearing model Supply side factor markets determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market

4 Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers

5 The production function: Y = F(K,L) shows how much output (Y) the economy can produce from K units of capital and L units of labor reflects the economy s level of technology exhibits constant returns to scale

6 Returns to scale: A review Initially Y 1 = F (K 1, L 1 ) Scale all inputs by the same factor z: K 2 = zk 1 and L 2 = zl 1 (e.g., if z = 1.2, then all inputs are increased by 20%) What happens to output, Y 2 = F (K 2, L 2 )? If constant returns to scale, Y 2 = zy 1 If increasing returns to scale, Y 2 > zy 1 If decreasing returns to scale, Y 2 < zy 1

7 Returns to scale: Example F( K, L) KL F( zk, zl) ( zk)( zl) 2 z KL z 2 KL z KL z F( K, L) constant returns to scale for any z > 0

8 Assumptions 1. Technology is fixed. 2. The economy s supplies of capital and labor are fixed at K K and L L

9 Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y F( K, L)

10 The distribution of national income determined by factor prices, the prices per unit firms pay for the factors of production wage = price of L rental rate = price of K

11 Notation W R P W /P = nominal wage = nominal rental rate = price of output = real wage (measured in units of output) R /P = real rental rate

12 How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand?

13 Demand for labor Assume markets are competitive: each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = real wage benefit = marginal product of labor

14 Marginal product of labor (MPL) definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F(K, L+1) F(K,L)

15 Example: Calculate & graph MPL a. Determine MPL at each value of L. b. Graph the production function. c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis. L Y MPL 0 0 n.a. 1 10? 2 19? 3 27? 4 34? 5 40? 6 45? 7 49? 8 52? 9 54? 10 55?

16 Example: Answers Marginal Product of Labor MPL (units of output) Labor (L)

17 MPL and the production function Y output F ( K, L) MPL 1 MPL As more labor is added, MPL 1 1 MPL Slope of the production function equals MPL L labor

18 Diminishing marginal returns As a factor input is increased, its marginal product falls (other things equal). Intuition: Suppose L while holding K fixed fewer machines per worker lower worker productivity

19 Example: MPL and labor demand Suppose W/P = 6. If L = 3, should firm hire more or less labor? Why? If L = 7, should firm hire more or less labor? Why? L Y MPL 0 0 n.a

20 MPL and the demand for labor Units of output Real wage Each firm hires labor up to the point where MPL = W/P. Quantity of labor demanded MPL, Labor demand Units of labor, L

21 The equilibrium real wage Units of output Labor supply The real wage adjusts to equate labor demand with supply. equilibrium real wage L MPL, Labor demand Units of labor, L

22 Determining the rental rate We have just seen that MPL = W/P. The same logic shows that MPK = R/P: diminishing returns to capital: MPK as K The MPK curve is the firm s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P.

23 The equilibrium real rental rate Units of output Supply of capital The real rental rate adjusts to equate demand for capital with supply. equilibrium R/P K MPK, demand for capital Units of capital, K

24 The Neoclassical Theory of Distribution states that each factor input is paid its marginal product a good starting point for thinking about income distribution

25 How income is distributed to L and K total labor income = W L P total capital income = R K P MPL L MPK If production function has constant returns to scale, then Y MPL L MPK K K national income labor income capital income

26 The ratio of labor income to total income in the U.S., Labor s share of total income Labor s share of income is approximately constant over time. (Thus, capital s share is, too.)

27 The Cobb-Douglas Production Function The Cobb-Douglas Production function satisfies the neoclassical properties (constant returns to scale, diminishing marginal returns, essentiality of inputs) MPK AK L MPL Y 1 AK L 1 1 Y (1 ) AK L K (1 ) Y L

28 The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: α = capital s share of total income: capital income = MPK x K = αy labor income = MPL x L = (1 α)y

29 Labor productivity and wages Theory: wages depend on labor productivity U.S. data: period productivity growth real wage growth % 2.0% % 2.8% % 1.2% % 2.3%

30 Outline of model A closed economy, market-clearing model Supply side DONE factor markets (supply, demand, price) DONE determination of output/income Demand side Next determinants of C, I, and G Equilibrium goods market loanable funds market

31 Demand for goods & services Components of aggregate demand: C = consumer demand for goods & services I = demand for investment goods G = government demand for goods & services (closed economy: no NX )

32 Consumption, C Disposable income is total income minus total taxes: Y T. Consumption function: C = C (Y T ) Assumption: (Y T ) C Marginal propensity to consume (MPC) is the change in C when disposable income increases by one dollar. Autonomous consumption is the part of C that is independent of the level of disposable income.

33 The consumption function C C (Y T ) 1 MPC The slope of the consumption function is the MPC. Autonomous consumption is the intercept Y T

34 Investment, I The investment function is I = I(r), where r denotes the real interest rate, i.e. the nominal interest rate corrected for inflation. r=i-π The real interest rate is the cost of borrowing the opportunity cost of using one s own funds to finance investment spending So, r I

35 The investment function r Spending on investment goods depends negatively on the real interest rate. I (r ) I

36 Government Spending, G G: Government spending on goods and services G excludes government transfers (unemployment benefits, social security transfers) Assume government spending and taxes are exogenous G = G & T = T

37 The market for goods & services Aggregate demand: C(Y -T ) + I (r ) +G Aggregate supply: Y F ( K, L) Equilibrium: Y = C ( Y T ) I ( r ) G The real interest rate adjusts to equate demand with supply.

38 The loanable funds market A simple supply-demand model of the financial system. One asset: loanable funds demand for funds: investment supply of funds: price of funds: saving real interest rate

39 Demand for funds: Investment The demand for loanable funds comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the price of loanable funds (cost of borrowing).

40 Loanable funds demand curve r The investment curve is also the demand curve for loanable funds. I (r ) I

41 Supply of funds: Saving The supply of loanable funds comes from saving: Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it does not spend all the tax revenue it receives.

42 Types of saving private saving = (Y T) C public saving = T G national saving, S = private saving + public saving = (Y T ) C + T G = Y C G

43 Notation: Δ = change in a variable For any variable X, ΔX = the change in X Δ is the Greek (uppercase) letter Delta Examples: If ΔL = 1 and ΔK = 0, then ΔY = MPL. More generally, if ΔK = 0, then Δ(Y T ) = ΔY ΔT, so ΔC = MPC (ΔY ΔT ) MPL= DY DL. = MPC ΔY MPC ΔT

44 Example: Calculate the change in saving Suppose MPC = 0.8 and MPL = 20. For each of the following, calculate ΔS : a. ΔG = 100 b. ΔT = 100 c. ΔY = 100 d. ΔL = 10

45 Example: Answers S Y C G Y 0.8( Y T ) G 0.2 Y 0.8 T G a. S 100 b. S c. S d. Y MPL L , S 0.2 Y

46 Budget surpluses and deficits If T > G, budget surplus = (T G) = public saving. If T < G, budget deficit = (G T) and public saving is negative. If T = G, balanced budget, public saving = 0. Governments finance their deficit by issuing Treasury bonds i.e., borrowing.

47 percent of GDP U.S. Federal Government Surplus/Deficit, and estimates for

48 percent of GDP U.S. Federal Government Debt, and estimates for

49 Loanable funds supply curve r S Y C ( Y T ) G National saving does not depend on r, so the supply curve is vertical. S, I

50 Loanable funds market equilibrium r S Y C ( Y T ) G Equilibrium real interest rate I (r ) Equilibrium level of investment S, I

51 The special role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: Thus, If L.F. market in equilibrium, then Y C G = I Add (C +G ) to both sides to get Y = C + I + G Eq m in L.F. market (goods market eq m) Eq m in goods market

52 CASE STUDY: The Reagan deficits Reagan policies during early 1980s: increases in defense spending: ΔG > 0 big tax cuts: ΔT < 0 Both policies reduce national saving: S Y C ( Y T ) G G S T C S

53 CASE STUDY: The Reagan deficits 1. The increase in the deficit reduces saving r S 2 S 1 2. which causes the real interest rate to rise r 2 r 1 3. which reduces the level of investment. I 2 I 1 I (r ) S, I

54 Are the data consistent with these results? variable 1970s 1980s T G S r I T G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown.

55 Mastering the loanable funds model Things that shift the investment curve: some technological innovations to take advantage some innovations, firms must buy new investment goods tax laws that affect investment e.g., investment tax credit

56 An increase in investment demand r S raises the interest rate. But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed. r 2 r 1 An increase in desired investment I 1 I 2 S, I

57 Saving and the interest rate Why might saving depend on r? How would the results of an increase in investment demand be different? Would r rise as much? Would the equilibrium value of I change?

58 An increase in investment demand when saving depends on r An increase in investment demand raises r, which induces an increase in the quantity of saving, which allows I to increase. r r 2 r 1 S( r) I(r) 2 I(r) I 1 I 2 S, I

59 Chapter Summary Total output is determined by: the economy s quantities of capital and labor the level of technology Competitive firms hire each factor until its marginal product equals its price. If the production function has constant returns to scale, then labor income plus capital income equals total income (output).

60 Chapter Summary A closed economy s output is used for: consumption investment government spending The real interest rate adjusts to equate the demand for and supply of: goods and services loanable funds

61 Chapter Summary A decrease in national saving causes the interest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise, but does not affect the equilibrium level of investment if the supply of loanable funds is fixed.

62 Macroeconomics I Chapter 4: The Monetary System: What It Is and How It Works & Chapter 5: Inflation: Its Causes, Effects and Social Costs

63 % change from 12 mos. earlier U.S. inflation and its trend, % 12% 9% % change in CPI from 12 months earlier 6% 3% 0% -3%

64 % change from 12 mos. earlier U.S. inflation and its trend, % 12% % change in CPI from 12 months earlier 9% 6% long-run trend 3% 0% -3%

65 Turkish inflation and its trend, % 100% 80% 60% 40% 20% 0%

66 Turkish inflation and its trend, % 100% 80% 60% 40% CPI CPI_TREND 20% 0%

67 The connection between money and prices Inflation rate = the percentage increase in the average level of prices. Price = amount of money required to buy a good. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

68 Money: Definition Money is the stock of assets that can be readily used for transactions

69 Money: Functions medium of exchange we use it to buy things store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values

70 Money: Types 1. Fiat money has no intrinsic value example: the paper currency we use 2. Commodity money has intrinsic value examples: gold coins, cigarettes in prisons

71 Example: Discussion Question Which of these are money? a. Currency b. Deposits in checking accounts ( demand deposits ) c. Credit cards d. Certificates of deposit ( time deposits )

72 The money supply and monetary policy definitions The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply.

73 The central bank Monetary policy is conducted by a country s central bank. In Turkey it is called the Central Bank of the Republic of Turkey, CBRT (TCMB in Turkish), in the EU zone, it is the European Central Bank, (ECB), in the U.S., the central bank is called the Federal Reserve ( the Fed ).

74 Money supply measures in the US, September 2013 symbol assets included Less Liquid amount ($ billions) C Currency $1135 M1 M2 C + demand deposits, travelers checks, other checkable deposits M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts $2535 $10703

75 Money supply measures in Turkey, September 2013 symbol C assets included Currency amount (TL billions) 67 TL M1 M2 C + demand deposits, travelers checks, other checkable deposits M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts 193 TL 838 TL

76 How Central Banks Control Money Supply? Three tools are available to the central banks for changing the money supply: 1. engaging in open market operations 2. changing the required reserve ratio 3. changing the discount rate

77 Open Market Operations Central Banks open market committees decides on general aims and objectives of monetary policy and sets monetary targets (bank reserves, money supply, and interest rates) Open market operations Buying and selling government securities to influence bank reserves Purchase securities expand reserves (money supply) Sell securities contract reserves (money supply)

78 Reserve Requirements Reserves: The deposits that a bank has at the Federal Reserve bank plus its cash on hand. can be in form of vault cash or deposits in central bank do not earn interest Required reserve ratio: The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. Reserve ratio (rr), Money Supply

79 Money Generation & Multiplier rr= 20% Bank Deposits Reserves Loans A $100 $20 $80 B $80 $16 $64 C $64 $12.8 $51.2 D $51.2 $10.24 $40.96 Total $500 $100 $400

80 Discount Rate Discount rate: The interest rate that banks pay to the central bank for a temporary loan Central Bank influences banks desire to borrow reserves by changing discount rate Discount rate, Bank Borrowing & Money Supply Actual borrowing) depends on banks willingness to use lender of last resort facility of the central bank

81 The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with the concept of velocity

82 Velocity basic concept: the rate at which money circulates velocity: the number of times the average dollar bill changes hands in a given time period example: In 2009, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2009 So, velocity = 5

83 Velocity, cont. This suggests the following definition: where V = velocity V T M T = value of all transactions M = money supply

84 Velocity, cont. Use nominal GDP as a proxy for total transactions. Then, P Y V M where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP)

85 The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables.

86 Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P) d = ky where k = how much money people wish to hold for each dollar of income. (k is exogenous)

87 Money demand and the quantity equation money demand: quantity equation: (M/P) d = ky M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small).

88 Back to the quantity theory of money starts with quantity equation assumes V is constant & exogenous: Then, quantity equation becomes: V V M V P Y

89 The quantity theory of money (cont d) M V P Y How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ). Real GDP is determined by the economy s supplies of K and L and the production function (Chap 3). The price level is P = (nominal GDP)/(real GDP).

90 The quantity theory of money (cont d) Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates: M V P Y M V P Y The quantity theory of money assumes V is constant, so DV V = 0.

91 The quantity theory of money (cont d) π (Greek letter pi ) denotes the inflation rate: P P The result from the preceding slide: M P Y M P Y Solve this result for π: M M Y Y

92 The quantity theory of money (cont d) M M Y Y Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation.

93 The quantity theory of money (cont d) M M Y Y ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.

94 Confronting the quantity theory with data The quantity theory of money implies: 1. Countries with higher money growth rates should have higher inflation rates. 2. The long-run trend behavior of a country s inflation should be similar to the long-run trend in the country s money growth rate. Are the data consistent with these implications?

95 Inflation rate (percent, logarithmic scale) International data on inflation and money growth Indonesia Belarus Ecuador 10.0 Euro Area Argentina U.S. 1.0 Switzerland Singapore China Money supply growth (percent, logarithmic scale)

96 % change from 12 mos. earlier U.S. inflation and money growth, % 12% 9% M2 growth rate 6% 3% 0% inflation rate -3%

97 % change from 12 mos. earlier U.S. inflation and money growth, % 12% Inflation and money growth have the same long-run trends, as the Quantity Theory predicts. 9% 6% 3% 0% -3%

98 Seigniorage To spend more without raising taxes or selling bonds, the government can print money. The revenue raised from printing money is called seigniorage The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

99 Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i π

100 The Fisher effect The Fisher equation: i = r + π Chap 3: S = I determines r. Hence, an increase in π causes an equal increase in i. This one-for-one relationship is called the Fisher effect.

101 U.S. inflation and nominal interest rates, % 14% 10% nominal interest rate 6% 2% inflation rate -2%

102 Inflation and nominal interest rates across countries Nominal interest rate (percent, logarithmic scale) 100 Georgia Brazil Romania Zimbabwe 10 Israel Kenya U.S. Germany 1 Ethiopia Inflation rate (percent, logarithmic scale)

103 Example: Applying the theory Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4%. a. Solve for i. b. If the Fed increases the money growth rate by 2 percentage points per year, find Δi. c. Suppose the growth rate of Y falls to 1% per year. What will happen to π? What must the Fed do if it wishes to keep π constant?

104 Example: Answers V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find π = 5 2 = 3. Then, find i = r + π = = 7. b. Δi = 2, same as the increase in the money growth rate. c. If the Fed does nothing, Δπ = 1. (increase) To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year.

105 Two real interest rates Notation: π = actual inflation rate (not known until after it has occurred) Eπ = expected inflation rate Two real interest rates: i Eπ = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i π = ex post real interest rate: the real interest rate actually realized

106 Money demand and the nominal interest rate In the quantity theory of money, the demand for real money balances depends on real income Y. Another determinant of money demand: the nominal interest rate, i. the opportunity cost of holding money (instead of bonds or other interest-earning assets). Hence, i in money demand.

107 The money demand function (M/P) d = real money demand, depends negatively on i ( M P ) L( i, Y ) i is the opp. cost of holding money positively on Y higher Y more spending so, need more money ( L is used for the money demand function because money is the most Liquid asset.) d

108 The money demand function ( M P ) L( i, Y ) When people are deciding whether to hold money or bonds, they don t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + Eπ. d L( r E, Y )

109 Equilibrium M P L( r E, Y ) The supply of real money balances Real money demand

110 What determines what variable M r M L( r E, Y ) P how determined (in the long run) exogenous (the Fed) adjusts to ensure S = I Y P Y F ( K, L ) adjusts to ensure M L ( i, Y ) P

111

112 How does P responds to ΔM? M P L( r E, Y ) For given values of r, Y, and Eπ, a change in M causes P to change by the same percentage just like in the quantity theory of money.

113 What about expected inflation? Over the long run, people don t consistently over- or under-forecast inflation, so Eπ = π on average. In the short run, Eπ may change when people get new information. EX: Fed announces it will increase M next year. People will expect next year s P to be higher, so Eπ rises. This affects P now, even though M hasn t changed yet.

114 How P responds to ΔEπ M P L( r E, Y ) For given values of r, Y, and M, E i (the Fisher effect) d M P P to make M P to re-establish eq'm fall

115 A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. (Chap. 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data

116 1965 = 100 The CPI and Average Hourly Earnings, Real average hourly earnings in 2009 dollars, right scale CPI (1965 = 100) Nominal average hourly earnings, (1965 = 100) $20 $15 $10 $5 Hourly wage in May 2009 dollars $0

117 The classical view of inflation The classical view: A change in the price level is merely a change in the units of measurement. Then, why is inflation a social problem?

118 The social costs of inflation fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected

119 The costs of expected inflation: 1. Shoeleather cost def: the costs and inconveniences of reducing money balances to avoid the inflation tax. π i real money balances Remember: In long run, inflation does not affect real income or real spending. So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

120 The costs of expected inflation: 2. Menu costs def: The costs of changing prices. Examples: cost of printing new menus cost of printing & mailing new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs.

121 The costs of expected inflation: 3. Relative price distortions Firms facing menu costs change prices infrequently. Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm s relative price will fall. Different firms change their prices at different times, leading to relative price distortions causing microeconomic inefficiencies in the allocation of resources.

122 The costs of expected inflation: 4. Unfair tax treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: Jan 1: you buy $10,000 worth of IBM stock Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%). Suppose π= 10% during the year. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!!

123 The costs of expected inflation: 5. General inconvenience Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning.

124 Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power Many long-term contracts not indexed, but based on Eπ. If π turns out different from Eπ, then some gain at others expense. Example: borrowers & lenders If π > Eπ, then (i π ) < (i Eπ) and purchasing power is transferred from lenders to borrowers. If π < Eπ, then purchasing power is transferred from borrowers to lenders.

125 Additional cost of high inflation: Increased uncertainty When inflation is high, it s more variable and unpredictable: π turns out different from Eπ more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, making risk averse people worse off.

126 One benefit of inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets. Another could be the ability of governments with limited financial capacities to raise revenue

127 Hyperinflation Common definition: π 50% per month All the costs of moderate inflation described above become HUGE under hyperinflation. Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency.

128 What causes hyperinflation? Hyperinflation is caused by excessive money supply growth: When the central bank prints money, the price level rises. If it prints money rapidly enough, the result is hyperinflation.

129 A few examples of hyperinflation country period CPI Inflation % per year M2 Growth % per year Israel % 305% Brazil % 1451% Bolivia % 1727% Ukraine % 1029% Argentina % 1583% Dem. Republic of Congo / Zaire % 2373% Angola % 4106% Peru % 3517% Zimbabwe % 9914%

130 Why governments create hyperinflation When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint.

131 The Classical Dichotomy Real variables: Measured in physical units quantities and relative prices, for example: quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: Measured in money units, e.g., nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future by lending one dollar today. the price level: The amount of dollars needed to buy a representative basket of goods.

132 The Classical Dichotomy Note: Real variables were explained in Chap 3, nominal ones in Chapter 4. Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

133 Chapter Summary Money def: the stock of assets used for transactions functions: medium of exchange, store of value, unit of account types: commodity money (has intrinsic value), fiat money (no intrinsic value) money supply controlled by central bank Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate.

134 Chapter Summary Nominal interest rate equals real interest rate + inflation rate the opp. cost of holding money Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation. Money demand depends only on income in the Quantity Theory also depends on the nominal interest rate if so, then changes in expected inflation affect the current price level.

135 Costs of inflation Chapter Summary Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors

136 Hyperinflation Chapter Summary caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt s need for printing money

137 Classical dichotomy Chapter Summary In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, money market eq m determines price level and all nominal variables. Most economists believe the economy works this way in the long run.

138 Macroeconomics I Chapter 7: Unemployment

139 Natural rate of unemployment Natural rate of unemployment: The average rate of unemployment around which the economy fluctuates. In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual unemployment rate falls below the natural rate.

140 Percent of labor force Actual and natural rates of unemployment, U.S., Unemployment rate Natural rate of unemployment

141 Percent of labor force Actual and natural rates of unemployment, Turkey, % 14% 13% 12% 11% 10% 9% 8% 7% Unemploymen Rate Natural Rate of Unemployment 6%

142 A first model of the natural rate Notation: L = # of workers in labor force E = # of employed workers U = # of unemployed U/L = unemployment rate

143 Assumptions: 1. L is exogenously fixed. 2. During any given month, s = rate of job separations, the fraction of employed workers that become separated from their jobs f = rate of job finding, fraction of unemployed workers that find jobs s and f are exogenous

144 The transitions between employment and unemployment s E Employed Unemployed f U

145 The steady state condition Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant. The steady-state condition is: s E = f U # of employed people who lose or leave their jobs # of unemployed people who find jobs

146 Finding the equilibrium U rate f U = s E = s (L U ) = s L s U Solve for U/L: (f + s) U = s L so, U L = s s + f

147 Example: Each month, 1% of employed workers lose their jobs (s = 0.01) 19% of unemployed workers find jobs (f = 0.19) Find the natural rate of unemployment: U L = s s + f = = 0.05, or 5%

148 Policy implication A policy will reduce the natural rate of unemployment only if it lowers s or increases f.

149 Why is there unemployment? If job finding were instantaneous (f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero. There are two reasons why f < 1: 1. job search 2. wage rigidity

150 Job search & frictional unemployment frictional unemployment: caused by the time it takes workers to search for a job occurs even when wages are flexible and there are enough jobs to go around occurs because workers have different abilities, preferences jobs have different skill requirements geographic mobility of workers not instantaneous flow of information about vacancies and job candidates is imperfect

151 Sectoral shifts def: Changes in the composition of demand among industries or regions. example: Technological change more jobs repairing computers, fewer jobs repairing typewriters example: A new international trade agreement labor demand increases in export sectors, decreases in import-competing sectors These scenarios result in frictional unemployment

152 CASE STUDY: Structural change over the long run 57.9% 1960 Agriculture Manufacturing Other industry Services 76.5% % 1.1% 9.9% 28.0% 8.5% 13.9%

153 Public policy and job search Govt programs affecting unemployment include: Govt employment agencies disseminate info about job openings to better match workers & jobs. Public job training programs help workers displaced from declining industries get skills needed for jobs in growing industries.

154 Unemployment insurance (UI) UI pays part of a worker s former wages for a limited time after losing his/her job. UI increases search unemployment, because it reduces the opportunity cost of being unemployed the urgency of finding work f Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

155 Benefits of UI By allowing workers more time to search, UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes.

156 Why is there unemployment? The natural rate of unemployment: U s L s f DONE Two reasons why f < 1: Next 1. job search 2. wage rigidity

157 Unemployment from real wage rigidity If real wage is stuck above its eq m level, then there aren t enough jobs to go around. Real wage Rigid real wage Amount of labor hired Supply Unemployment Demand Labor Amount of labor willing to work

158 Unemployment from real wage rigidity If real wage is stuck above its eq m level, then there aren t enough jobs to go around. Then, firms must ration the scarce jobs among workers. Structural unemployment: The unemployment resulting from real wage rigidity and job rationing.

159 Reasons for wage rigidity 1. Minimum wage laws 2. Labor unions 3. Efficiency wages

160 1. The minimum wage The min. wage may exceed the eq m wage of unskilled workers, especially teenagers. Studies: a 10% increase in min. wage reduces teen employment by 1-3% But, the min. wage cannot explain the majority of the natural rate of unemployment, as most workers wages are well above the min. wage.

161 2. Labor unions Unions exercise monopoly power to secure higher wages for their members. When the union wage exceeds the eq m wage, unemployment results. Insiders: Employed union workers whose interest is to keep wages high. Outsiders: Unemployed non-union workers who prefer eq m wages, so there would be enough jobs for them.

162 Union membership and wage ratios by industry, 2008 industry # employed (1000s) U % of total wage ratio Private sector (total) 108, % Government (total) 21, Construction 7, Mining Manufacturing 15, Retail trade 14, Transportation 4, Finance, insurance 6, Professional services 11, Education 3, Health care 15, wage ratio = 100 (union wage)/(nonunion wage)

163 3. Efficiency wage theory Theories in which higher wages increase worker productivity by: attracting higher quality job applicants increasing worker effort, reducing shirking reducing turnover, which is costly to firms improving health of workers (in developing countries) Firms willingly pay above-equilibrium wages to raise productivity. Result: structural unemployment.

164 Efficiency wages: Shapiro-Stiglitz Model One representative firm, many workers Each day workers decide on: work or shirk Firm cannot perfectly monitor workers effort Either way, payment is W The cost of working is E. Hence: Worker s payoff is (W-E) if s/he works Worker s payoff is (W) if s/he shirks

165 Efficiency wages: Shapiro-Stiglitz Model Suppose that the technology of the firm is such that W m > E W m : Market-clearing wage

166 Efficiency wages: Shapiro-Stiglitz Model On a given day there is some given probability p that a worker is separated for his job (e.g. retirement) If the worker shirks there is an extra probability q for job separation (i.e. worker is fired) Worker s reasoning: Given the wage rate W, what is the value of my job to me if I work vs. if I shirk? If the probability of separation is p, then I expect to work 1/p days (no shirking) 1/(p+q) days (shirking)

167 Efficiency wages: Shapiro-Stiglitz Model Then the worker compares the following: Value of actually working: Value of shirking: V w = (1/p) (W E)= (W E)/p V s = (1/(p+q)) W= W/(p+q) Implicit assumption: once a worker is fired, he/she does not find a job again

168 Efficiency wages: Shapiro-Stiglitz Model Since the firm can figure all this out, the firm wants to make sure V w V s No Shirking Condition (NSC) Solve (W E)/p W/(p+q) for W: W [(p + q)/q]e = E + (p/q)e Firm would pay the minimum: W* = E + (p/q)e

169 Efficiency wages: Shapiro-Stiglitz Model Efficiency wage level W* is W* > E Note: If W* W m then (no implication for unemployment) As p increases or q decreases (e.g. because the firm is unable to monitor), efficiency wage and unemployment increase

170 Labor Market Experience-US: The duration of U.S. unemployment, average, Jan 1960 June 2009 # of weeks unemployed # of unemployed persons in group (% of all unemployed persons) time spent unemployed by this group (% of time spent unemployed by all groups) % 8.1% % 21.5% 15 or more 27% 70.4%

171 The duration of unemployment The data: More spells of unemployment are short-term than medium-term or long-term. Yet, most of the total time spent unemployed is attributable to the long-term unemployed. This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries. Knowing this is important because it can help us craft policies that are more likely to work.

172 Percent of labor force TREND: The natural rate rises over , then falls over

173 Dollars per hour EXPLAINING THE TREND: The minimum wage $9 The real minimum wage and natural u-rate have similar trends. $8 $7 $6 $5 minimum wage in 2009 dollars $4 $3 $2 $1 minimum wage in current dollars $

174 EXPLAINING THE TREND: Union membership year Union membership selected years percent of labor force % % % % % % Since early 1980s, the natural rate and union membership have both fallen. But, from 1950s to about 1980, the natural rate rose while union membership fell.

175 Percent of labor force Unemployment in Europe, France Germany Italy United Kingdom

176 Why unemployment rose in Europe but not the U.S. Shock Technological progress has shifted labor demand from unskilled to skilled workers in recent decades. Effect in United States An increase in the skill premium the wage gap between skilled and unskilled workers. Effect in Europe Higher unemployment, due to generous govt benefits for unemployed workers and strong union presence.

177 Percent of workers covered by collective bargaining, selected countries United States 13% United Kingdom 35 Switzerland 48 Spain 80 Sweden 92 Germany 63 France 95 Belgium 96 Turkey 24

178 Chapter Summary 1. The natural rate of unemployment definition: the long-run average or steady state rate of unemployment depends on the rates of job separation and job finding 2. Frictional unemployment due to the time it takes to match workers with jobs may be increased by unemployment insurance

179 Chapter Summary 3. Structural unemployment results from wage rigidity: the real wage remains above the equilibrium level caused by: minimum wage, unions, efficiency wages

180 Chapter Summary 4. Behavior of the natural rate in the U.S. rose from 1960 to early 1980s, then fell possible explanations: trends in real minimum wage, union membership, prevalence of sectoral shifts

181 Chapter Summary 5. European unemployment has risen sharply since 1970 probably due to generous unemployment benefits, strong union presence, and a technology-driven shift in demand away from unskilled workers