ECON 100 Tutorial 19

1. ECON 100Tutorial 19 Rob Pryce www.robpryce.co.uk/teaching

2. M/PAM/PB r Question 1 L r L(Y, r) I I A fall in prices leads to a rise in real money supply, shifts to the right Leads to lower interest rate, which leads to increased investment

3. Question 1 (cont’d) LM1(PA) r P PA PB LM1(PB) IS YA YB Y YA YB Y LM curve shifts right (and rotates due to curve), lower r and greater Y.

4. Question 2 AS(w2) Money wages are constant along an AS curve But real wages fall when you move up the curve, because P increases. RW = MW / P P'2 AS(w1) P2 P1 AD2 AD1 Q1 Q2 real output (Q)

5. Question 3 What would be the locus of the Aggregate Supply schedule, if money wages and prices always changed by the same proportionate rate? Vertical at the point of the ‘natural rate of unemployment’

6. Question 4 Prices Aggregate Q

7. Question 4c Prices Prices Aggregate Q Aggregate Q

8. Price-Wage Spiral Source: tutor2u.net

9. AS curves VERTICAL Long run equilibrium, ‘expansionary’ macroeconomic policy generates inflation only HORIZONTAL Unit costs of production are unchanged as income/output rises UPWARD SLOPING Keynes addresses this in his work. ‘Expansionary’ macro policy raises both output and unit costs. Higher prices, reduces real wages and eliminates involuntary unemployment.

10. Question 6 “Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods, relative to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of unemployment.”

11. 6a: Gerry’s proposed answer • Suppose price inflation erodes the purchasing power of existing earnings. If the effect were to increase (beyond the current level of employment) both (1) the number of individuals willing to work at those earnings levels, and (2) the number of jobs that are available at those earnings levels, then involuntary unemployment could be said to exist.

12. 6b: Changing the words the price of wage-goods the money-wage

13. Question 7 • The assumption (highly dubious) is that the impact of aggregate demand management policies is upon factors other than the general level of prices. You might open a general discussion: a model delivers results determined by its assumptions; that all cause originates from change in exogenous variable (that is, those about which we know nothing!) • By Keynes’s General Theory, an economy in recession need have no fear of inflation*. However, once full employment is reached, inflation sets in. Two key passages are: • ‘ .. an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by an increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand’ (TGT: 295)

14. Question 7 (cont’d) When a further increase in the quantity of effective demand produces no increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation’ (‘ .. an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that unemployment will increase in exact proportion to any increase in effective demand brought about by an increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand’ (TGT: 303) ( * as many economic pundits argued for the UK 2010/2011; see http://www.samuelbrittan.co.uk/text326_p.html http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0270.2009.01930.x/pdf http://www.iea.org.uk/blog/how-can-so-many-economists-be-wrong-headed-on-inflation)

15. Question 7 (cont’d) Keynesians argue that immediate short-term measures (i.e., raising public expenditure) to lift an economy from recession, no inflationary consequences because of spare productive capacity and unemployed labour. Their disputed argument is that short-term palliatives have no long-term adverse consequences: The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again. (Keynes 1923) ‘Are we not told that ‘since in the long run we are all dead’, policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they wish’ (Hayek, 1941)

16. Question 8 Phillips’s explanation: ‘When the demand for labour is high we should expect employers to bid wage rates up quite rapidly. On the other hand it appears that workers are reluctant to offer their services at less than prevailing rates when the demand for labour is low’

17. Question 9 The Keynes-Phillips orthodoxy: inflation cannot occur when there is large-scale unemployment ‘ … an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment …’ (TGT: 295) Demand pull inflation when Ms > Md

18. Question 10 • With the expectations-augmented Phillips curve represented conventionally as • DW/W = f(U) + φ(DP/P)e • a. Identify each of the variables DW/W, P , U, and (DP/P)e • b. What sign respectively would be expected for each of the coefficients fand φ. Explain. • c. Which description is usually given for φ < 1. Explain. • d. What is the ‘reservation wage’ in the analysis of job search? • e. What is the likely impact upon the reservation wage of the length of time a worker remains unemployed? • f. What is the likely impact upon unemployment of a rise in benefits received by unemployed workers? • g. Explain the likely impact upon unemployment of (DP/P) > (DP/P)e. • h. Explain the likely impact upon unemployment of (DP/P) = (DP/P)e.

19. Question 10a DW/W = f(U) + φ(DP/P)e • Q. Identify each of the variables DW/W, P, U, and (DP/P)e

20. Question 10b DW/W = f(U) + φ(DP/P)e Signs for f and φ U is negatively related to wage inflation Expectations of inflation are positively related to wage inflation

21. Question 10c DW/W = f(U) + φ(DP/P)e What does it mean if φ < 1 ? Not all the expectations are passed on in to wages Money illusion

22. Question 10d • What is the ‘reservation wage’ in the analysis of job search? w Labour Supply Reservation wage h

23. Question 10e • What is the likely impact upon the reservation wage of the length of time a worker remains unemployed? It will probably go down over time They will get less fussy

24. Question 10f • What is the likely impact upon unemployment of a rise in benefits received by unemployed workers? Reservation wage represents opportunity cost If benefits are high, reservation wage will increase People will choose to take benefits instead of working Note: this assumes that you lose benefits when starting work

25. Question 10g/ 10h • Explain the likely impact upon unemployment of (DP/P) > (DP/P)e. • The period of job seeking is likely to be curtailed, if the inflation rate is underestimated • Explain the likely impact upon unemployment of (DP/P) = (DP/P)e. • Unemployment finds its ‘natural rate’

26. Any Questions? Email: r.pryce@lancaster.ac.uk Web: www.robpryce.co.uk/teaching OfficeHour: Wednesday, 9:45 – 10:45 Charles Carter C Floor or by appointment (email me)