MACROECONOMICS

Economics Department Xavier University- Ateneo de Cagayan

Why are wages sticky?

Stickiness pertains to flexibility Thus, wages are not flexible in ensuring full

employment.
The Phillips curve can be analyzed in another

angle (as a range of change in wages):

(u-u*) = (N*-N) / N*

 We can use the original Phillips curve

equation and manipulate it into: Gw - e = [ (Wt+1 Wt) / Wt ] - e = - (u-u*) = - (N*-N) / N* Thus, at a certain level of unemployment, we adjust the wages for the next period.

 Three cases:

Gw - e

= - (N*-N) / N*

1. If N* > N , then Gw - e is (+), w high, emp low leading to ( ) 2. If N* > N , then Gw - e is (-), w low, emp high leading to (+) 3. If N* = N , then Gw - e is 0, no inflation; At full employment

Is inflation bad?
Yes and No.

Other issues: 1. Inflation means wages increase (Not always right)

By imperfect information, we may not know the real w that will compensate the increasing cost of living.

2. Coordination problems
Firms may adjust prices more when its all on demand,

but not on wages.

PC to AS: Okuns law

3 steps:
1. Translate output in terms of employment 2. Link prices to costs of adjusting 3. PC and WN relationship and combine

Okuns law
There is an inverse relationship between

unemployment and GDP (by gaps).

(Y-Y*) / (Y*) = - (u-u*)

PC to AS: Costs and Prices

I f we set the price, then there should be:

P = [(1+z) w] / a

Where: z =mark up price a= units of labor w=cost of labor

PC to AS: Costs and Prices

Pt+1 = (1+ e ) Pt [1 + (u-u*)] = actual + expected

Where:

e = expected inflation Pt = present prices Pt+1 = future prices = responsiveness of unemployment gap with respect to future prices

Employment, Wages and the AS

Thus,

Pt+1 = (1+ e ) Pt [1 + (u-u*)] = (1+ e ) Pt [1+ (/w) {(Y-Y*)/ Y*} ]

If = (/w) / Y and Pet+1 = (1+ e ) Pt , then:

Pt+1 = Pet+1 [1+ (Y-Y*) ]

What will happen to AD-AS curve?

Again with inflation, the AS curve will shift to

the left (if upward- sloping) and upward if AS curve is flat. (medium-run and short- run)

Supply shocks
Adverse
If AS shifts up, an increase in prices Example: oil shock 2 effects: Assuming that we are in the medium run, the we have a new equlibrium when the As shifts to the left, given no change in AD. Now at higher P (new eq), unemployment is also high, and with sticky wages theory, prices adjust slowly back to the old price. (Transitory shock only)

 Solution:
Impose expansionary policies Shift AD to the right, Caution: can be, in the long run, inflationary too.

Thus, anything thats expansionary is inflationary.

Chapter 7: anatomy of unemployment and inflation

Reasons for unemployment
New entrant Quit Laid- off Shut down

Reasons for employment

Hired re-calles Leave labor force

Cyclical and Frictional

Frictional
Unemployment at full employment (NRU)

Cyclical
Excess of frictional unemployment (if Y < Y*)

Issues:
Unemployment benefits can also affect the

behavior of labor

Other terms
Spell of unemployment
Continuous unemployment period

Unemployment duration
Average period a person is unemployed

Frequency of unemployment
Average number of times a person is unemployed

Unemployment: CBA
Costs of unemployment
Can hit poorer people Lower spending

Benefits of unemployment
More leisure More business start ups

Inflation CBA
Cost of inflation
If Perfectly anticipated, then make sure you

perfectly adjust
taxes and interest rates (boost spending) Exchange rates (trade)
If imperfectly anticipated, Incomplete contracts are wasted (an efficient contract should be state- contingent) Wealth redistribution can be bad (lag effects on income)

QUIZ

(No erasures, maximum of 3 sentences only)

Part I
Discuss how the following can affect

unemployment: 1. Elimination of unions 2. Increased participation of teenagers in the market 3. Larger fluctuations in the AD 4. Increase in unemployment benefits 5. Elimination of minimum wages 6. More drop-out rates

QUIZ

(No erasures, maximum of 3 sentences only)

Part II
Demonstrate in a graph the following: 1. There is a supply shock in oil. What happens to ADAS curves:
a) During the shock b) After the shock

2. Explain the equilibrium paths.

(Assume that it is a transitory shock)