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Economics Assignment: Labor Market, AS-AD Model, and Phillips Curve

## Part A - Basics

Part A - Basics

1.The Labor Market

a.Briefly explain what economists mean when they say the labor market doesn’t clear in the sense of the classical model.

b.Briefly explain why the labor market doesn’t clear.

c.Conceptually explain the concept of the natural rate of unemployment.

d.Briefly explain what determines structural differences in unemployment rates across geographies, based on the assumptions made about the labor market in class.

e.Why is the labor market a critical determinant of equilibrium GDP?

a.Briefly explain the major difference in assumptions between the IS-LM model and the AS-AD model.

b.Briefly comment on which model describes which aspect of the business cycle.

c.Explain why the AS curve is upwards sloped under assumptions made about the production function in class, i.e. Y=N.

d.How would your answer in c. change if we used a more realistic/more flexible production function like a Cobb-Douglas function

Part B – Labor markets

1.Background

a.Write down and intuitively explain the wage-setting relationship.

b.Write down and intuitively explain the price-setting relationship.

c.Briefly explain labor market dynamics if Pe>P, using a suited diagram or thorough discussion.

d.Briefly provide a general expression of the natural rate of unemployment as implied by part 1. and 2. Note: general means do not impose a specific functional form on F(u,z), but provide a simple expression instead.

2.Say that firms set prices according to and that wage setters bargain for real wages according to .

a.Find an algebraic expression for the natural rate of unemployment. How does your expression for the natural rate of unemployment depend on the markup m and the catchall variable z?

b.Assume that a = 0.1, z=25 and m =0.05. Find the natural rate of unemployment.

c.Using a graph of the labor market, briefly illustrate how a reduction in unemployment benefits would affect the natural rate of unemployment. Provide a brief, intuitive explanation

d.An easy way to think of the impact of other production factors like capital, short of using a more complicated production function is to include their role in the markup m, which simply indicates the difference between labor cost and firm prices. How, all else the same would the recent drop in oil prices affect the equilibrium unemployment rate under this approach? Briefly explain.

Part C – AS – AD

1.Briefly use a suited diagram to show the impact of a negative demand side shock on prices and output in the short and medium run, starting from the economy’s medium run equilibrium. EXPLAIN the process intuitively.

2.Briefly use a suited diagram to show the impact of a positive supply side shock on prices and output in the short and medium run, starting from the economy’s medium run equilibrium. EXPLAIN the process intuitively.

3.Name and briefly explain an example of 1. and 2. each.

4.Recently there has been a drastic decline in the price of oil. See, e.g.: https://www.bloomberg.com/news/articles/2020-04-16/saudi-arabia-russia-hint-at-further-action-to-stem-oil-s-plunge

a. Briefly explain the short run effects on AS. Graph or explanation will do.

b. What are the likely implications for expected inflation?

5. The ongoing COVID-19 crisis has caused an unprecedented shutdown of the world economy. The crisis both has supply and demand shock qualities.

a.Briefly explain what aspects of the event affect U.S. aggregate supply and its impact on equilibrium GDP. Note: Stay top-level, conceptual. If you dig into the details, this is a never-ending list.

b. Briefly explain what aspects of the event affect U.S. aggregate demand and its impact on equilibrium GDP.

c.In practice there are more complications in identifying which effect, a. or b., is stronger, but assuming that nothing else changes (no fiscal nor monetary policy), how could you identify theoretically which shock, supply or demand, is stronger in the AS-AD model? Briefly explain.

Part D – The Phillips Curve

1.The Textbook Phillips Curve

a)Briefly explain the empirical relationship laid out by original the Phillips Curve and explain why such a relationship might exist in theory. Under which assumptions about expect inflation is the original Phillips Curve likely to hold?

b)Suppose that the Phillips Curve is given by pt = pte + 0.3 – 2ut. Find the natural rate of unemployment.

c)Assume that expected inflation is given by pte = q pt-1. Say that q is initially equal to zero. Say that a boom in demand changes the unemployment rate to 10% in year t+1. Find the inflation rate in t+1 and t+2. Is it feasible to assume that q remains equal to zero if the unemployment rate remained at 10% for some time? Briefly explain.

d) How would the inflation rates in t+1 and t+2 change if q was equal to 1? Briefly explain the phenomenon of overheating in this context.

2.Wage indexation

In response to the Lucas Critique, economists past 1970 have focused on how wages adjust to changes in inflation. One such mechanism was studied by Stanley Fisher (1977) who stressed that we index wages, i.e. automatically adjust them to inflation, in inflationary economies.

Usually, not everyone’s nominal wages is indexed, but only say a fraction l of all wages. Under such an arrangement, the modified Phillips Curve becomes:

pt=[l pt + (1-l)pte]+ m +z – aut

Assuming adaptive expectations (i.e. pte=qpt-1 and q=1) find an expression for the modified Phillips Curve (i.e. the change in the inflation rate) for

a.a non-indexed regime (i.e. l=0) and

b.an inflation indexed regime (i.e. l>0).

c.Say that a government aimed at reducing the unemployment rate through a macro-policy measure, fiscal or monetary. Under which regime would the policy be more inflationary? Provide a brief explanation of the events.