ECON2004 Term 2 Tutorial 2 PDF

Preview

Summary

ECON2004 Tutorial 3Medium-run open economy model (AD-ERU) Independent of exchange rate regime MRE implies constant inflation Inflation is defined as domestic inflation  price index of home good and services not the CPI (consumer price index), which includes import prices WS and PS behaviour is defi...

Description

ECON2004 Tutorial 3 Medium-run open economy model (AD-ERU) 1. Independent of exchange rate regime 2. MRE implies constant inflation 3. Inflation is defined as domestic inflation  price index of home good and services not the CPI (consumer price index), which includes import prices 4. WS and PS behaviour is defined in terms of domestic price level  Example: Oil price will not affect WS or PS behaviour in domestic economy What does the ERU curve represent? The ERU curve is defined by the intersection of the wage- and price-setting curves. It shows the combinations of the real exchange rate and output at which there is supply-side equilibrium (constant inflation) We can write the ERU curve as Y = Ye(Zw,Zp) Zw= union bargaining, unemployment benefits, labour market regulations Zp = tax, mark-up (competitiveness), the level og technology (i.e. labour productivity) Demand shock – ERU will never shift as it represents the supply side

What would happen to the ERU curve if unemployment benefits were raised? The WS shifts upwards and reduces equilibrim output. In the open economy diagram, this is represented by a leftward shift in the vertical ERU curve to the new lower level of equilibrium output.

Why does WS shift upwards? At any level of output and associated unemployment rate, higher unemployment benefits reduce the cost of job loss. Because the outside option for workers has improved, the expected real wage that can be negotiated is higher, i.e. bargaining power in the labour market shifted from employers to workers. In the production function, only labour supply as an input  Labour supply increases, output increases  Labour supply decreases, output falls Outside options have improved – they will leave the labour fource, labour is the only input, labour supply will fall, output will fall If you think about inflation – think about the bargaining power and the labour marrket 

Workers have higher bargaining power due to the rise in benefits, they will bargain for higher nominal wages



Firms will set their prices as their markup over wages

Why does the ERU shift left? Why is the ERU curve vertical? In a mechanical sense, this is because the real exchange rate is a determinant of neither the WS nor the PS curve, and hence, intersection will be independent of q. This implies a vertical ERU curve. What is the economics behind this? Whatever happens to the real exchange rate, this does not affect either behaviour in the labour market. There is no feedback from a change in q to wage- or price-setting.  Whatever happens to the real exchange rate, that won’t affect the behaviour in the labour market

What is being assumed about the real wage-setters care about (in their utility function)? They only care about changes in domestic price level.

What would you expect to happen in inflation (after unemployment benefits are raised)? When the WS curve shifts, the PC indexed by expected inflation, which equals world inflation, shifts go through the new equilibrium output level. Hence at the initial output level, inflation goes up. With an increase in unemployment benefits, wage setters will expect in the next round of wage setting to get a wage increas given that they have higher bargaining power. In turn, firms will increase their prices to maintain their profit margins in the face of higher labour costs.

What does the AD curve represent? Why is it upward sloping? In closed economy: IS curve represents goods market equilibrium In open economy: AD, derived from IS The AD curve shows the medium-run combinations of the real exchange rate, q, and level of output, y, at which the goods market is in equilibrium with the real interest rate equal to the world interest rate, i.e. r=r* A higher level of output requires a depreciated real exchange rate, hence, AD is upward sloping.

Derive the AD curve graphically from the IS curve To derive the AD curve, we use the dynamic version of the IS curve. This formulation captures the fact that aggregate demand responds negatively to the real interest rate r and positively to a depreciation in the real exchange rate q.

Suggest two variables that shift both the IS and the AD curves and summarize their effect on the medium run real exchange rate In order for the AD to shift, there must be a shift in A or in r* Shocks on investment, consumption, world tradem government would shift both AD and IS A includes the multiplier and demand shift variables in the open economy such as world trade as well as government spendng (G) and the variables that shift the consumption and investment functions

1c) Rise in the world interest rate – what happens to MRE? If there is an increase in the world interest rate from r* to r*’ in the new MRE, home’s real interest rate will be equal to the world’s new higher interest rate This would result in a decrease in consumption and investment given the real exchange rate qbar Hence, for real exchange rate qbar, there is a point on the new AD curve at B What happens to the MRE? There is no change in the supply side of the economy so in medium run the new MRE for the economy is at point C with a depreciated real exchange rate q’ This is reflected by a rightward shift in the IS curve from IS(q) to IS(q’) Thus the reduction in demand through reduced consumption and investment associated wth the higher real interest rate is compensated by an increase in net exports through increased competitiveness due to the depreciated exchange rate in the medium run.

Cevat: Small open economy, we are at r=r* If r* goes up, r also goes up (pegged) Then output falls since consumption, investment and spending will fall Our interest rate depreciates, become more competitive because our goods become cheaper for eigners, export more

Permanent positive demand shock, i.e. an increase in G The differences in the impulse response functions between the open and closed economy simulations. Is the change in interest rate necessary to stabilize the economy larger in the open or closed economy? Why? 

In the closed economy, the adjustment of the economy to the new medium run equilibrium is very similar to that in the closed economy. The big exeption is the path of interest rates.



In the closed economy, the stabilizing real interest rate in the new medium run equilibrium is higher than in the initial equilibrium. This reduction in interest sensitive demand exactly offsets the permanent increase in exogenous demand (A) so that output returns to its equilibrium rate in the medium run.



In contrast, in the open economy, the interest rate of the home country cannot differ from the world real interest rate in medium run equilibrium because of the UIP condition. This means demand is instead dampened by an appreciated exchange rate.

Open economy IS equation Closed economy IS equation Why would we not expect the coefficient on the real interest rate to be the same in the open and closed economy IS curves. Would you expect the IS curve to be flatter or steeper in the open economy? You would not expect the coefficient to be the same in the open and closed economy, due to the presence of the external sector in the open economy. Take the example of a reduction in interest rate

In the closed economy, this would boost consumption and investment by agents in the home economy, as it reduces the cost of borrowing. In the open economy, some of this increased spending on consumption and investment goods would be satisfied by imports. This would suggest that any interest rate change would have a smaller effect on domestic output in the open economy – i.e. the coefficient on the real interest rate would be smaller (i.e. IS curve is steeper in the open economy). IS will be flatter in closed economy – change in interest rate has a greater effect on output Change in interest rate will 100% fall on domestic economy Open economy a will be smaller, since the impact of the interest rate on output is less due to mp to import Sensitivity to the real interest rate in the open economy a represents the effect of the real interest rate on output The lower is a, the less sensitive is output to a fall in r and the steeper is the IS curve. Hence, the higher the interest rate needs to initially be raised in order to stabilize the economy after a permanent demand shock.

Other comments Mpc increases, this will go into A If mpc increases the same amount in open and closed, will have lower effect in open economy Mpi is part of mpc...