Submitted By jajayhj
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Formula’s you should KNOW
• IS: Y = c0 + c1(1-t)Y + I(Y,i) + G + NX
– Goods market equilibrium

• LM: M/P = YL(i)
– Money market: higher interest decreases money demand

• AD: Y = Y(M/P , G, T)
– Equilibria in goods and money market

• AS: P = (1 + μ)PeF(1 – Y/L , z)
– Equilibrium wage market
– WS: W = Pe.F(u, z) u = 1 – N/L ; Y = N & in MR Pe = P
– PS: W/P = 1/(1+μ) real wage W/P is constant

Shifting Dynamics
• The trick to understanding the dynamics in ISLM, AS-AD and Ls-Ld is to know

The initial situation is believed to be stable: Y = Yn
That SR means a few years
Where movement is initiated
How it affects everything else
That Yn has “magnetic pull” in the MR and LR
Money is neutral in the MR  monetary policy only affects price level
– Fiscal policy is also ineffective in the MR

Exercise
• The wage setting relationship of the workers is W = Pe *
15/100u , where W is wage, Pe is expected price level and u is unemployment rate. A typical firm set prices according to the following price setting relationship P = W/3. Output is produced with the following production function Y = 2N, where N is the number of workers hired. The labour force is
100 000.
• What is natural rate of unemployment?
• What is potential output?
• Is this economy sustainable in the long run?

Solution
In MR, Pe = P 
– W / P (Price Setting) = W / Pe (Wage Setting)
 3 = 15 / 100u
– 100u = 5 and u = 0.05

Given the labour function Y = 2N
• GDP = Y = 2*(100,000 * 0.95) = 190,000
Sustainable?
Markup ~ W/P = 2/(1+mu) = 3
Thus 2/3 = 1 + mu mu = -1/3

What happens?
1.
2.
3.
4.

Decrease of bank reserves
Higher government expenditure
Rise in bargaining power
Productivity increase (see pdf on the Hub)

Rise in Government Spending
1. IS: Z = C(Y-T) + I(Y, i) + G

Shift in IS curve to the right
This means increase in Y > Yn and increase in i

2. AD: Y = Y(M/P , G, T)

AD curve shifts right and follows IS
But moves slightly less due to increase in Prices P

Rise in Government Spending
3. LM: M/P = Md/P =Y.L(i)

LM responds to changes -> higher Y and higher I => ambiguous effect
Rising prices lead to a small shift left of the LM-curve

4. AS: P = (1 + μ)PeF(1 – Y/L , z)

Price rise leads to friction between current prices and expected prices => Adaptive expectations
As long as expected price is below actual price AS keeps shifting Rise in Government Spending
5. LM: Shifts back following the AS shifts (higher
P and decreasing Y)
Result: Same equilibrium output Y but higher prices and higher interest rate
- How do investments and consumption evolve over time?

Rise in bargaining power
1. W/Pe = F(u, z): Wage setting curve moves right, while price setting P = W*(1 + μ) is stable –

This means an increase in natural rate of unemployment and thus a decrease of potential output Yn
Additionally, higher z means higher W and given that μ is a constant, prices P need to rise

Rise in bargaining power

Rise in bargaining power
2. AS: P = (1 + μ)PeF(1 – Y/L , z) shifts left due higher z

This is accompanied by higher prices P and declining Y as it should be

3. LM follows AS because the higher prices are increasing demand for money, while M is assumed to stay constant => increasing interest rate
4. This cycle continues until new equilibrium Yn’

Increase in Productivity
• Production function: Y = N
• Increase in productivity: Y = AN (A > 1)
– TC = WN = WY/A -> MC = W/A
– PS: P = W/A * (1 + mu) -> P goes down
– W/P = A/(1 + mu)
• Real wage jumps up following the increase in A

– In MR: PS and WS have to be in equilibrium again
• when Pe = P

Price-setting & Wage-setting

What happens in MR?
• PS-WS shows that unemployment will decrease permanently following the productivity increase => Y will move towards a new higher potential output Yn
– Yn = (1 – un)*AL
– Decrease in u and increase in A show that Yn has to increase in MR!

Firms will increase supply at lower costs
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