/69-17_files/69-1700001im.jpg" width="695" height="1066" useMap="#Map">

Macroeconomics ECO 403

LESSON 17

OPEN ECONOMY (Continued...)

Purchasing Power Parity (PPP)

· def1: a doctrine that states that goods must sell at the same (currency-adjusted) price

in all countries.

· def2: the nominal exchange rate adjusts to equalize the cost of a basket of goods

across countries.

· Reasoning: arbitrage, the law of one price

· PPP: e xP = P*

Where

e x P - Cost of a basket of domestic goods, in foreign currency.

P - Cost of a basket of domestic goods, in domestic currency.

P* - Cost of a basket of foreign goods, in foreign currency.

Solve for e : e = P*/ P

PPP implies that the nominal exchange rate between two countries equals the ratio of the

countries' price levels.

P* P

ε =e× * =

× * =1

If e = P*/P,

then

Does PPP hold in the real world?

No, for two reasons:

1. International arbitrage not possible.

· Non traded goods

· Transportation costs

2. Goods of different countries not perfect substitutes.

Nonetheless, PPP is a useful theory:

· It's simple & intuitive

· In the real world, nominal exchange rates have a tendency toward their PPP values

over the long run.

Issues in Unemployment

The natural rate of unemployment:

· What it means

· What causes it

· Understanding its behavior in the real world

Natural Rate of Unemployment

· Natural rate of unemployment:

the average rate of unemployment around which the economy fluctuates.

· In a recession, the actual unemployment rate rises above the natural rate.

· In a boom, the actual unemployment rate falls below the natural rate.

/69-17_files/69-1700002im.jpg" width="695" height="1066" useMap="#Map">

Macroeconomics ECO 403

Unemployment Rate of Pakistan

Years

A first model of the natural rate

Notation:

= # of workers in labor force

= # of employed workers

= # of unemployed

U/L= unemployment rate

Assumptions:

L is exogenously fixed.

During any given month,

s = fraction of employed workers that become separated from their jobs,

f = fraction of unemployed workers that find jobs.

s = rate of job separations, f = rate of job finding (both exogenous)

Transitions between employment and unemployment

The steady state condition

· Definition: the labor market is in steady state, or long-run equilibrium, if the

unemployment rate is constant.

· The steady-state condition is:

s xE = f xU

number of employed people who = number of unemployed people who find jobs

lose or leave their jobs

/69-17_files/69-1700003im.jpg" width="695" height="1066" useMap="#Map">

Macroeconomics ECO 403

Solving for the "equilibrium" U rate

f xU = s xE

= s x (L U)

Solve for U/L:

(f + s)xU = sxL

L s +f

So,

Example:

· Each month, 1% of employed workers lose their jobs (s = 0.01)

· Each month, 19% of unemployed workers find jobs (f = 0.19)

· Find the natural rate of unemployment:

0.01

= 0.05, or 5%

L s +f

0.01 + 0.19

Policy implication

· A policy that aims to reduce the natural rate of unemployment will succeed only if it

lowers s or increases f.

Why is there unemployment?

· If job finding were instantaneous (f = 1),

then all spells of unemployment would be brief, and the natural rate would be

near zero.

· There are two reasons why f < 1:

1. Job search

2. Wage rigidity

Job Search & Frictional Unemployment

· Frictional unemployment: caused by the time it takes workers to search for a job

· Occurs even when wages are flexible and there are enough jobs to go around

Job Search & Frictional Unemployment

Occurs because

· Workers have different abilities, preferences

· Jobs have different skill requirements

· Geographic mobility of workers not instantaneous

· Flow of information about vacancies and job candidates is imperfect