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Macroeconomics
ECO 403
VU
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* P
ε
=e× *
=
×
*
=1
P
PP
·
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.
62
Macroeconomics
ECO 403
VU
Unemployment
Rate of Pakistan
9
8
7
6
5
4
3
2
1
0
Years
A
first model of the natural
rate
Notation:
L
=
# of workers in labor
force
E
=
# of employed workers
U
=
# of unemployed
U/L= unemployment
rate
Assumptions:
1.
L
is exogenously fixed.
2.
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
63
Macroeconomics
ECO 403
VU
Solving
for the "equilibrium" U
rate
f
xU
= s
xE
=
s
x (L
U)
=s
Ls
U
Solve
for U/L:
(f
+ s)xU
= sxL
U
s
=
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:
U
s
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
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