ZeePedia

OPEN ECONOMY (Continued…):A first model of the natural rate

<< OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
ISSUES IN UNEMPLOYMENT:Public Policy and Job Search >>
img
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
img
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
img
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
64
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand