week 20

```ECON 100 Tutorial: Week 20
a.ali11@lancaster.ac.uk
office hours: 3:45PM to 4:45PM tuesdays LUMS C85
Some notes for the last section of ECON 100
• You’ve had some experience with David
Peele’s questions – on Exam 4, I expect to see
similar style of questions from him, so practice
the maths that he is teaching.
• Gerry Steele doesn’t change his questions
much from year to year – so past exams are a
great resource for preparing for Exam 4.
(Past papers can be found on the student registry site; select
a year, select ECON 100, then look at approximately the last
10 questions on each year’s exam.)
• Gerry’s Tutorial Questions are also great for
preparing for Exam 4.
Question 1
What precisely did A.W. Phillips show on the vertical
axis in his original presentation of the ‘Phillips
curve’? (http://www.jstor.org/stable/2550759)
‘Rate of change of money wage rates, % per year’
Note: Some texts show inflation on the Y axis when
drawing the Phillips Curve. Gerry prefers to use this
notation instead. Question 2 looks at why he makes
this choice.
Question 2
How was ‘inflation’ irrelevant to the original
presentation of the ‘Phillips curve’?
‘Inflation’ was not the general experience of the UK
economy during the period of Phillip’s analysis
(1861-1957). Rather, for much of the 1920s and
1930s, prices were falling’ ’
Question 3
The Phillips inflation-unemployment relationship is
better described as “L-shaped” rather than a curve.
Explain.
ΔW/
Phillips’s explanation: ‘When the
demand for labour is high we should
expect employers to bid wage rates up
quite rapidly. On the other hand it
appears that workers are reluctant to
offer their services at less than
prevailing rates when the demand for
labour is low’
(Gerry covers this in lecture 1)
W
% unemployment
rate
Question 4 – Gerry’s solution
In the 1960s, ‘the Keynes-Phillips orthodoxy was sailing on smooth waters, the
object of much congratulation, rather like the liner Titanic prior to its collision with
the fateful iceberg’ (Edmund Phelps).
What is the nature of ‘the Keynes-Phillips orthodoxy’ and why was a collision
inevitable?
Steele’s suggested solution:
The Keynes-Phillips orthodoxy argues that inflation cannot occur with
large-scale unemployment:
‘ … an increase in the quantity of money will have no effect whatever on prices,
so long as there is any unemployment …’ (TGT: 295)
‘ … the general level of prices will not rise very much as output increases, so long
as there are available efficient unemployed resources of every type.’ (TGT: 300)
As subsequent analysis (the Friedman-Phelps expectations-augmented
Phillips curve) predicts, the co-existence of high inflation and high
unemployed is likely when monetary growth is excessive (i.e., when
ΔMS/MS &gt; ΔMD/MD, demand-pull inflation is results)
Question 5(a)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Identify each of the variables:
ΔW/W
proportionate increase in wages
P
prices
U
percentage unemployment rate
(ΔP/P)e
expected proportionate increase in prices
Question 5(b)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What sign respectively would be expected for the
coefficients f and φ. Explain.
f
negative.
There is an inverse relationship between unemployment and Δmoney
wages. This is the same as in the original Phillips curve.
φ
positive
When workers accept employment contracts, they choose wages that
reflect anticipated price changes. This is expectations-augmented
part.
Question 5(c)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Which description is usually given for φ &lt; 1. Explain.
money illusion
If the rate of increase in wages &lt; the rate of increase in
prices, then, workers are being paid less in real terms.
The workers would be mistaken to accept this, but they
might due to money illusion.
Money illusion is the idea that if you’re paid more you
must be wealthier. You’re only wealthier if you’re paid
more relative to the price levels.
Question 5(d)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the ‘reservation wage’ in the analysis of job
search?
the minimum level of acceptable wage offer
Question 5(e)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon the reservation wage
as the duration of unemployment increases?
reservation wage falls
Question 5(f)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon unemployment if
unemployment benefits increase?
unemployment is likely to rise as job search is
extended
Question 5(g)
With the expectations-augmented Phillips curve represented
conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of (ΔP/P) &gt; (ΔP/P)e.
So, we are asking, if the proportionate change in prices is greater
than the expected proportionate change in prices, what will be the
impact on unemployment. (Note, this is another way of saying if
inflation &gt; expected inflation, or if we underestimate the inflation
rate)
The period of job search is likely to be curtailed (cut short), if the
inflation rate is underestimated.
Question 5(h)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of
(ΔP/P) = (ΔP/P)e.
unemployment finds its ‘natural rate’
Question 6
With prices rising at 4.0 percent annually, and wages rising at 3.5 percent per
annually, what would be the percentage reduction in real wages over a five year
period?
To answer this question, we need to the difference between future real wages and
the current period real wages.
To find the future period real wages, we have to calculate three things here:
real wages, and wages in a future period, and prices in a future period.
Here are the three equations we’ll need:
Real Wages = nominal wage &divide; prices
Wagefuture period = Wagecurrent period * (1 + growth ratewages)ΔT
Pricefuture period = Pricecurrent period * (1 + growth rateprices)ΔT
We can put it all together into the following equation:
Real Wagesfuture period =
Wagecurrent period*(1 + growth ratewages)ΔT &divide; Pricecurrent period*(1 + growth rateprices)ΔT
Question 6 ctd.
With prices rising at 4.0 percent annually, and
earnings rising at 3.5 percent per annually, what
would be the percentage reduction in real wages
over a five year period?
First, find Real Wages (R) in Year 5:
W5 W1 1.035 5
R5 =
=
= 0.9762 R1
5
P5 P1 (1.04)
Next, find the percentage change from Year 1 to 5:
(0.9762)R1
R5
Percentage Change = 1 - = 1 = 2.4%
R1
R1
Note: Some students used another method and got 2.5% as an answer – I am showing Gerry’s
method here, and would recommend that you learn this for the exam.
The Phillips Curve
The following game is a fun way to look at the relationship
between unemployment and inflation (the Phillips Curve).
It allows you to pretend that you are the Central Bank and can
set interest rates as a tool to control inflation and
unemployment.
A high interest rate will attract people to purchasing bonds and
holding less money, restricting money supply and reducing
inflation.
A low interest rate will make investments more attractive.
People will invest in capital stock with a rate of return greater
than the return on bonds. Because the return on bonds is low,
this implies lots of capital investments will seem profitable.
These investments will create jobs and lower unemployment.
In summary:
IR↑ → inflation↓
IR↓ → unemployment↓
The game lasts 16 rounds (16 quarters = 4 years).
You have two goals:
Keep the inflation rate at or under 2%
Keep unemployment below 5%.
If you accomplish these two goals, you get re-elected as chair of the Central Bank.
Remember:
IR↑ → inflation↓
IR↓ → unemployment↓
Inflation and unemployment don’t respond immediately, there are
some lags, so it’s good to start by slightly raising the interest rate.
It’s not as easy as it sounds – let’s see how well you do:
http://sffed-education.org/chairman/
Next Week
Check Moodle for a tutorial worksheet and work
through it before coming to class.
I’ll try to add in some examples of past exam multiple
choice questions that relate to the tutorial, if possible.
Note:
Tuesday’s 5:00PM Tutorial will move to 1:00 PM in
Charles Carter Room A02 for the remainder of the
term. If you have a timetable problem, contact Sarah
Ross.
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