ECON 100 Tutorial: Week 20 www.lancaster.ac.uk/postgrad/alia10/ firstname.lastname@example.org 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 > 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 < 1. Explain. money illusion If the rate of increase in wages < 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) > (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 > 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 ÷ 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 ÷ 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.