Download ECON366 - KONSTANTINOS KANELLOPOULOS

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: ECON-211-01-SUI13 Intermediate Macroeconomics
SEMESTER: Summer Session I, 2013
Tutorial 10 – for tutor
INSTRUCTIONS
Students are required to study the following questions and problems indicated and to be
able to solve them by themselves.
Although this is not a required part of a coursework, the purpose of the tutorial is
twofold: to help the student understand the methodology for solving the problems and to
help him/her prepare for the courseworks and/or exams. The utilisation of this resource
can be maximised depending on the time and effort each individual student devotes.
Konstantinos Kanellopoulos
17th June 2013
PART 1 SELF-TEST QUESTIONS
1. True or false? Why?
“Frictional unemployment does not exist when unemployment is at its natural rate.”
False. The natural rate of unemployment is the rate that exists when the economy has reached the fullemployment level of output. But even when the economy is at full employment there is always some
unemployment due to new entrants into the labor force, people between jobs, and the like. This rate of
unemployment is considered normal, due to frictions in the labor market, and is often called frictional
unemployment.
2. What kinds of policies would you suggest to reduce the natural rate of
unemployment?
The answer to this question is student specific. Policies to reduce the natural unemployment rate must
reduce the frequency or duration of unemployment and affect the composition or demographic makeup of the labor force. Policies that make workers more mobile, make information regarding job
vacancies more accessible to the public, or reduce the variability of the demand for labor across
industries can also be considered. Other possibilities include a reduction in the minimum wage rate or
a unemployment benefits, but these proposals are controversial due to their negative effects on
individual workers.
3. “Restrictive monetary policy will help to decrease inflation; the resulting increase in
the natural unemployment rate is a small price to pay.” Comment on this statement. In
your answer, explain what policies the government should design to lower the natural
rate of unemployment.
Restrictive monetary policy will lower the rate of inflation at the cost of increasing the actual rate of
unemployment, but in the long run the economy will adjust to the natural rate of unemployment. In
other words, monetary policy does not affect the natural unemployment rate; only employment
policies or changes in the composition of the labor force affect it. Employment policies involve
educating workers or increasing their skills to make them more mobile, making information about job
opportunities more readily available to them, or reducing discrimination to allow certain groups to
find jobs faster.
4. Comment on the following statement:
"Financial innovation raises the income velocity of money."
Money demand can be expressed as a function of interest rates, income, and financial innovation (e),
where a positive value of the term “e” reduces the demand for money, that is,
md = L(i, Y, e).
Velocity is defined as V = (PY)/M = Y/(M/P).
If we assume that the money sector is in equilibrium, money demand can be substituted for
money supply, and we get
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md = L(i,Y, e) = M/P = ms ==> V = Y/L(i, Y, e) ==> V = f(Y, i, e),
that is, velocity is a function of income, the interest rate and financial innovation. Therefore, if there
are financial innovations (and the value of e goes up), the demand for money declines. This raises the
number of times a dollar bill circulates in the economy during a given period of time. In other words,
it increases the income velocity of money.
5. Assume you know that nominal money supply (M) has increased by 6%, real output
(Y) has increased by 2.5% and the income velocity (V) of money has dropped by 3%.
What rate of inflation should we expect?
From the quantity theory of money equation MV = PY
==> %M + %V = %P + %Y ==> %P = %M - %Y + %V
==> %P = 6% - 2.5% + (-3%) = + 0.5%.
Therefore the rate of inflation (%P) should be 0.5%.
Note: The equation that shows the percentage changes in money supply, output, velocity, and prices
generally only applies for very small changes in these variables. Therefore, the result above is only an
approximation of the actual change we should expect in the price level.
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