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INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A. COURSE: ECON-211-01-SUI13 Intermediate Macroeconomics SEMESTER: Summer Session I, 2013 Tutorial 8 – 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 13th June 2013 PART 1 SELF-TEST QUESTIONS 1. “If wages are very rigid, the government can reduce inflation easily without creating higher unemployment.” Comment on this statement. If wages are rigid, there is a trade-off between unemployment and inflation. In other words, if policy makers implement demand management policies (restrictive monetary policy) to reduce inflation, unemployment will increase at least in the short run. Only in the long run, when wages become completely flexible, will the unemployment rate return to its natural level. Some think that supply-side economics, that is, policies designed to shift the AS-curve to the right, can be used to lower inflation without increasing unemployment. According to supply-siders, a decrease in income tax rates will increase the incentive to save, work, and invest. This will shift the upward-sloping AS-curve to the right, simultaneously decreasing inflation and unemployment. However, tax cuts generally also affect aggregate demand and therefore it is unclear whether these results will actually materialize. 2. Distinguish unemployment between frictional, structural, search, seasonal, and cyclical Frictional unemployment exists because labor markets do not work perfectly. At any given time, some workers are between jobs and therefore temporarily unemployed. Structural unemployment occurs since the economy constantly undergoes structural changes, resulting in a mismatch of available skills and available jobs. Search unemployment exists because some workers who are offered a job wait for a better opportunity; they can do this for some time because they receive unemployment insurance benefits. Seasonal unemployment occurs since workers are needed at different times in different areas. (Ski instructors are only needed in winter; college students tend to enter the labor force temporarily during the summer, etc.) Cyclical unemployment refers to the unemployment that occurs as the economy enters a downturn. 3. 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. 4. “The natural rate of unemployment is a helpful guide for policy makers, since most inflation is driven by wage increases.” Comment on this statement. While the natural rate of unemployment can be estimated, it cannot be accurately measured. If policy makers assume the rate to be lower than it actually is, they may try to stimulate the economy through expansionary policies as soon as unemployment rises above the assumed rate. But this will reduce the actual unemployment rate only temporarily, since the economy has a tendency to return to its true natural rate. As unemployment continues to rise, policy makers may be induced to stimulate the 2 economy again, creating inflationary pressure. Since inflation reduces real wages, workers may subsequently ask for wage increases, so there is a danger that we will enter a wage-price spiral. The assertion that most inflation is driven by wage increases also does not hold. Instead, global competition seems to have broken down the relationship between wage increases and increases in inflation. In the long run, inflation can only persist if monetary growth is excessive. 3