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 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