At 11:38 AM 1/11/2005, you
wrote:

Professor here are my 2
questions:

1) When we went over the paradox of thrift, we said that private saving + government
saving equals

investment. You then went on to write the equateion :

-Co + (1-C1)(Y-T) + T(bar) + G(bar) = I(bar). My question is how you derived
this equation. I

understand the T(bar) G(bar) and I(bar) parts but im not quite sure where the first part came from.

Answer: The national income
identity is Y=C+I+G, or, after rearranging, Y-T-C = I + G-T, which says that
private saving, Y-T-C, must equal borrowing by business to finance investment
plus borrowing by the government. This must always be true, whether in
equilibrium or not. In equilibrium, the national income identity holds with all
variables equal to their planned values. Private saving, given our consumption
function, is -c0 + (1-c1)*(Y-T(bar)), where T(bar) is
the assumed value of taxes. Also, planned investment is I(bar)
and planned government spending is G(bar). This is where the equation you cite
in your question comes from. That equation only holds in equilibrium, because I
is equal to I(bar) only in equilibrium. Outside of
equilibrium, I is I(bar) plus unintended inventory
accumulation.

2) When we talked about the financial markets, we talked about what would
happen if consumption

went from 80 to 75. And I think what happens is that when C goes down by 5,
that means people are

buying 5 less shirts so that means firms have left over inventory of 5, which
means that investment

goes up by 5, so to finance this extra investment they have to borrow this
amount from the

financial markets, but this all works out because since C goes down by 5,
households are depositing

an extra 5 in the financial markets?

Answer: that's exactly right.

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Question: Hi,

I do not understand the accelerator effect. Could you please explain it
in detail?

Answer:

Hi:

In our discussion of the IS-LM model, we made planned investment a
negative function of the interest rate:

I = I(bar) - b*i,

where i is the interest rate. I spent some time
motivating this negative relationship.

In class, I discussed the fact that some people think investment is usefully
thought of as being a function of aggregate economic activity, Y, too (see, for
example, the book, on page 106). Why might investment be a function of the
general level of economic activity? To see why, it is useful to go back to my
discussion of why investment is a negative function of the interest rate. Each
potential investment project has associated with it an 'internal rate of
return'....the amount of extra revenues the investment project is expected to
generate in the future, per dollar spent today. An example I gave in class was
that of a restaurant contemplating investing in a new pizza oven. That oven
cost some amount of dollars today (say $100), and was expected to produce an
addition to revenues in the future of (say) $5. In this case, the internal rate
of return is 5%. The pizza oven will be invested in if the interest rate is 5%
or less. But, think about those extra $5 in revenues
the oven is expected to produce. Obviously, that expectation incorporates some
assumption about how many people out there will come in to buy pizzas. If more
than expected come in for pizzas, then the internal rate of return could be
higher, as the restaurant sells more pizza. If fewer customers show up, then the
internal rate of return could be lower. The idea is that the demand a
restaurant (or any other firm) can expect is related to what total economic
activity, Y, is. When current Y is high, individual firms deduce that a lot of
demand will show up at their doorstep, and this leads them to revise upward
their assessment of the internal rate of return on investment projects. The
result is a right-shift in the investment demand equation (the down-sloped
graph with i on the vertical axis and investment on
the horizontal). Similarly, when Y is low investment demand shifts left. This
is summarized in the equation,

I = I(bar) + b1*Y - b2*i, b1, b2>0.

So what does all this have to do with an accelerator? To see this, notice that
with b2>0, there are now two things in aggregate planned spending that
respond positively to income: household consumption and business investment.
That is, the slope of planned spending is now c1+b1 (here, c1 is the marginal
propensity to consume). The Keynesian Cross multiplier is just

1/(1-slope of ZZ curve) =
1/(1-c1-b1).

Notice that this multiplier is BIGGER than the Keynesian Cross multiplier. For
example, if c1=.75 and b1=.1 then the multiplier is not the number 4 that it is
when b1=0, but a bigger number, 1/(1-.85)=6.67. So,
with b1>0 equilibrium output rises by more (potentially, a lot more if b1 is
big) in the Keynesian Cross model. In addition, since the Keynesian Cross
multiplier is the amount by which the IS curve shifts right in the IS-LM model,
b1>0 also increases the multiplier in that model.

The fact that the effect of an exogenous shock on equilibrium output is bigger
when b1 > 0 is why it is said that setting b1 > 0 in the investment
equation introduces an 'accelerator' effect into the model. For example, if
there is a rise in G of $1, the rise in equilibrium output with b1 = 0 is $4.
When there is an accelerator effect on investment, then the rise in equilibrium
output is $6.6. Setting b1 > 0 in effect added some juice to the multiplier.

What's the intuition for all this? It's just a continuation of the intuition
underlying the multiplier itself. That is, when there is an exogenous shift up
in spending (say a rise in G), then output increases by more than just that
increase in spending. The reason is that the initial increase in spending
triggers additional increases in spending by households (due to c1 > 0) and
now, by firms. This extra spending by firms acts in the same way on the economy
as if households simply had a higher marginal propensity to consume.

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Question:

At 08:35 PM 1/22/2005, you
wrote:

Hey
Professor,

I just had a quick question. Why does an increase in taxes shift IS curve
to the left? I would think that with an increase, govt
spending would increase to offset the decrease in consumer spending. Therefore keeping it the same. Thanks.

Answer:

Hi:

In our model, government spending is a exogenous
variable. This means that it does not shift, unless we specifically assume it
does. So, when you say that taxes go up and you say nothing else, this
implicitly says that none of the other exogenous variables (including G) moved.

You are referring to what is perhaps a more interesting model, a model that is
different that the one we've discussed in class. In your model, G is a function
of T. In that model, if you raise T, the contraction would be less severe, as
you say, because the increase in G itself exerts a positive effect on output.
Indeed, the contraction could actually turn into an expansion. For example, if
when T rises by $1, G rises by the same amount, then we get the balanced budget
multiplier: in the KC model, equilibrium output would RISE by $1 and in the
IS-LM model the IS curve would shift RIGHT by $1.

Larry

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11:54 AM 2/13/2005, my answers immediately follow the questions in this email:

Hi Professor Christiano,

I have some questions about the material I am studying for the midterm.

1) In the globalization graph, why does the decrease of "z", thus the
decrease of workers'

bargaining power, lead to lower unemployment? I understand the graph, but not
the intuition.

In our model, in the medium run, the outcome of worker bargaining must be
consistent with the real wage implied by firms' price setting equation. The
only endogenous variable, in the medium run, in the bargaining relationship
that can accomplish this is the unemployment rate (other variables appear in z,
but they are exogenous variables). A higher unemployment rate is associated
with a worse outcome (i.e., a lower real wage) for workers. A lower
unemployment rate is associated with a better outcome. So, if something happens
(i.e., a shift in some exogenous variable in z) which reduces the bargaining
power of workers, but does not change the price setting equation of firms, then
the unemployment rate consistent with the unchanged real wage is lower.

2) In the oil shock example
when government intervened and increased M to push the AD up,
does this

push in AD occur after the first upward shift of the AS curve, or after the
second upward shift of

the AS curve?

Most of the experiments that we have done involve a shift in just one exogenous
variable. In the oil shock example, two exogenous variables were shifted. The whole
analysis was done simultaneously, though perhaps with a small delay in M,
because the move in M was viewed as a reaction to the recession produced by the
oil shock. Still, in my analysis, the short run equilibrium involves a
right-shift in the AD curve (due to the increase in M) as well as a left-shift
in the AS curve (due to the oil shock). The short run equilibrium occurs at the
intersection of these two new curves (holding Pe
fixed). The medium run equilibrium occurs at the intersection of the AD curve
(this does not shift any further after the short run) and the new Yn.

3) Is there some kind of rule about AD and AS moving up, down only, or left,
right only? Like how

the LM curve moves up and down, and the IS curve moves left and right?

If the economy finds itself above the AS curve, we can expect the price level
to rise. If below, P falls. These things happen fairly
slowly because not everyone is renegotiating their wage at every moment. In
many cases, wage negotiations only come up once a year or even less often.
Similarly, price-setting decisions are not revised continuously by all firms.
So, what we say is that when the economy finds itself off the AS curve, forces
come into play that slowly move the price level to that curve. Analyses of the
data suggest that P may respond more slowly to being off the AS curve than Y
responds to being off the AD curve. But, the evidence is not particularly sharp
on this. So, I'll just maintain that they both move slowly. In any case, note
that how fast P, Y, i move when in disequilibrium has
nothing to do with where the short run and medium equilibria
are.

4) Is stagflation's
definition: Price increases when output decreases? In this case, stagflation

doesn't only occur when government increases M in the oil shock, correct?
Because with or without

government increasing M, an oil shock is can always decrease output and
increase price?

The word stagflation means P going up when output falls (stag - stagnation, flation - inflation). This received a special word in the
1970s because observers at the time thought it was quite unusual.

5) Whenever there's a change
in the AS relation, we find the new Yn' and then find
the point where

Yn' intersects P, where P is Pe=P
in the old MR equlibirum.
And then we draw the new AS curve

through this point. Why does the new AS curve have to
be on this point? What is the signficance of

the intersection between Yn' and P when Pe=P?

In algebraic terms, the AS curve is:

P = (1+mu)*Pe*F(1-Y/L,z),
(*)

where mu is the markup, Pe
is the expected price level, Y is aggregate output, L is the labor force and z
is a 'catch all' for other exogenous variables that impact on the labor market
(examples we have discussed include globalization and the quality of the
unemployment system). Here, the unemployment rate, u, corresponds to 1-Y/L,
under the assumption that Y=N, where N is aggregate employment (when we discuss
the effects of increased labor productivity, we set Y=aN and consider the effects
of a change in a). Because F is decreasing in u (make sure you understand why
this is so), it follows that F is increasing in Y. This is why the AS curve is
positively sloped. Note that the precise location of the AS curve depends on
the value of Pe as well as on the exogenous variables,
mu and z.

We define the natural rate of unemployment, un, as the unemployment rate that
occurs when the expected (i.e., Pe) and actual (i.e.,
P) price levels coincide. That is to say, un is defined by 1=(1+mu)*F(un,z). We define the natural rate of output, Yn, as the level of output that occurs when the actual and
expected price levels coincide, i.e., 1=(1+mu)*F(1-Yn/L,z).

From the last relationship, you can see that if you take the AS curve and
evaluate it at P = Pe, you get:

Pe = (1+mu)*Pe*F(1-Yn/L,z).

So, when you graph the AS curve and you look at the point on the vertical axis
were the actual price level equals Pe, then the
associated value of Y is Yn. This is so, because this
is how we defined Yn.

Suppose now that we shift the AS curve for some reason, say by shifting z, or
changing the value of mu. Then, the new value of Yn, call it Yn', solves the new
equation: 1=(1+mu')*F(1-Yn'/L,z'). So, when you graph
the new AS curve (holding Pe fixed at its old value),
then when you look up Pe on the vertical axis, you
find that the level of output it is associated with is Yn'.
Again, this is because of the way Yn' is defined.

6) About the analysis of
"a" increasing in u=1-Y/aL, I understand why u does not change in the
W/P

vs. u graph, but I don't understand why AS(pe) shifts down. I am looking at the AS relation

function and I see that it is P=(1+mu) Pe*F (1-Y/aL, z). From what I understand, Y and a increase

by the same amount in order to keep u constant in u=1-Y/aL. Wouldn't this mean
the proportion Y/aL

stays the same in the AS relation equation as well? Then wouldn't this mean the
AS would stay

constant and not move down?

Let's first make sure we understand why the natural rate of unemployment, un, does not change with the change in a. The natural rate
of unemployment solves 1=(1+mu)*F(un,z).
This is an equation that does not involve a and this is why un
does not respond to a. However, Yn is the solution to
un=1-Yn/(a*L). This equation does involve a, and so Yn does change with a. Yn
increases.

Consider the version of the AS curve that takes into account a. Appropriately
modifying the logic that resulted in (*) above, we find that the AS curve is:

P = (1+mu)*Pe*F(1-Y/(aL),z).

From this, you can see that when a goes up, for given Y, Y/(aL) goes down and 1-Y/(aL) goes
up. Because F is decreasing in u, it follows that an increase in a results in a
lower value of F(1-Y/(aL),z)
for each value of Y. That is to say, the AS curve
shifts down. The intuition for this is simple. At a given level of output, if a is higher, then employment is lower and so unemployment is
higher. But, the higher unemployment reduces the bargaining power of workers
and their wage outcomes deteriorate.

The preceding logic explains why the AS curve shifts DOWN, when we consider the
vertical direction of shift (i.e., we hold fixed Y). It is also useful for us
to think about the horizontal direction of shift. We can see this by
considering the point on the vertical axis that corresponds to Pe, the expected price level that was used in the
construction of the AS curve. For the reasons discussed above, this value of
the price level is associated with the natural rate of output. I argued above
that the natural rate of output increases with an increase in a (let Yn denote the old natural rate of output, and Yn'>Yn the new one). This
means that if you draw a horizontal line emanating from the vertical axis at P=Pe, the new AS curve intersects that line at the point Yn' > Yn. That is to say, the
AS curve shifts to the RIGHT.

In your question you note that Y/(aL)
in the medium run remains unchanged with the change in a, and so perhaps the AS
curve should not shift. You are right that Y/(aL) does not change in the medium run. However, this does
imply a change in the AS curve, because for Y/(aL) not to change when a changes implies that Y changes.
And, it is Y that appears on the horizontal axis.

7) I wrote down in my notes
that AS shifts to the right because Y increases as a
increases (but I

am still confused about what exactly moves AS, is it what I mentioned in #6 of
is it just the Y

increasing?) If the increase in Y is what moves the AS curve outward, does this
move the AS curve

to AS', where short run eq. is, or does this move the
AS curve to AS'', where medium run is? If the

increase in Y is only responsible for one of these AS shifts, what is
responsible for the other one?

Most of this was answered (I hope!) in the previous question. But, here is one
thing to keep in mind. The movement of an object (like a curve) in a two-dimensional
space is complicated. You can describe it as a move in the horizontal
direction, the vertical direction or any combination of the two. In practice,
it is convenient for us to think of movements in the vertical or horizontal
direction. For example, it is easiest to think of the shift in the IS curve
that occurs with an exogenous shock in the horizontal direction. That's because
this corresponds to the Keynesian Cross multiplier, and we've spent a lot of
time talking about this. In principle, you could think of the SAME shift in the
IS curve in the vertical direction. With the LM curve, I find it most
convenient to think of its response to an exogenous shock (e.g., to money
supply or demand) in terms of the vertical dimension of the shift...i.e., the move
in the interest rate. This seems natural when you think of the money
demand/money supply graph that underlies the LM curve. However, you can also
think of a shift in the LM curve in the vertical dimension.

Thank you so much for your
time and help; I really appreciate it.

I hope this helps, Larry

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2/13/2005 email answers
follow questions:

**Why is there 100% Crowding out in the Medium Run? (I think that we used the scenario of decreasing government spending in class).**

The medium run occurs as Pe moves to equality with P.
The fact that the economy is on the AS curve implies that output is at its
natural rate (for a discussion, see my response to question #5 in the 11:54 AM
2/13/2005 email). That is, Y = Yn (*). The fact that
the economy is on the AD curve implies that the goods market (also the
financial markets) is in equilibrium. That is, Y = Cp + Ip
+ Gp (**), where Cp, Ip and
Gp are planned consumption, investment and government
consumption, respectively. Here, Gp is exogenous in
our model, and equal to G(bar). Putting (*) and (**)
together, we conclude that Yn = Cp + Ip + Gp. Since Yn is the same in the new and old equilibria,
Cp must also be the same in the new and old equilibria.
But, Gp is higher in the new equilibrium, so Ip must be lower by the same amount. That is, in the medium
run there is complete crowding out.

**For globalization, I don’t quite understand why would F(u,z) go down? I know it affects z, but how do we know if it goes up or down? Does F(u,z) generally stands for the bargaining power of workers, so globalization would weaken the bargaining power and thus causing F(u,z) to shift downward?**

You are exactly right. Globalization makes F(u,z) move down. Workers can't be so demanding when the
number of workers they compete with goes up with globalization.

**When a shock occurs, sometimes Yn changes and sometimes it doesn’t in the Medium Run. Is it true that the only time there will be a new Yn after the shock is if markup, labor productivity or natural rate of unemployment change?**

Recall the equation that defines Yn: It is 1=(1+mu)*F(1-Yn/(aL),z) (for
explanation, seem my response to the 11:54 AM 2/13/2005 email). If the
variables we have lumped into z (i.e., unemployment insurance, globalization)
or mu, or a, or L does not change, then Yn cannot change.

I hope this helps, Larry

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2/13/2005 email:

Question: In my notes, i have that the natural rate of unemployment is high in

Answer: In class, in response to a very insightful question, I described the
so-called 'ticking time bomb' theory of how high unemployment benefits in

The 'problem' with any theory that relates the high quality unemployment
benefits in

One answer is that the system put in place after WWII was like a ticking time
bomb. It needed the right circumstances to have its effect on the unemployment
rate. The key feature of the system is the 'replacement ratio'. This is the
fraction of the wages you earned in your previous job that the system replaces
when you become unemployed. For example, if the replacement ratio is 70
percent, then when you lose your job, the unemployment benefits give you 70
percent of the wage you had before you lost your job.

The idea is that the nature of job turnover in the first few decades after WWII
was very different from what it was starting in the late 1970s. The idea is
that in the early period, people who lost their jobs typically could find
another one (after some search) at roughly the same wage rate (e.g., you quit
your job working at one gas station, and moved to another one across town where
the pay was similar). Since the replacement ratio typically put you at a lower
income than before you lost your job, unemployment was not particularly
attractive. Then, in the 1970s job turnover increasingly was associated with
people losing their jobs because of technological change. People who lose their
jobs under these circumstances often find that their basic job skills have
become redundant (examples are secretaries when the pc came in and people started
doing their own typing). As a result, their next best job may involve a very
substantial drop in wage. Under these circumstances, the replacement ratio in
the unemployment system can look a lot more attractive. This is one (not
uncontroversial) explanation of how the European unemployment system caused
unemployment to rise in the 1970s.

Best,

Larry

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2/13/2005

Quick question about
Investment. Say there is a decrease in Government spending and the AD curve
shifts to the left and decreases price level and output, what happens to
Investment in the short run and medium run? I figure it would be unclear
because there is a decrease in interest rates as well as output.

Answer: You are right. When we include the accelerator effect on investment,
then a fall in output produces a fall in investment. So, when there is a cut in
government consumption and the interest rate rises and output falls, it is
unclear what the net effect on investment is in the short run. Without the
accelerator effect (i.e., with b=0) investment unambiguously rises because of
the fall in i. However, with a big enough accelerator
effect (i.e., with b positive and big enough to produce a really big KC
multiplier) the fall in output could be so big that investment actually drops.
So, in the short run the impact of a cut in G on I depends on the magnitude of
the accelerator effect. In the medium run the accelerator effect is irrelevant
because there is no impact of G on the natural rate of output. In the medium run
I rises by the same amount as G falls.

Larry

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2/15/2005

Question: What is the fatal
flaw in returning to the gold standard? I'm not clear how you said it in
class. Thanks.

Answer: The phenomenon of
interest is that after 1919

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2/15/2005

Question:

In lecture on Feb. 2nd, at the end of class you were finishing the analysis of Governent spending

increasing leading to a decrease in unemployment, an increase in Money Supply,
better wages, higher

Price...why does the higher G lead to a lower u? Why does Money supply
increase?

Answer:

I don't have my lecture notes here, so I'm not sure exactly what I did on
February 2. However, the analysis you describe involves a movement in two
variables that we have treated as exogenous, G and the Money supply. It's not
until recently that I have talked about the effects of two exogenous shocks
simultaneously. In my answer I'm going to assume that you meant Money demand,
not money supply. Money demand is endogenous because it depends on three
endogenous variables, the interest rate, output and the price level.

Here is a long answer.....I hope it addresses your concerns

In our model (the AD-AS model), an increase in G shows
up as a shift right in the AD curve. That's because at a given price level, a
higher level of income is associated with equilibrium in the goods and
financial markets. To see this, consider the IS-LM diagram. An increase in G
shifts the IS curve right by the amount of the KC multiplier, and this leads to
an increase in output that is somewhat less (because of the rise in the
interest rate) than what is predicted by the KC multiplier. That is, the IS-LM
multiplier is less than the KC multiplier. This analysis implies that the AD
curve shifts right by the amount predicted by the IS-LM multiplier. So, the
short run equilibrium, which occurs at the intersection of the AS curve and the
new AD curve involves a higher price level and a higher level of output. In the
medium run, output is back to where it was before (assuming, as we typically
do, that we began in a long-run equilibrium), though the price level is now
higher. The way this works is that as the short run turns into the long run,
people notice that the price level is higher than the original value of Pe, and so Pe starts to rise,
shifting the AS curve to the left. It stops shifting left when it intersects
the vertical line above Yn at the point where the AD
curve intersects that line. We are now in medium run equilibrium and the raw
technical part of the analysis is complete.

The AD curve and the AS curve summarize a lot of economics in a concise way.
Let's now 'unwrap' all that economics. What would an
observer in this economy see? The initial rise in G would show up as an
unintended drop in inventories of firms. The rise in G would start hitting
actual production when those firms start to order more goods from producers and
producers increase output and employment. In the AD-AS diagram, the economy is
starting to move right from its original medium run equilibrium point (this is
a point that is no longer an equilibrium, because the
AD curve is now sitting to the right). Similarly, in the IS-LM diagram, the economy
is moving from its initial position to the right (the original point is not an
equilibrium because the IS curve shifted to the right). The expansion in output
has an impact in two places: financial markets and labor markets. In financial
markets, the rise in output leads to an increase in the demand for money,
because the number of transactions is increasing. People in financial markets
begin to react by trying to sell bonds. This drives their price up and the
interest rate down. In terms of the IS-LM diagram, the economy rises to the LM
curve to clear the financial market (in terms of the money demand equation -
this is summarized in the LM equation - with real balances on the horizontal
axis and the nominal interest rate on the vertical, the demand for money is
shifting right with the increase in Y). The expansion in output also
impacts on the labor market, in the supply side of the economy. This is because
the unemployment rate drops as employment is increased. The drop in
unemployment increases the bargaining power of workers and so their wages rise.
The rise in wages, because they reduce costs, leads firms to post higher
prices. This connection from higher output to a higher price level is
summarized in the upward-sloping AS curve. The increase in output and the
increase in price level finally take us to the short run equilibrium point.
There, the interest rate is higher, unemployment is lower and consumption is
higher (this is because consumption depends on Y). We can't say for sure what
happened to investment unless there is no accelerator effect (i.e., q=0). When
q=0, we know investment is lower because of the higher interest rate. when q>0 investment might be higher, if the accelerator
effect dominates the interest rate effect.

Question:

Another question I have is
from my notes on globalization (02/09), I think I have a decent

understanding of globalization now, but I was confused as to what you meant in
class when you said,

monopoly of firms leads natural rate of unemployment to decrease to nat. rate of unemp. prime...and

then monopoly of workers leads nat. rate of unemp. to shift to nat. rate of unemp. double

prime...what is the monopoly of workers and firms? I understand the graph and
why in one case nat.

rate of unemp. would move to
one point depending on what forces are affecting it, but I was

confused with the meaning of monopoly of firms and workers.

Answer:

My answer is a little long, because I want to put it into proper context.

In class, I argued that globalization might show up in three places: (i) it would hurt workers' bargaining power relative to
firms, because globalization expands the set of workers that the firm could
potentially hire....as a result, a break-down in the bargaining process hurts
the worker doing the bargaining more than it hurts the firm, since the firm can
now more easily find another worker (say, by moving to Mexico, or India). In
this sense, because workers now have to compete with more workers,
globalization reduces the monopoly power of workers. We modeled this effect of
globalization as a shift down in the F function. (ii) globalization
also cuts into the monopoly power of firms. They now have to think twice about
posting high prices. If they set prices too high it is more likely after
globalization that they would lose their customers to another firm. We modeled
this effect of globablization by a decrease in mu. (iii) globablization
is also likely to increase the efficiency of firms. This would happen in two
ways. First, inefficient firms are more likely to disappear with globalization
because the competition is greater. Second, firms that do survive have a strong
incentive to become more efficient - aggressively adopt more advanced
technologies, maintain better discipline and accountability in their work
force, etc. - with the increased competition from globalization. We captured
this by thinking of an increase in a. (In class, I argued that an increase in a could also occur in the absence of globalization, when new
technical discovers occur. Similarly, mu and F could
shift for reasons other than globalization too.)

I hope this helps, Larry

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2/15/2005

Question:

Hello Professor,

I had a quick question about
shocks to the AS curve. I understand graphically what happens when a or L change, however, I'm having trouble understanding why
unemployment doesn't change. Un solves the equation 1=(1+mu)*F(un,z) and thus b/c a and L aren't in that equation,
unemployment can't change. But isn't Un also given by Un=1-Yn/(aL)? Would it make
more sense to say that b/c a or L go up, we are given a new natural rate of
output and therefore, Un does goes up in the short run, due to aL increasing more than Y. Not until the new MR, in
which Yn has increased proportionally to aL, does Un return to it's
previous MR value. Is that correct? Sorry for the repetition, I
know you went over this with other students already, I
was just having problems understanding exactly why unemployment would remain
unchanged.

I was also wondering if
questions 1 and 2 from your fall '97 midterm #2 were relevant. You speak
of NAIRU and I don't remember doing that as well as a time consistency problem
which seems to be from Ch 8.

Answer:

In terms of coverage of the exam, it will only cover material up until last
Wednesday. We did not do time consistency or NAIRU. So, they aren't covered.

On the connection between un and a, L. We have two
equations for output and unemployment in the medium run: (i)
1=(1+mu)*F(un,z) and (ii)
un=1-Yn/(aL).
An analogy might be helpful. Consider the following two equations: (I)
x=8 and (II) q*x+y = 10. Note that equation (I)
determines x and that q has no impact on the value of x. Equation (II) takes
the value of x determined by (I) as given and (II) then determines y. Equation
(I) corresponds to (i) and equation (II) corresponds
to (ii). This is why un is independent of a or L: un
is determined by (i) and a and L just don’t
appear there. (Actually, it would be odd for a or L to
determine the unemployment rate. Both a and L have
steadily increased over the past 200 years. We haven’t observed any
corresponding trend in the unemployment rate.)

You suggest that un goes up in the short run. But, by
definition, un is a medium run object. It's where the
actual unemployment rate moves to in MR because of the nature of the
assumptions we made about disequilibrium dynamics. After a change in a or L,
there is no change in un (just like the value of x in
the example doesn't change with a change in the value of q). What does change
in the short run is the unemployment rate, u.

Larry

&&&&&&&&&&&&&&&&&&&&&&&&&

2/15/2005

Question:

Say there is an increase in L
and the AS curve shifts to the right, what happens to unemployment in the short
and mediun run? I remember being told that it was the
same in the MR and it increases in the short run, and that was because in the
medium run the new and old natural rates of out are the same. I dont understand why this is so.

Answer:

When in the first sentence you said that the AS curve shifts to the right,
implicitly you were saying that the natural rate of output increases. But, in
the second sentence you suggest that the natural rate of output may be the same
in the initial and final medium run equilibria,
without noting the contradiction.

Be careful to understand why it is that an increase in L shifts the AS curve to
the right. It is the fact that the natural rate of output increases. In fact,
if you consider the point on the horizontal axis where P = Pe,
then the horizontal shift at that point in the AD curve corresponds exactly to
the increase in Yn. To see this, look at the equation
that corresponds to the AS curve:

P = Pe*(1+mu)*F(1-Y/(aL),z)

When P=Pe, then this equation reduces to

1 = (1+mu)*F(1-Y/(aL),z).

The value of Y that solves this equation is what we call the natural rate of
output, Yn.

To see what happens to unemployment in the short run, shift the AS curve to the
right, and note that because the AD curve is downward-sloping (recall the
economic reasoning for this), output in short run equilibrium is less than the
new natural rate of output. But, output would have to rise at least as much as
the natural rate of output rises, in order to keep unemployment at the natural
rate. Since in the short run output necessarily rises by less, if follows that
unemployment rises in the short run.