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lecture7 - Lecture VII Economics 202A Fall 2007 Distribute...

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1 Lecture VII Economics 202A Fall 2007 Distribute section assignments. Announce date of midterm. Tuesday, October 23. There is no class on Thursday and I will unfortunately miss office hours since I have to be in Ottawa. Either next Tuesday or next Thursday I will spend some time in class on the current macroeconomic situation. This class covers Yellen on Efficiency Wages, and Shapiro and Stiglitz on the same topic. The next class will cover Akerlof and Yellen on Near Rationality. Then next Tuesday I will claw back some time to talk about the current macroeconomic situation. I think that I will take time from Mankiw°s article on small menu costs. I will leave some comments on it in the notes, and I will also expect you to read it. vvvv Today we are going to begin talking about New Keynesian economics and theories of unemployment. I will begin with an overview and an introduction. This introduction begins with an explanation for why it is hard to find an adequate theory of unemployment. The basic problem of unemployment is the following: Involuntary unemployment occurs only when the supply of labor is not equal to the demand. Economics, at least until fairly recently, was only about supply and demand. In Economics 1 the standard picture of market equilibrium comes from the standard supply-demand graph:
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2 p S(p) p e D(p) Q e D, S Equilibrium price and quantity occur where supply equals demand. What happens if price and quantity are not at equilibrium? Then, there is some agent who could profitably engage in trade with some other agent. This is the fundamental truth about competitive markets: if S D two agents could mutually exchange with one another and both could benefit from the exchange. The fundamental truth is very far reaching. It is genuinely difficult to construct models in which S D , yet in some meaningful sense, all agents are in equilibrium ± so that there are no mutually beneficial trades that have not been made. That is the result of standard economic theory. At the same time there seems to be a lot of unemployment , some of it of long duration. Also, the total amount of this unemployment varies over time. If supply equals demand, why should there be large macroeconomic fluctuations in unemployment? It is possible to construct models with fluctuating unemployment, in which Supply equals Demand .
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3 The simplest examples are Search Theory Models of unemployment. But such models almost of necessity make a very wrong prediction about the cyclical nature of labor turnover. In search theory labor does not always accept jobs in the downturn because the terms of existing jobs have deteriorated. But if workers are shunning jobs because of bad terms of employment, that does not explain why voluntary quits fall dramatically as unemployment rises.
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