Macro.Week5.2008 - II 5/1 Continue working with the...

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II - 5/1 Continue working with the extended model we used last week: eg. C = 20 + (7/8)DI T = (2/7)Y - 20 TR = 220 - (1/7)Y I = 100 G = 250 X = 120 IM = (1/8)Y Remember, AE = 700 + (3/8)Y, Y * = 1120 We argued that the deficit was ENDOGENOUS Let’s show that analytically: Government Budget Balance = GBB = T - TR - G [Note: if GBB > 0, surplus, if GBB < 0, deficit] GBB = (2/7)Y - 20 - [220 - (1/7)Y] - 250 = (3/7)Y - 490 Thus, if anything causes Y to rise, GBB rises conversely, if anything causes Y to fall, GBB falls [Of course, if G rises, then we get a double effect on GBB: rise in G causes GBB to fall, but consequent rise in Y causes GBB to rise.]
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II - 5/2 Now look at concept of gap 1. Recessionary or deflationary gap occurs if Y * < Y F 2. Inflationary gap occurs if Y * > Y F Before we can discuss gaps, we must be clear on what is meant by Y F Y F is defined as the level of GDP consistent with “full employment” What does “full employment” mean? List of roughly what we mean: “good” workers find it “easy” to find a job “young” workers find it “easy” to find first job “old” workers are not forced out of LF if lose job
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II - 5/3 Remember that “full employment” does not mean that everyone is working. Why? structural and frictional unemployment Young workers move around Bad workers lose jobs, look for new Industries decline, it takes time for displaced workers to adjust Regions decline, it takes time for displaced workers to adjust So this means that we can produce at Y * > Y F which means that we are producing more output than is normally associated with full employment How? overtime, hire bad workers, etc. The problem, as we will see later, is that this usually generates upward pressure on wages and prices Hence the name: “inflationary” gap The unemployment rate at Y F is sometimes called the NAIRU
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II - 5/4 And of course we can end up producing at Y * < Y F which means that we are producing less output than is normally associated with full employment How? fire workers! The problem here is that we have lots of unemployed workers when this happens, we say we are “in a recession” [technically, a recession occurs when there are two successive quarters in which real GDP falls] Hence the name: “recessionary” gap I also used the name “deflationary” gap if extreme, will lead to downward pressure on prices, MAYBE! We will discuss this later!
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II - 5/5 Let’s graph these two situations: 1. Recessionary or deflationary gap (occurs if Y * < Y F ) (insufficient demand to sustain production at full employment): graph Keynesian cross, showing recessionary gap and excess supply at full employment
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II - 5/6 2. Inflationary gap (occurs if Y * > Y F )
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