Macro.Week7.2008 - II - 7/1 Review: expansionary fiscal...

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II - 7/1 Review: expansionary fiscal policy in situation of deflationary gap: This means a much flatter AS: full linked diagram
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II - 7/2 Now suppose expansionary fiscal policy, inflationary gap This means a much steeper AS: full linked diagram
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II - 7/3 eg. Contractionary fiscal policy Suppose deflationary gap, flatter AS (causes unemployment): Now inflationary gap, steeper AS (fights inflation): COUNTER- CYCLICAL FISCAL POLICY
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II - 7/4 Now turn to the long run: issue is whether there is a natural adjustment mechanism that can eliminate inflationary or deflationary gap in the long run. THEORY says that problems are solved by changes in wages 1. What do changes in nominal wages do to the curves? a) a rise in wages: NO EFFECT on AD, since wages have no effect on AE [why? - rise in wages raises workers’ incomes, but lowers shareholders’ incomes; overall no change in real income, so no change in AE] BUT EFFECT on AS, since wages affect cost of production rise in wages makes production less profitable, so firms willing to supply less at any level of price, so AS shifts up and to left: show shift in AS as w rises
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II - 7/5 b) a fall in wages: NO EFFECT on AD, since wages have no effect on AE [why? - fall in wages lowers workers’ incomes, but raises shareholders’ incomes; overall no change in real income, so no change in AE] BUT EFFECT on AS, since wages affect cost of production fall in wages makes production less profitable, so firms willing to supply more at any level of price, so AS shifts down and to right: show shift in AS as w falls
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II - 7/6 Now, what happens in long run if there is a deflationary gap: IN THEORY wages should FALL Why? with a deflationary gap, there is lots of unemployment. Eventually, this should cause wages to go down, as unemployed workers offer to work for less In fact, that is what micro labour market supply and demand predicts: show labour market supply and demand with high unemployment (wage set too high) so wage forced down by excess supply wages should fall because of pressure on both sides: unemployed workers offer to lower price firms should pressure existing workers to take less, because of alternative workers
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II - 7/7 so IF the deflationary gap causes wages to drop in the long run because of slack labour markets, then we have a mechanism in the long run that might drive us back to full employment: look at AS-AD dynamic, with a linked diagram: show deflationary gap flat AS AS moving down as wages fall; fall in P causes AE to rise
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II - 7/8 We could also illustrate this algebraically Return to previous example with deflationary gap (flat AS) AD: P = 300 - (1/4)Y AS: P = 20 + (1/10)Y
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Macro.Week7.2008 - II - 7/1 Review: expansionary fiscal...

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