Question 5
Question 5 (35 points)
The closed economy of Tundra Island is characterized by the following equations:
Consumption: C = XXXXXXXXXXY – T)
Investment: I = 1500 – 300
Government spending: G = 5000
Taxes: T = 4500
Real money demand: L = 0.65Y – 500i
Expected inflation = 0
Production function: Y = (K)^1/2(L)^1/2 (i.e. K to the power 0.5 times L tot he power 0.5)
The nominal money supply = 35000 Note: Interest rates, both i and r, are expressed in
percentage points, i.e., if r = 5.5, then the real interest rate is interpreted as being equal
to 5.5%.
Suppose the IS-LM model can be to describe Tundra Island, and answer the
following questions. Keep your answer to at least THREE decimal points if
necessary.
a) Derive the IS and LM equations for this economy. (4 points)
) Suppose we are in the base period, so the price level is fixed at 1.00. Calculate
the resulting short-run equili
ium values of real output, real interest rate,
investment, consumption, the government budget balance, and price level. (3
points)
c) Suppose, in the long-run, XXXXXXXXXXreal) units of capital are utilized and 36000
workers are employed. Calculate the resulting full-employment values of real
output, real interest rate, investment, consumption, the government budget
alance, and the price level.
d) Suppose the government decides to change the level of taxation to create
udget surplus of 600. Calculate the resulting (new) short-run equili
ium values
of real output, real interest rate, investment, and consumption. Determine the
unemployment rate that results in short-run equili
ium.
e) Suppose, instead, we are also told that when the economy was in long-run
equili
ium (in part C, above) 1500 people were unemployed. Further, when the
shock hit the economy (in part D, above) in net terms no people have exited the
labour force. Determine the unemployment rate that results in the short-run
equili
ium from part D. What portion this unemployment is represented by
cyclical unemployment and what portion is comprised of those in the natural rate
(level of) unemployment (NRU).
Hint: Cyclical unemployment is the level of unemployment that results from
deviations of output from the full-employment level (Actual U = Cyclical U + NRU).
f) When the economy returns to long-run equili
ium what unemployment rate
should we expect to see? Explain why/when this makes sense.
g) Determine the (new) LR equili
ium values of real output, real interest rate,
investment, consumption, and the real money supply that result due to the shock
described in part D (above).
h) Draw one well labeled IS/LM diagram that depicts the initial LR, the new SR and
new LR equili
ia for this economy. Be sure to clearly identify the different
equili
ium points on your diagram, but no further written explanation is required.
Money, Prices & Inflation in the LR (Ch4)
Unemployment in the LR - (Ch7)
MGEB06
Key Labour Market Definitions
Working Age Population (WAP) is the entire population between the ages of 15 and death.
Canadian labour force statistics cover the entire population 15 years old and up. So in ALL cases (below) we are summing over people aged 15 & up.
With this convention are 14 year olds with jobs skewing the statistics?
In 2016, according to Statistics Canada, 16.5% of the population was over the age of 65 years old, and 16.1% was younger than 15 years old.
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Employed (E)
Employed (E) if work full-time; or part-time in a paid job (or was on sick leave; vacation; or on strike).
The number of employed E is in some sense an over estimate since it does not take into account:
- underemployment that is people with part-time jobs who want full-time jobs;
- it does not address whether employed people are dissatisfied with the occupation of job they have (could be trained as a doctor and end up driving a taxicab full-time) - in the statistics each is one job; &
- ALSO ignores discouraged workers (LF dropouts).
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Unemployed (U)
A person, aged 15 & up, is considered to be Unemployed (U) if they:
1) are without a (paid) job;
2) had actively sought (paid) work; AND
3) was available for work.
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Unemployed (U)
You are not unemployed if you are:
- a full-time student;
- so disabled/sick that you are unable to work;
- on vacation;
- in prison;
- a homemaker;
- retired; OR
- a discouraged worker (labour force dropout)
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Unemployed (U)
You are unemployed if you:
i) have been temporarily laid off from work;
ii) are waiting for a new job to start;
iii) are on maternity leave (a forced definition); OR
iv) any other situation where all 3 conditions hold.
When someone is unemployed they may, or may not, be eligible for unemployment benefits from the gov’t. Eligibility for employment insurance (EI) benefits depends on a longer more detailed test.
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Labour Force (LF)
Labour Force (LF) is the entire collection of working age persons who participate in the (paid) labour market either by being employed (E) or by attempting to become employed (U).
LF = U + E
A working age person is Not In the Labour Force (NILF) if they didn’t work in a paid job (not E) AND did not look for work; or was not available to work (not U)
WAP = LF + NILF (NILF = WAP - LF)
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Unemployment Rate (UR)
Unemployment Rate = UR = U/LF
= (LF-E)/LF = 1 – (E/LF)
= U/( U + E )
= Percentage of the labour force that is unemployed
Clearly, 0 ≤ UR ≤ 1, in fact since usually U > 0 then
UR > 0, and since usually E > 0 then UR < 1
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Unemployment Rate
If anything this figure underestimates the pool of available workers since membership in the U group (the numerator) is limited via a restrictive definition (3 part test) & membership in the E group (the majority of the denominator) is aided by a loose definition of membership.
Because of the potential downward bias of the unemployment rate and to learn more about the dynamic behaviour of non-participants in the labour force (remember a large percentage of the people who are in the NILF pool are there voluntarily) Statistics Canada considers two other ratios
ates.
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Employment Rate (ER)
Employment Rate = ER = E/WAP
= E/( LF + NILF ) = E/( E + U + NILF )
= Percentage of the working age population that is employed
Notice that the employment rate is NOT one minus the unemployment rate as each rate is with respect to a different reference population (denominator).
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Participation Rate (PR)
Participation Rate = PR = LF/WAP
= LF/( LF + NILF )
= ER/( 1 - UR ), as (ER/PR) = (E/LF) = (1 - UR)
= Percentage of the working age population that participates in the (paid) labour force
The participation rate tends to rise during economic upturns and fall during downturns.
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LF Statistics - CANADA
May 2020 (seasonally adjusted) LF statistics
WAP = 31,114.3 (thousands)
LF = 19,093.7 (thousands) down 1,049 vs May 2019
E = 16,474.5 (thousands) down 2,575.9 vs May 2019
Full-time (13,882.2) & part-time (2,592.3) down 1,557.3 & 1,018.6
U = 2,619.2 (thousands) up 1,526.9 vs May 2019
The LF statistics vary: 1) over time (with health of the economy); 2) regionally; 3) by gender; 4) by age;
5) by occupation; 6) by education; etc
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LF Statistics – CANADA (May 2020)
Youth: Both sexes, 15 – 24 years old, UR = 29.4 %
Men, 25+, UR = 11.1 % - Women, 25+, UR = 11.8 %
Toronto, UR = 11.2 %
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CANADA Ontario MAX MIN
UR 13.7 % 13.6 16.3 (NL) 11.2 (MAN)
PR 61.4 % 60.1 66.1 (Alb) 53.9 (NL)
ER 52.9 % 52.0 56.8 (Sask) 45.1 (NL)
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LF Statistics – CANADA (May 2012)
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LF Statistics - CANADA
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LF Statistics - CANADA
Employment (up in Sept 2013)
Unemployment Rate (down 0.2 pts to 6.9%)
Causes of Unemployment
There are two basic CAUSES (or types) of U:
There is unemployment due to Short-Run reasons (i.e. U due to the SR Business Cycle) called Cyclical Unemployment.
There is also unemployment due to Long-Run reasons, (i.e. U that still exists in the long-run), this is called the Natural Rate Level of Unemployment.
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LR Unemployment (names)
There are several names for the (level or rate of) unemployment in the long-run (or steady state). They all basically have the same meaning. They are the:
Natural Rate of (level of) Unemployment (NRU)
Full Employment Level of Unemployment
LR (equili
ium) Level of Unemployment (LRU)
Potential (level of) Unemployment
Non-Accelerating Inflation Rate Level of Unemployment (NAIRU)
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LR Unemployment (NAIRU)
These all represent the rate or level of unemployment when the economy has reached a LR equili
ium where UR has stopped changing.
It has stopped changing since the economy has reached the natural rate or full employment rate of output (i.e. , the economy is not cu
ently experiencing a boom or bust due to short-run cyclical factors, which means that short-run or cyclical unemployment is equal to ZERO).
Since output is at the optimal LR level for the economy there is no pressure to create additional inflation OR deflation.
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Measured Unemployment
(Total) Observed or Measured Unemployment (U) consists of Cyclical (SR) Unemployment plus the Natural Rate Level of Unemployment (LR U).
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SR versus LR U: LR Equili
ium
If the economy is in LR equili
ium then XXXXXXXXXXwhich implies ,
this in turn implies
In LR equili
ium nobody is unemployed for SR reasons.
Looking at the level of real GDP (relative to the size of ).
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SR versus LR U: LR downturn
If the economy is in a LR downturn then XXXXXXXXXXwhich implies ,
this in turn implies
In a LR downturn fewer workers are needed – this creates a positive level of cyclical unemployment (i.e. people are unemployed due to the SR business cycle driving the economy away from LR equili
ium).
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SR versus LR U: LR upturn
If the economy is in a LR upturn then XXXXXXXXXXwhich implies ,
this in turn implies
In a LR upturn additional workers are needed – this creates a negative level of cyclical unemployment (i.e. less people are unemployed, than normal in the