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ECO 212
Nicole Nelson

Final Study Guide 05/01/2014 Lecture 6- Unemployment and the Labor Force Cyclical Unemployment vs. Natural Rate Unemployment Natural Rate of Unemployment: The normal rate of unemployment around which the actual unemployment rate fluctuates Cyclical Unemployment: The deviation of unemployment from its natural rate;Associated with business cycles (GDP and economy fluctuates over time) Explaining the Natural Rate Two ways to Evaluate Unemployment (1) Frictional Unemployment: Occurs when workers spend time searching for jobs that best suit their skills and tastes; this is short-term for most workers Time between when workers are switching jobs Economy is always changing so some frictional unemployment is inevitable (2) Structural Unemployment: Occurs when there are fewer jobs than workers; usually this is long term; Not enough jobs for the amount of workers in work force Job Search Job Search: The process of matching workers with appropriate skills Some government programs dedicated to matching individuals with jobs Sectorial Shifts: Changes in the composition of demand across industries or regions of the country (Example- Cars were built with steel and now they are built with plastic, so the demand for these products shift) Shifts displace workers who must search for new jobs appropriate for their skills and tastes; Can lead to unemployment Public Policy and Job Search Government employment agencies give out information about job vacancies to speed up the matching of workers and jobs Public training programs aim to equip workers displaced from declining industries with the skills needed in growing industries Unemployment Insurance Unemployment Insurance: Agovernment program that partially protects workers’incomes when they become unemployed Negatives of Unemployment Incentives: Increases frictional unemployment; People respond to incentives- Insurance ends when workers take jo less incentive to search or take jobs while eligible to receive benefits Benefits of Unemployment Insurance: Reduces the uncertainty over incomes- people know they are getting some sort of money, reducing stress and pressure to provide Gives unemployed more time to search; better job match, higher productivity Explaining Structural Unemployment Basic concept here is that structural unemployment occurs when there are not enough jobs to “go around”; Wages are kept above the equilibrium wage Use demand and supply to make sense of this basic notion Who demands labor? Firms Who supplies labor? Households When demand = supply, there is an equal wage at an equal point between the demand for labor and the supply for labor; the labor market is going to clear at a given wage (wage at which firms demand for labor and a wage at which households demand for labor), a.k.a. Market Clearing Wage When Market Wage is Above Equilibrium Wage  Unemployment Excess supply of labor being demanded, so there is unemployment When Market Wage is Below Equilibrium Wage  Excess Jobs Excess supply of labor being supplied, so there are excess jobs Factors Causing Wage Rate to beAbove the Equilibrium Rate 1. Minimum Wage Laws The minimum wage may exceed the equilibrium wage for the least skilled or experienced workers, causing structural unemployment Not enough jobs in the economy This group is a small part of the labor force, so the minimum wage cant explain most unemployment; Only a subset of workers are at minimum wage 2. Unions Union: Worker association; Bargains with employers over wages, benefits, and working conditions Unions exert their market power to negotiate higher wages for workers Typical union worker earns 20% higher wages and gets more benefits than a nonunion worker for the same type of work When unions raise the wage above equilibrium, unemployment results Firms are going to demand less workers, and households are going to want more jobs > unemployment Insiders: Workers who remain employed, better off Outsiders: Workers who lose their jobs, worse off Some outsiders go to non-unionized labor markets, which increase labor supply and reduces wages in those markets 3. Efficiency Wages Theory of Efficiency Wages: Firms voluntarily pay above-equilibrium wages to boost worker productivity; 4 Reasons why firms might pay efficiency wages 1. Worker Health: In less developed countries, poor nutrition is a common problem Paying higher wages allows workers to eat bettr workers will be more healthy workers will be more productive 2. Worker Turnover: Hiring and training new workers is costly Paying high wages gives workers incentives to stay and reduces turnover of workers- don’t need to replace workers that are not leaving or train new ones Different Types of Capital: Human Capital (stock of knowledge in humans); Physical Capital; Firm Specific Capital (firms have to spend and deplore resources to train workers in the way in which the firm operates business) 3. Worker Quality: Offering high wages attracts better job applicants Results in an increase in the quality of the firm’s workforce Reservation Wage: The lowest wage that a worker is willing to except; More productive workers will demand a higher wage 4. Worker Effort: Workers can work hard or slack and get fired Being fired might be good; depends on how hard it is to find another job If market wage is above equilibrium wage, there are not enough jobs to go around so workers have more incentive to work, not slack Supply of labor is greater than demand for labor Lecture 7- Savings, Investment, and the Financial System Review Amajor limitation of the Circular-Flow-Diagram  doesn’t take into account savings;Assumed that all income of households was spent on goods and services In a real economy, some people save income, some people spend all of their income, and some people spend more of their income Savers: Consumption is less than income; Surplus Borrowers: Consumption is more than income; Deficits The role of the financial system is to bring savers and borrowers together Financial Institutions Financial System: Group of institutions; Help match savings with investments Financial Markets: Institutions through which savers can directly provide funds to borrowers Example- The Bond Market Abond is a certificate of indebtedness;Apiece of paper that says if you lend me money now, on some given date in the future when the bond matures, I will pay you back that money and I will pay you a fixed amount per year/month/etc. Server or the lender is providing funds directly to the bond holder Example- The Stock Market Astock is a claim to partial ownership in a firm; When you purchase shares in a companies stock, you have partial ownership in a company Primary Market: When firms/companies issue stock at an IPO; Normally when IPOs are issued, investment companies buy stock and sell it to investors Secondary Market: After the IPO and stock is done trading, secondary market is where people take to stock market; Companies/firms resell stock (securities) When you purchase securities, you’re lending directly to that company Financial Intermediaries: Institutions where savers can indirectly provide funds to borrowers Example- Bank When individuals deposit money into baksbank can then issue that money in a loan to a borrower Example- Mutual Funds: Institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds Creates a pool of cash that it uses to buy portfolios of stocks and bonds Allows small investors to participate in the financial market Different Kinds of Savings Private Saving: Portion of household income that isn’t used for consumption/taxes; = Y – T – C Y: Income (Y = C + I + G +NX)(Closed Economy, no imports/exports Y = C + I + G) T: Taxes C: Consumption Public/Government Saving: Tax revenue less government spending; = T- G T: Tax Revenue G: Government Spending National Saving: Portion of national income not used for consumption / government purchases; = Y – C - G = Private Savings + Public Saving = (Y – T – C) + (T- G) = Y – C – G Saving and Investment So, I = Y – C –  National Saving = Y – C –G Same equation Investment in Closed Economy = National Saving Low savings rates lead to high levels of trade deficits Budget Deficits and Surpluses Budget Surplus:An excess of tax revenue over government spending; Public Saving = T – G Budget Deficit: Shortfall of tax revenue from gov’t spending; Negative Public Saving = G – T The Meaning of Saving and Investment Private Saving: Income remaining after households pay taxes and consumption Households may buy corporate bonds or equities, certificate of deposit at a bank, mutual funds, etc. with this money Investment: The purchase of new capital; Referring to physical capital Example: Company buys factory/machine, households buy computers Remember: In economics, investment is NOT the purchase of stocks & bonds The Market for Loanable Funds Supply-demand model of the financial system (Loanable Funds Model) Helps us understand how the financial system coordinates saving and investment and how government policies and other factors affect saving, investment, and interest rate Assume: 1. There is only one financial market 2. All savers supply the savings in this market; Deposit their savings in market 3. All borrowers borrow from this market; Take out loans from market 4. Single interest rate for return to saving and cost of borrowing XAxis: Loanable Funds; Y-Axis: Interest Rate Supply for Loanable Funds The Supply of Loanable Funds comes from Savings  Households with extra income can loan it out and earn interest Public Saving, if positive, adds to national saving and the supply of loanable funds; If negative, it reduces national saving and the supply of loanable fund The Slope of the Supply Curve: Upward sloping (bottom left to top right), at a given rate of interest, a given amount of loanable funds is available When the interest rate increases, it makes saving more attractive which will increase the quantity of loanable funds supplied Demand for Loanable Funds The demand for loanable funds comes from investments: Firms borrow the funds they need to pay for new equipment, factories, etc. Households borrow funds they need to purchase new houses If K = Capital Stock, then Investments = Change in K The Slope of the Demand Curve: Decreasing (top left to bottom right) Afall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded Equilibrium Combine both the demand curve and supply curve for loanable funds; Intersection between the two gives us the equilibrium interest rate and the equilibrium loanable funds amount Demand for L.F. = Supply of L.F (investment) = (savings) The interest rate adjusts to equate supply and demand Policy 1: Saving Incentives: Tax incentives to save money increase the supply of loanable funds; Reduces equilibrium interest rate and increases equilibrium quantity of loanable funds Policy 2: Investment Incentives: Investment tax credit increases the demand for loanable funds; Raises the equilibrium interest rate and increase the equilibrium quantity of loanable funds Budget Deficits, Crowding Out, and Long-Run Growth Increase in budget deficit (Negative Public Saving; = G – T) causes fall in investment Government will borrow to finance deficit, leaving less funds for investments This is called Crowding Out Budget deficits reduce the economy’s growth rate and future standard of living Lecture 8- Money Growth and Inflation The Value of Money P = Price Level (CPI or GDP Deflator) The price of a basket of goods, measured in money 1 / P = The value of $1, Measured in Goods Example: If the basket contains one candy bar If P = $2, the value of $1 is ½ of a candy bar If P = $3, the value of $1 is 1/3 of the candy bar The value of the candy bar is going down as the price increases As price increases, there is a lot less that you can buy Inflation drives up prices and drives down value of money; Affects poor people first The Quantity Theory of Money th Developed by 18 century philosopher- David Hume,Advocated by Milton Friedman Asserts that the quantity of money determines the value of money; value of money is determined by the quantity of money; Study this theory using two approaches: 1. Supply-Demand Diagram Money Supply: Money supply determined by FED, banking system, and consumers FED precisely controls Money Supply and sets it at some fixed amount Money Demand: How much wealth people want to hold onto in liquid (cash) form Depends on P (Price) ;An increase in P reduces the value of money so more money is required for goods and services Money Supply and Demand Model As the value of money rises, the price level falls Value of Money Decrease  Quantity of Money Increase (negatively related) Price Increase Quantity of Money Increases (positively related) If the FED were to increase the money supply, then the value of money would fall and the Price would rise Increasing money supply causes price to rise Nominal Variables: Measured in monetary units Real Variables: Measured in physical units Prices are normally measured in terms of money Relative prices are measured in physical units; They’re real variables Example- Price per CD: $15, Price per pizza: $10 Relative Price: Price of One Good / Price of Other God Relative price of CDs in terms of pizza: Price of CD / Price of Pizza= 15/10 = 1.5 pizzas per CD Real vs. Nominal Wage W = Nominal Wage = Price of Labor Example- $15/hour P = Price Level = Price of Output (Goods and Services) Example- $5/unit of output Real Wage = Price of Labor / Price of Output W / P = 15 hours / 5 units = 3 units of output per hour Classical Dichotomy: Theoretical separation of nominal and real variables; Hume Monetary Neutrality: Proposition that changes in money supply don’t affect real variables; Doubling money supply = double nominal prices What Happens to Relative Prices? Initial Relative Price of CD in Terms of Pizza: Price of CD / Prize of Pizza = 15 / 10 = 1.5 pizzas per cd After Nominal Prices Double: Price of CD / Price of Pizza = 30 / 20 = 1.5 pizzas per cd Relative Price is Unchanged Quantity of labor supplied does not change; Quantity of labor demanded does not change; Total employment of labor does not change; same applies to employment of capital and other resources; Total output is also unchanged 2. Equation Velocity of Money: Rate at which money changes hands in economy between per
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